What Is Decentralized Finance (DeFi)?

The decentralized finance (DeFi) sector is an alternative to traditional financial services with applications in cryptocurrency or blockchain technology.

The modern DeFi era truly began with Bitcoin, the first widespread implementation of a decentralized method of record-keeping that is permissionless yet reliable and secure. Bitcoin effectively provides a currency that doesn’t rely on the stability of a central authority.

The implications of such a technology are huge for developing economies where faith in central government is low and bank runs are a serious risk, if not a reality. Moreover, much of the world’s population is, at most, one generation removed from being forcibly chased from their homes. Consider these events:

• Just 70 years ago, Seoul, the capital of Korea, was captured and recaptured four times, and families were permanently separated in a war that ultimately resulted in two separate nations.
• The fall of Saigon 50 years ago resulted in a mass exodus of Vietnamese refugees seeking asylum.
• More recently, the fall of Kabul in 2021 and the Russian invasion of Ukraine in 2022 led to more waves of emigrants who found themselves in sudden exile.

But aside from more dire circumstances — like the collapse of a banking system or the fall of your government — it’s natural to question what true value Bitcoin’s underlying technology adds in a stable and wealthy nation.

After all, I trust that Bank of America won’t maliciously siphon funds from my account, and despite the infamous Wells Fargo fake account scandal (for which it was ultimately fined $3 billion), I would even entrust my money to a Wells Fargo checking account.

Nonetheless, reliable economies still have submarkets that are inherently rife with distrust of the central operator, with dark pools (securities exchanges in which participants can trade anonymously and with less transparency) being a case in point. (Try Googling “dark pool lawsuit”!)

The trust issue naturally goes away if there is no central operator to distrust, and with the advent of Bitcoin, a proven technology now exists to implement modern DeFi processes across many use cases in finance.

Demystifying DeFi

The idea of decentralized processes is certainly not new. After all, before centralized finance (CeFi) arose to establish trusted intermediaries, primitive DeFi was the status quo. Transactions were all peer-to-peer, and you were constrained by your local neighborhood to gain access to capital and to obtain goods by bartering one item for another. Record-keeping was minimal, and ownership was determined by physical possession.

In modern markets, transactions require confidence in the validity of the agreement, which is provided by reliable and secure record-keeping systems. After all, when you sell your car, you are really transferring the legal right to access the car. Without a reliable record-keeping system in place, chaos would ensue. (Imagine the return of finders keepers as a rule of law!)

What’s truly exciting now is the distributed-ledger technology that provides a reliable and secure method of record-keeping that is not maintained by a trusted intermediary, such as Bank of America or the DMV. Behold the dawn of the modern DeFi era!

From autonomous collectives to trillion-dollar DAOs

Well-functioning, leaderless communities are all around us, and in each circumstance, an inherent governance mechanism incentivizes and gels the group to act in concert — all without an elected official to assign roles and lead the process.

From homework teams to neighborhoods to informal potlucks, small groups can effectively and efficiently self-govern when there are grades to maintain, property prices to protect, or reputational concerns at stake.

These small-scale examples probably feel reasonable and natural. But what if I told you that a trillion-dollar organization could autonomously validate, execute, secure, and provide ongoing updates to an entire system without an elected leader to assign tasks? The concept sounds naïve at best, and possibly crazy.

And yet, Bitcoin has provided a battle-tested case in point for the underlying technology that enables it to function in a decentralized and autonomous fashion. Yes, Bitcoin is indeed a trillion-dollar decentralized autonomous organization (DAO)!

Of course, at this scale and with the value at stake, a DAO can’t rely solely on simple mechanisms like reputational concerns to incentivize participants to behave honestly and in a way that upholds the values of the system. Instead, the underlying protocol must be protected against malicious players who may work hard to cheat the system.

Transacting in DeFi versus CeFi

Borrowing assets

Suppose you want to borrow money. How would this transaction be implemented in primitive DeFi versus modern CeFi versus modern DeFi?

• Under a primitive DeFi process: You hit up everyone you know within reasonable geographic proximity — a neighbor, a friend, a family member — and hope that someone will lend you something that you can barter with at your local marketplace.
• Under a modern CeFi process: People have checking accounts, savings accounts, CDs, and so on with the bank, which means that all these people have lent money to the bank. In turn, the bank lends some of this money to you.
• Under a modern DeFi process: People lock up funds in a smart-contract account, which is a software program on a public blockchain that automatically enforces and executes the rules in the smart-contract code. This smart-contract account is programmed to function as a lending pool from which you can borrow funds.

Selling assets

Suppose that instead of borrowing assets, you have assets that you want to sell. Comparing the three types of processes again, here’s how this transaction would be implemented:

• Under a primitive DeFi process: You again hit up everyone you know within reasonable geographic proximity — a neighbor, friend, family member — and attempt to barter by trial and error.
• Under a modern CeFi process: Liquidity providers stand by, waiting to buy the asset from those who want to sell and to sell the asset to those who want to buy. These liquidity providers commit to buy and sell a certain quantity of assets at varying prices on designated exchanges that serve as official marketplaces for the assets in question. In turn, you place an order to sell the asset through your brokerage firm (who has custody of the asset).
• Under a modern DeFi process: Liquidity providers lock up assets and funds in a smart-contract account. This smart-contract account serves as a liquidity pool and is programmed to function as an automated market maker. In turn, you can swap your assets for funds from this smart-contract account.