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What is DeFi? Explaining banks in the blockchain

February 17, 2022, 3:33 PM UTC

A new kind of alternative to traditional banking has been gaining traction recently called decentralized finance, also known as DeFi.

DeFi refers to financial applications built on blockchain technology that enable digital transactions between multiple parties. The blockchain is essentially a public ledger for digital assets, including cryptocurrencies

DeFi can involve lending crypto, sending crypto, or investing crypto.

And crucially, DeFi happens without a central authority, or the involvement of banks or other traditional financial organizations, hence “decentralized.” Some of the most popular DeFi applications include Uniswap and Curve Finance. The DeFi finance market, nonexistent just a few years ago, has now grown into an industry worth hundreds of billions. 

“Just like the internet enabled the free transfer of information, DeFi aims to enable the transfer of value in an open, transparent, auditable system that doesn’t need any centralized 3rd party or gatekeeper—but just the agreement of two parties,” Johann Kerbrat, Robinhood Crypto CTO, told Fortune. 

How does DeFi differ from traditional banking?

The traditional banking sector (also known as TradFi) relies upon KYC—know your customer—which refers to procedures that financial organizations use to verify a client’s identity and legitimacy before doing business with them. In short, a customer must prove they are who they say they are. 

If you want to borrow money from a bank you need a credit check, proof of identity, and likely some kind of income verification. 

But with DeFi, a customer can often be anonymous, and keep their personal information and identity a secret. The only thing you usually need is digital assets

Instead of going through financial institutions, DeFi participants enter into a “smart contract,” which is computer code that acts as the intermediary to make sure everyone fulfills their obligations. 

“By removing middlemen, DeFi promoted ‘access’ to create a fluid, global financial system open to everyone, with no barriers,” Kerbrat told Fortune. 

Aside from identifying customers, many traditional banks also require a minimum deposit when opening a savings account—usually $25 to $100. And most savings accounts come with a minimum balance fee or monthly maintenance fee as well. 

DeFi is different, in part, for how few barriers there are to enter. To use a DeFi application, like Compound, a project on the Ethereum blockchain which focuses on loans, or Yearn Finance, a project which focuses on lending and trading cryptocurrencies, generally all you need is a crypto wallet and internet access. And there is usually no minimum funds required. If you forget a password to an account, though, it’s really gone. There’s no third party to go to for help. 

To begin engaging with DeFi apps, you can create a cryptowallet through companies like Metamask or Frame, and buy some cryptocurrency to get started. 

What’s the big deal?

The champions of DeFi say that it is a fundamental shift in the ways people interact with finance, and expands access to that world to anyone who wants to join.

But detractors say that because of a lack of regulation, the industry is risky, and prone to scams. More than $10 billion from DeFi applications was lost to thieves in 2021. DeFi apps have also become a more popular tool for money laundering—criminals laundered about 8.6 billion through DeFi last year, according to Chainalysis, a blockchain data platform. 

In a speech last month, the Acting U.S. Comptroller of the Currency Michael Hsu compared DeFi a “fool’s gold rush.” 

“I have seen one fool’s gold rush from up close in the lead up to the 2008 financial crisis,” Hsu said. “It feels like we may be on the cusp of another with cryptocurrencies (crypto) and decentralized finance (DeFi).”

Correction: A previous version of this story misspelled the name of the Robinhood Crypto CTO.

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