What Is DeFi and How Does it Work?

Imagine lending, borrowing or investing money without ever needing a bank—no intermediaries, no unnecessary rules, no high fees, no delays, quick transactions, transparent, and completely in your hands. Those benefits would be amazing, right? Now with decentralized finance, it’s a reality.

Over the years, ‘’TradFi’’ and financial institutions have called the shots, deciding who uses their services based on customer information, and often charging excessive unfair fees. However, blockchain has come to change the rules. This tool empowers customers by cutting banks and any other intermediaries completely.

Decentralized finance often called ‘’DeFi’’ can run in several blockchains such as Solana, Phantom, Ethereum, Binance Smart Chain, and more. This technology brings to the table smart contracts and implementation of decentralized apps ‘’dApps’’ to create a public ecosystem, where everyone can access. Through this article, we’ll explore step by step what is about this technology, how it works, and how benefits any business:

What is Decentralized Finance (DeFi)?

Decentralized finance, refers to financial services running in blockchain technology through dApps. Unlike traditional services, where banks or companies have entirely customer data acting as gatekeepers, this solution provides interaction with financial tools efficiently without intermediaries and lower fees by not relying on banks or brokers. So, how to invest in DeFi?

• Lend and Borrow: With decentralized finance it’s possible to lend and borrow crypto to earn rewards by providing a relative portion of cryptocurrencies as collateral, unlike traditional finances where this process requires several steps and time to be approved.
• Trade Cryptocurrencies: Through decentralized exchanges, often called ‘’DEX’’, it’s possible to trade cryptocurrencies directly with other individuals. This is especially beneficial for users preferring to protect their data and not complete sensitive know your customer ‘’KYC’’ procedures on centralized exchanges.
• Earn Passive Income: Earn passive income through cryptocurrencies also it’s possible, with yield farming or staking. Decentralized finance allows customers to lock a large variety of assets to earn rewards.

Example: Pancakeswap, Uniswap, Compound and trader Joe provides these services for trade, yield farming, staking, borrow and lend cryptocurrencies. Smart contracts make this possible, in seconds, with cheaper commissions, higher ROI and simultaneously increasing efficiency and adoption.

Key Components of DeFi

1. Blockchain Technology: As we mentioned, DeFi platforms and decentralized apps are built on blockchains; this technology is a public ledger, recording every single transaction securely, transparently and unmodifiable. Years ago, decentralized finance platforms were mostly running in Ethereum for its compatibility with smart contracts, but now, blockchains such as BNB chain, BASE, Linea and more allow compatibility with smart contracts. Which are the backbone of DeFi. 
2. Smart Contracts: Imagine executing any action automatically when a requirement is met, exactly, that’s a smart contract. For example trading USDT to Bitcoin, or staking any cryptocurrency through pancakeswap or uniswap, all these actions are carried out through automated agreements written in code, often called ‘’smart contracts’’.
3. Decentralized Applications (dApps): Decentralized apps are the key tools. This technology allows trading, staking, yield farming, borrowing and interacting with different options of services without depending on banks, brokers, financial institutions or any centralized server.
4. Stablecoins: Stablecoins as the name refers ‘’Stable’’ are cryptocurrencies without volatility like Bitcoin. These currencies can be pegged to different real word assets such as US dollar, EUR, etc. Stablecoins provide the possibility to be part of the ecosystem without handling volatility risks, making them an essential part in the ecosystem.

Benefits of DeFi

As web3 grows, decentralized finance becomes more popular, as it solves several problems of TradFi. Here’s a breakdown:

• Access for everyone: Everybody can adopt DeFi protocols, it’s not needed to pass through KYC process, credit checks or even have a bank account. Only internet connection and a cryptocurrency wallet is enough to interact with the whole ecosystem.

Example: Imagine a farmer in the south of the world without a bank nearby, with DeFi it’s possible to borrow by providing the respective quantity of assets as collateral.

• Lower Fees: By cutting banks, brokers and intermediaries the protocols reduce transaction costs and fees for different operations such as transfer, borrow, or lend assets, providing over 51% lower fees than traditional financial institutions. 
• Transparency: Blockchain it’s transparent, each transaction in this technology it’s publicly visible for anyone through different platforms such as etherscan in ethereum. This transparency helps both the protocol and the customer. Many decentralized finance platforms are integrating transparency into iOS and Android systems, offering users real-time transaction tracking directly from their smartphones.
• Full Control of Your Money: To utilize decentralized protocols, having a Hot wallet or a Cold Wallet it’s mandatory, both with private and public keys allows the transactions through blockchain giving you the assets ownership. Unlike traditional finance, your assets are controlled by banks and the government has the capability to freeze or set limits.
• New Earning Opportunities: Now digital staking and yield farming is a reality, both options provide higher rewards to incentivize your investment. These tools are not currently available on traditional banking, and may carry out higher benefits but with increased risks.

Risks and Challenges of Decentralized Finance

While this solution is a game changer, it’s not without risks. Here’s what you need to watch out for:

Security Risks
Smart contracts are an amazing tool, but it’s code. This means it’s exposed to bugs or vulnerabilities in the code itself, hackers or bad actors could exploit it to steal funds. For that reason, the DeFi wallet development companies are implementing different security measures such as frequent audits to ensure everything is secure and running smoothly.

Example: In march 2023, a popular DEX known as ‘’SushiSwap’’ was the target of an attack, where the attackers exploited a vulnerability in the project stealing over $3M in assets.

• Lack of RegulationDeFi is not controlled by regulatory entities. This is a huge advantage on freedom, but also means there’s no safety with scams or fraudulent activities. 
• Volatility
  Cryptocurrencies are often known for wild volatility, including in Bitcoin which is one of the stronger assets in the ecosystem. But that’s not everything, even stablecoins aren’t always immune.

Example: TerraUSD, the stablecoin of Terra Luna ecosystem, lost the peg with USD in mid 2022, resulting in huge losses for investors.

• Steep Learning Curve
  For beginners in the crypto space, new technologies may feel difficult in comparison with centralized options which are often more intuitive. In DeFi learn how to create, manage a wallet, understanding concepts such as Dapps, staking, yield farming, APY and APR. Staying informed is key to start utilizing different protocols successfully. A company can improve this process by providing quality support and step by step guides.
• High Transaction Fees
  Blockchains can be expensive to run a decentralized protocol, especially ethereum; it's known for its high fees when the network is congested. However, over the last few months those gas fees have been reduced considerably and could be addressed utilizing another blockchain such as BNB Chain or BASE.

How to Invest in DeFi

Starting in DeFi might sound complicated, but it’s not! Here’s a quick step by step guide to introduce yourself into any protocol:

• Create and Set Up a Wallet

Start by downloading and setting up a crypto wallet like metamask or trustwallet, both are highly compatible with dApps and DeFi protocols. This tool allows storage of cryptocurrencies and interacts with dApps effectively.

• Buy cryptocurrency

Purchase ETH or BNB to cover gas fees in Ethereum or BNB chain and stablecoins such as USDT on a centralized exchange like Bybit or Binance and then send those assets to a wallet to start interacting with dApps.

• Choose a Platform 

Explore intuitive platforms such as Pancakeswap or Uniswap, review and learn all their features to pick one that matches your needs.

• Start Small

A beginner must start step by step, with small amounts. Thus it’s essential to get familiar with any protocols without handling volatility risk.

This technology is a game changer in finances, providing total control over the assets without relying on banks or other entities. Making finances accessible, efficient and comfortable for everyone, with over 50% lower operational costs, faster transactions, and transparency. DeFi provides a fair tool for everyone, everywhere.

However, this technology it’s not perfect. From wild volatility to exploits, these risk are important to consider and address. Anyone wanting to deal with cryptocurrencies must begin step by step and learn everyday in the process.

Even with that fewer challenges, it’s possible to address them by taking different security measures, such as realizing regular audits to handle any potential security breach and prevent any potential exploits with anticipation, and at the same time fostering security, transparency and satisfaction for both the customer and the protocol, becoming a standout solution. Companies who are implementing DeFi into their operations are setting up a foundation for long term success from the very beginning and potentially preparing for massive adoption as web3 grows over 10% every year.