A term that gets used so often these days, it seems like it’s always been there, is DeFi. When people at the office, your friends at dinner and even your clients are mentioning it, it may be uncomfortable to ask someone to explain. You know it’s a crypto thing, but that’s about it, and that generally gets you by. The idea of this article is to make sure you actually know what it is.
DeFi is an acronym for decentralized finance, but what does that mean?
Centralized Finance
To understand what decentralized finance is, it’s helpful to first understand what centralized finance (CeFi) is. CeFi is really all the finance you’ve ever known. A bank and a brokerage firm are examples of CeFi. All traditional financial institutions are centralized finance institutions, we just never used to call them that until DeFi emerged. Centralization refers to the concentration of the planning and decision-making processes inside an organization to a single leader or location (like a head office).
If we use a bank as an example, all the financial transactions, whether it’s the savings in your account, your mortgage or any long-term deposits/investments, are controlled by the bank and by extension, the bank manager. They tell you how it operates, how much they’ll pay or charge you and therefore they are in full control. Generally, the pushback comes when we hear about bank failures due to mismanagement, and that ultimately led to crypto. In fact, one of the main reasons cryptocurrencies were created was with the goal of decentralizing the financial system.
Decentralized Finance
In contrast to CeFi, DeFi refers to the same financial products you’re used to, like a loan, but the difference is that there’s no central authority in control. No bank manager. And this is all made possible by the blockchain. The transfer and trade of financial assets without trusted intermediaries is one of blockchain’s most powerful features. In contrast to CeFi, DeFi allows customers to directly control their assets anytime (there is no need to wait for the bank to open).
Explaining it to a child
The ultimate test of whether you truly understand a topic is when you’re able to explain it to a child. I asked ChatGPT how it would explain DeFi to a child and here’s what it said:
DeFi is like a piggy bank that anyone can use, without needing a grown-up to help. This piggy bank is not owned by anyone in particular but is instead run by a computer program that anyone can access. You can put your money in this piggy bank and earn interest on it, just like you would with a bank. You can also borrow money from the piggy bank, using your own money as collateral, and pay it back later with interest.
Because DeFi is decentralized, there is no single person or company that controls it. This means that there is no risk of the piggy bank being taken away or shut down, and no one can charge you extra fees or deny you access to your money. It also means that you can use DeFi from anywhere in the world, as long as you have an internet connection.
I thought that was a brilliant explanation. Some terms like interest and collateral may not be entirely child friendly, but I think the piggy bank analogy is perfect.
The benefits by comparison
Unlike DeFi, CeFi is controlled by a centralized authority, which means that there is a higher risk of censorship, hacking, and fraud.
In CeFi, you need to trust the financial institution to keep your money safe and to provide you with fair and transparent financial services. You also need to go through a lengthy and often cumbersome process of verification and approval before you can access these services. Moreover, CeFi services are often limited to certain regions or countries, making it difficult for people in other parts of the world to access them.
In contrast, DeFi offers a more open and transparent financial system that is not controlled by any single authority. DeFi services are also often cheaper, faster, and more efficient than their CeFi counterparts, due to the absence of intermediaries and the use of smart contracts.
Final thoughts
In summary, DeFi is a way of using blockchain technology to create financial services (like savings, investments and loans) that are open to anyone, anywhere in the world, without the need for intermediaries like banks. It’s like having your own piggy bank, but with the added benefits of being decentralized and open to anyone.
Here are some links that can help you learn more about DeFi:
- DeFi Dad: http://defidad.com – provides educational content and resources on DeFi for beginners and advanced users alike.
- DeFi Education Fund: https://defieducationfund.org/ – a non-profit organization that aims to promote education and adoption of DeFi by providing grants and funding to educational initiatives and research projects.
- DeFiPulse: https://defipulse.com/ – a website that provides real-time data and analytics on the DeFi ecosystem, including the total value locked, top DeFi protocols, and more.