What Is Decentralized Finance (DeFi) & How Does It Work?

By Ehis Ohiwerei

What Is Decentralized Finance?

Decentralized finance, popularly known as “DeFi,” is a financial system that runs its structures and procedures similarly to cryptocurrency. Just like with cryptocurrencies, DeFi uses a secure distributed ledger for its operations, making it a part of the public blockchain domain.

The advent of decentralized finance benefits the financial sector and its users more than one can state, as this system, at its core, empowers peer-to-peer exchanges. DeFi, unlike the centralized finance system, eliminates the need for users to follow and abide by the rules of the Securities and Exchange Commission (SEC), for example, in dealing with banks and brokerages.

One can easily access his money and not be burdened by the controversial charges banks extend to their customers. With DeFi comes access, trust, ease, and rapid transactions, so long as one has access to the internet and a digital wallet.

At its inception, decentralized finance was known as “Open Finance” and was kicked against by traditional bank owners. This is because with every transaction one makes in the conventional system, there is an overseer and a level of third-party control.

For example, when you pay for gas, take a loan, place bets on games, or even use your credit/debit card on a platform, there is a third party in that transaction that stands between you and your bank that aids this process but also gains from it.

These financial institutions often have the power to control your transactions, thereby putting users at their mercy and having access to your data by recording these transactions. DeFi breaks these norms. It puts you in front of these transactions and eliminates all third-party control and influence.

Also read: Proof of Stake vs Proof of Work

DeFi vs CeFi

To understand the similarities and differences between DeFi and CeFi, we must first understand how traditional banks work. Commercial banks, among their services, allow you to make deposits in a savings-like structure when you open an account with them.

They keep your money while you make transactions with them, which enables you to a tiny percentage of their profit paid to you as interest earned. Due to this, they also allow you access to capital through loans and mortgage requests, insurance policies, and often securities.

These banks even allow petty transactions such as online shopping and sending and receiving funds. These are the essential workings of a traditional banking system.

However, the truth is that with all of these functions come control and limitations. For instance, if you want to carry out a transaction in bulk, you will need to visit the bank and be delayed by queues and banking hours.

On other days, the bank will request details that are repetitive and should already be in their systems to perform a transaction on your behalf while also keeping tabs on what trades you can and cannot do. This level of control by the banks grants them access to your money and your data.

Decentralized finance, a system of financial products and services easily accessible to anyone with an internet connection, rids financial transactions of the massive control and intrusion of a third party. With free access to one’s money, the transaction can happen anytime, anywhere, and on any day without limitations or barriers.

This is major because DeFi depends on the blockchain to function, making transactions faster, easier, and more secure, like bitcoins and other cryptocurrencies. DeFi allows participants to access borrowing and lending markets, take long and short positions on cryptocurrencies, earn returns through yield farming, and more.

Another notable difference between these two systems is the handling of assets. With centralized finance, humans are involved. Traditional banks employ people to help carry out these transactions on your behalf.

But because DeFi was created to eliminate the mountain of problems found in CeFi, its system places trust in a collection of smart protocols for handling assets and transactions. Unlike in traditional banks, where confidence is placed in man, DeFi puts trust in technology and its ecosystem.

Finally, about 3 billion people traditional banks have yet to be able to reach with their services due to lack of access, geographical constraints and other reasons. The decentralized financial system can reach all who have access to the internet.

Because DeFi is built on a peer-to-peer structure, the structure does not need participant documentation. This feature removes the geographical constraint faced by its counterpart, as it relies solely on smart contracts and interactions based on distributed ledger technology.

How Does DeFi Work?

It is common knowledge that most DeFi platforms are built on the Ethereum blockchain. This means that decentralized finance uses smart contracts and technology that do not require a third party, like traditional banks, to play a part in the transaction process. What it does instead is allow users to transact directly with one another under the peer-to-peer (P2P) structure of a secure blockchain technological structure.

By choosing DeFi over CeFi, users can access their funds at will using a secure digital wallet employed for the transaction. The choice of crypto wallet is totally in the hands of users and is safe to use. Transactions in decentralized finance use smart contracts between parties involved.

This means that peers must agree to a set of rules or specific conditions set by both parties before a transaction is made. These smart contracts are usually unchangeable and cannot be tweaked at a later date. For instance, a smart contract can be created to send funds to a particular account regularly, which will continue, provided enough funds are available to initiate the transaction.

Also Read: What are DeFi Loans?

Uses of DeFi

Margin and Leverage

The margin and leverage concept allows users in DeFi to borrow crypto on margin while using another crypto as collateral. One could borrow BTC on margin while using ETH as collateral in its place. This arrangement in DeFi often comes with leverage that ramps up the user’s returns with smart contracts.

However, this concept is often risky as it exposes users to loss. The system is based on an algorithm, and when things go south, there is usually no human intrusion to help set it back on track.


Traditionally, one can walk into a bank and request to change one currency for another. This feature also exists with DeFi. With decentralized finance, exchanges and swaps are possible. Users can exchange one currency for another with just a click, eliminating the stress of bank procedures and form filling. Decentralized exchange points such as Uniswap carry out billions of dollars of exchanges every week safely and securely.

DeFi Stablecoins

The financial market often finds a way to peg its worth to a stable currency, e.g., the USD or the Euro, and so does DeFi. The DeFi stablecoin is pegged to the USD and other assets like gold, which helps curb and reduce volatility in the crypto ecosystem.

Using stablecoins in DeFi is safe, as this coin is universally suited for everyday financial transactions. They are easy to access and easy to transfer globally.

Lending and Borrowing

Due to how DeFi works, its P2P feature allows for unlimited transactions to be carried out. When third-party systems are eliminated, one can do a plethora of things. In DeFi, the peer-to-peer feature makes loans easy and accessible. The blockchain algorithm matches a lender and a borrower via a series of checks and rotations. A loan is issued once the terms are agreed upon. Another means of borrowing is through the decentralized lending protocol.

Users lend their crypto to those in need and earn interest from it, decided upon by the smart contract that must be paid when a lender is paying back the money. An example of this protocol is AAVE and COMP.

Also: What is an IDO?

Merits and Demerits of DeFi



With DeFI, everyone can see the complete transaction documentation and process length. Unlike in traditional banks, where information and paperwork are often done behind closed doors, DeFi grants you access to the process. It also shows updates as quickly as possible. With DeFi, you can get your interest or rewards before the end of the month; DeFi updates them in real time.

Easy Access

With DeFi, a user does not need to open an account or fill out a series of forms like traditional banks do. All one needs is an internet connection and a digital wallet. This makes access easy, as you do not need to provide personal information before transactions.

Fast and Flexible

With DeFi, transactions are fast and flexible. A user can access his assets 24/7 from anywhere he likes. They do not need to seek permission, stand in queues, or pay hefty fees to complete their transaction. This allows for a real-time transaction to be possible.


User Experience

DeFi has no support system. Eliminating the third party also removes the support for customers. This means that such transactions cannot be retraced or called back when a transaction goes wrong—for example, when a transaction is made into an incorrect wallet ID.

This challenge puts security in the hands of users and can sometimes be detrimental.


Since DeFi is still new, there has yet to be a lot of upgrading or work done to aid the intense exchanges and transactions going on there. Public blockchains like Ethereum and Bitcoin can no longer handle the number of transactions, and this has caused transaction fees to surge in recent times. When transactions are high, users sometimes pay as much as $75–150 to complete them.


Due to its decentralized nature, DeFi is gradually becoming the new home for illegal activities. Since anyone from anywhere with internet access can transact on DeFi, regulating money laundering and terrorism funding has become a challenge. This is one of the most significant disadvantages of DeFi.

Why Is DeFi Important?

Decentralized finance is the antagonist of traditional centralized financial institutions. The concept creates more free, easily accessible, low-cost, easy-to-use, and fair financial markets for anyone with an internet connection. The entire ecosystem is built on the blockchain premise that gave birth to cryptocurrency. Its importance is mainly in the benefits and the shift it creates for the financial industry.

What Is the Future of DeFi?

DeFi is gradually catching the interest of traditional financial experts, and with a new protocol launched weekly, the ecosystem will see updates soon enough. The system takes the concept of cryptocurrency to a new level of innovation and development. With continuous efforts from developers and entrepreneurs, some of the challenges and demerits of the DeFi system will soon be solved, thereby making it a perfect system to challenge the norm of the business world, CeFi.

Also read: What is a rug pull?

How Do You Make Money With DeFi?

There are different ways to make money with DeFi. The two most common processes are passive income and direct income. Passively, a user can make money with DeFi by depositing his crypto on a platform for an expected annual percentage yield. A user could also passively earn money by loaning out his crypto and getting interested in return from this loan.

If one wants to make money directly with DeFi, one can do so through staking, also known as “yield farming.” Staking is when a user locks tokens into a smart contract in exchange for more of the same token or a new token. However, yield farming has its risks. It takes the lending and borrowing aspect of DeFi, and generates greater returns for parties involved but is often complex and, in most cases, not transparent.

Also: APR Vs. APY in Crypto

Is It Safe to Invest In DeFi?

No market structure has no risks, and the same tale can be told of DeFi. There is no DeFi protocol without risks. However, there are ways to evaluate an investment risk before putting funds into it. One way to establish risk is to look at the token’s liquidity and how long the protocol has been in operation.

You also want to look at how much the protocol has in its deposit and the credibility of the website it’s being hosted on. Suppose the website has enough credible steps to mitigate risks and prevent thefts, losses, and hacking. In most cases, this is the case. In that case, those protocols are safe to invest in.

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What Is Decentralized Finance (DeFi) & How Does It Work?

What Is Decentralized Finance (DeFi) & How Does It Work?

By Ehis Ohiwerei - min read
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