Decentralized Finance – or DeFi, for short – is the natural evolution of the financial system. We used to rely on the postal service but today rely largely on e-mail, and similarly, we used to rely on an assortment of financial services and financial technology (fintech) companies, but can now rely on DeFi. 

Interested, but don’t know where to start? Here are 10 things you need to know about DeFi.

1. DeFi, Defined

DeFi is a software system of financial applications that allow individuals to have full control of their financial transactions online: they make decisions and maintain control over their digital assets; there are no intermediaries or middlemen like banks or credit card companies involved. How? DeFi runs on a technological innovation: permissionless blockchains.

If you want to know more about the technology itself, we explain it here. Put simply, a blockchain is a decentralized digital ledger that securely records and verifies transactions across a network of computers without a central authority. 

2. Why DeFi Exists

DeFi is a direct response to the technology developments of the 21^st century. DeFi has become popular because it removes the gatekeepers and frictions that exist in finance today, making it faster, cheaper, and more accessible for all individuals to transact online. DeFi delivers instant, low-cost, 24/7, global access to markets with better liquidity and pricing, ensuring open access to financial services for all. 

3. Trusting Software, Not Humans   

Smart Contracts are an important part of blockchain innovation; they are a specialized type of computer code that functions automatically when predetermined conditions are met. A smart contract is like a vending machine: the vending machine automatically releases a bag of chips on the condition that it receives $2. Smart Contracts help minimize the risk of human error or intermediary risk. Smart contracts are essentially deterministic code. 

4. Important Difference Between Front-Ends and Back-Ends

Front-ends refer to websites or software applications that allow users to communicate desired transactions or interactions to other software. Front ends provide a visual display of human-readable information and “translate” users’ inputs into software code so that users can communicate with the back-end software. In Web2, the back-end software is proprietary and owned by a company (e.g., Facebook or Venmo); in Web3, the back-end software is open source or transparent, which means it is available for anyone to use. (See DEF Front-End Explainer). 

5. Wallets & Keys, Not Bank Accounts

A digital wallet is software that enables users to custody and control their digital assets. Wallets have a “public key,” which is the address where assets can be sent, and a “private key,” akin to an email password that only the holder knows. A wallet is like an email app: you have an address you can share, and a secret password you keep safe — but instead of email, wallets are used to send and receive value on the blockchain. Of note, there are also hardware wallets that keep user’s private keys offline, like a secure USB stick.

6. DeFi Enables Better Financial Markets 

DeFi allows users to trade digital assets without extractive transaction middlemen, allowing anyone who owns a digital asset to “make a market” in that asset by depositing it into a liquidity pool. A liquidity pool is a smart contract where liquidity providers commit digital assets according to a pre-set formula that automatically determines the price of the digital assets. An automated market maker (AMM) is software that allows users to trade assets in a decentralized manner; instead of buyers and sellers being matched in real-time by an entity with a central limit order book, people trade using AMM software. Liquidity providers (also called “LPs”) earn a share of the fees paid by people transacting on the AMM. The fees are paid programmatically (distributed through deterministic code) to the LPs by the AMM software. 

7. Protocols Are Next Generation Financial Infrastructure

DeFi Protocols, sometimes referred to as applications, decentralized applications, or dApps, refer to a set of rules or procedures for decentralized software systems. DeFi protocols are made of smart contracts that work together to create the rules for back-end software that automates users’ financial transactions — e.g., exchange one digital asset for another (see “DEX”), borrow one digital asset against another (see “Lending Protocol”), etc. Importantly, DeFi protocols and their developers do not take custody of or control user assets; protocols are intermediary-less. When a software developer writes and deploys a protocol on the internet, they are not acting as middlemen, nor is the software protocol. 

8. Lower Fees: To The Network, Not The Middleman

DeFi transactions usually involve a “gas fee” to the network. Unlike bank fees (e.g., overdraft, ATMs, or wires), these costs are not discretionary – they are predetermined by the blockchain’s economics and are typically a fraction of the price. Fees in DeFi can be significantly lower than fees charged by middlemen in transactions. DeFi provides financial alternatives that can help lower financial barriers for lower income communities. 

9. Reimagined Governance and Control 

While each DeFi protocol is programmed uniquely, many DeFi protocols are governed by Decentralized Autonomous Organizations, or DAOs, for short. DAOs are communities of token holders that help make decisions on the maintenance and continued development of a DeFi protocol. Remember, there is no one person or company that can make unilateral decisions in DeFi, so DAOs provide a new, evolving type of governance solution.  

10.  Community of Entrepreneurial Innovators

DeFi is a vibrant community of individual contributors: software developers, entrepreneurs, small businesses, investors, academics, ideologues, and more. Though the community uses lots of technical jargon (sorry!), we are excited you are interested in learning more about DeFi and the possibilities its tech innovations can unlock.

Questions? Please never hesitate to reach out to info@defieducationfund.org for more information about DeFi or DEF – or to schedule your live DeFi demo.

For more information on components of the DeFi technology stack, refer to DEF’s Educational Knowledge Base. 

DeFi Terminology 
As warm and approachable as the DeFi community is, we use *a lot* of jargon. We have created a DeFi Dictionary, so you have a one-stop-shop for industry jargon. 

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