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What is Decentralized Finance, or DeFi?

The last time you swiped a credit card, dipped a debit card, or tapped your Apple Pay at checkout, you probably did not think about the complicated financial process that you were triggering. Records were created. Fees were charged. Credit was extended. One account grew smaller while another grew bigger. Multiple institutions were involved.

The system that manages the typical financial transaction — whether it is buying a car or a cappuccino — is part of something that is known as centralized finance. It involves institutions that issue money and influence its value. It also involves businesses that safeguard that money, make it conveniently available, and sometimes lend it to those who do not have what they need—all for a fee. Generally, these institutions control the flow of financial transactions by approving or denying them.

For many people, the centralized finance system is empowering and safe. It may be limiting in some ways (for example, think of the daily spending limits you might have on a debit or credit card), but those limitations are accepted in exchange for security and convenience.

However, centralized finance does not work for everyone. Globally, there are many who are denied access to the system. In some cases, simple logistics — such as the lack of banks in a geographic area — keep people from accessing the system. In other cases, the businesses that control the system deny access to those who are seen as a risk. Whatever the reason, the exclusivity of centralized finance has prompted the development of alternative systems aimed at making the financial system more accessible. One of the alternative systems is known as decentralized finance, or DeFi.

The origins of DeFi

It is difficult to point to a moment when the concept of DeFi emerged. However, its evolution is often said to be closely connected to the development of blockchain technology. Blockchain is a digital technology that provides an immutable public ledger that can be used to conduct a wide range of transactions, allowing for that ledger to be decentralized.

A traditional ledger is kept in a central location. When transactions are made that affect the ledger, they are reported to the central location and changes are made accordingly. This is how banks work; when you exchange money via a check or a debit card, or when you remove cash from a bank branch, a record of the transaction is sent to the bank’s central ledger.

With blockchain, there is no centralized ledger; rather, the record is kept in a decentralized ledger that travels with the digital asset that is exchanged. Every time a new transaction is conducted, a new “block” of data regarding the transaction is created and connected to the chain.

Applying blockchain technology to financial transactions does away with the need for centralized institutions like banks. Access to the system is available to anyone who has an internet connection, regardless of their geography. The records contained in the blockchain provide security by establishing ownership. Peer-to-peer transactions are authorized by the creation of new blocks on the chain and managed by the smart contracts that reside on the blockchain, instead of being authorized and managed by a central organization. That is what DeFi looks like.

Is crypto DeFi?

While the terms “crypto” and “DeFi” are often found in the same news articles, cryptocurrencies like Bitcoin and Ethereum are not decentralized finance in and of themselves. They serve the same function as currency in a fiat financial system; they are the asset exchanged, but not the system that facilitates the exchange.

DeFi is a system that allows for the decentralized movement of financial assets. That system requires a digital asset that has value. Cryptocurrency could serve as that asset, but it would still be just a part of a system that also includes decentralized apps, or dApps, that are used to store and exchange those assets.

The future or DeFi

At this point, the viability of a fully functioning DeFi system has yet to be tested. Its future development seems to be increasingly tied to the development of regulations that would govern just how decentralized the system could be.

In late 2021, MakerDAO founder Rune Christensen responded positively to the direction being taken by the US Working Group on Financial Markets in relation to DeFi. Christensen said the group recognized the value of DeFi in a way that encouraged further development and innovation. MakerDAO, which provides a platform for borrowing and lending crypto via smart contracts, is considered one of the top DeFi projects in the world.

In March 2022, however, a new law was proposed in the wake of the Russia/Ukraine war that suggested official attitudes toward DeFi might be changing. The Digital Asset Sanctions Compliance Enhancement Act of 2022, which was introduced in the Senate on March 17, looks to empower the government to monitor and limit the types of transactions conducted by “digital asset transaction facilitators,” a term that would include any “decentralized finance technology.”

While the Digital Assets bill has made little progress toward becoming law, it sends a clear message that at least some officials are okay with DeFi. So long as they have a say in how it works, that is.
Mark Fidelman is the Founder of Smart Blocks and Fanatics Media. As a Global Marketing Executive focused on Blockchain and eCommerce organizations, Mark’s passion is to provide education and inspiration to crypto enthusiasts about innovative DeFi projects. Mark is also the host of the Cryptonized podcast.

Opinions expressed by Market Daily contributors are their own.