What’s DeFi? How it works and why it matters

Decentralized finance (DeFi) technically began with the launch of Bitcoin (BTC) in 2009. As the first successful blockchain protocol, Bitcoin revolutionized global financial transactions by offering a secure peer-to-peer (P2P) network. But today, the term DeFi goes far beyond simple online value transfers. DeFi is now part of the broader cryptocurrency ecosystem, and it offers global traders access to financial services and instruments once reserved for industry professionals.

Despite its impressive potential uses, it’s not always clear what DeFi is and whether it’s safe to use these services. In this guide, we’ll explain the essentials of DeFi, including its risks and benefits, so you know whether it’s worth your investment.

What’s decentralized finance (DeFi)?

DeFi is an ecosystem in the decentralized web (aka Web3) that offers intermediary-free access to financial tools and services, so users can access traditional financial services using blockchain technology.

Bitcoin first demonstrated that DeFi was possible by launching a globally distributed P2P value-exchange network. However, growing demand for more sophisticated financial tools have fueled DeFi's expansion.

Smart contracts – self-executing agreements that run on blockchains – ushered in a new wave of DeFi applications that offer services like lending, borrowing, and swapping. Now, most DeFi protocols run as decentralized applications (dApps) on blockchains and use automated smart contracts to handle tasks without intermediaries.

Although Ethereum typically has the highest DeFi activity with a large portion of crypto funds on its protocols, other blockchains, like Binance Smart Chain and Solana, have gained traction.

What are some uses for decentralized platforms? DeFi examples

Not every financial task has made its way to Web3, but DeFi now runs many foundational services also found at banks and brokerages. Blockchain developers are constantly introducing new features that they hope will make DeFi the hub for global financial activity. Here are a few of the most common DeFi uses.

Stablecoins

Tether Limited introduced the category of cryptocurrencies known as stablecoins with the launch of its USDT token in 2014. Unlike other cryptocurrencies, stablecoins have a 1:1 value with another real-world asset, such as the United States dollar. This pinning gives more predictability to crypto users for their financial services.

Although stablecoins aren’t a DeFi-specific innovation, they’re a key part of Web3’s infrastructure, providing liquidity and a convenient, low-volatility option for global traders.

Decentralized exchanges (DEXs)

DEXs are DeFi’s answer to traditional brokerages. On these smart contract-controlled protocols, traders link their self-custodial wallet and swap between cryptocurrencies without third parties. Although each DEX uses its own algorithmic system, most follow the automated market maker (AMM) model perfected by Uniswap, which automatically balances 50/50 token pairs in liquidity pools using crypto deposited by users (aka liquidity providers). Anyone who sends their crypto as a liquidity provider gets to claim a portion of trading fees and sometimes airdrop rewards like DeFi coins.

Since trades on DEXs happen within a user’s self-custodial wallet, they don’t have to worry about counterparty interference at any part of the transaction. Plus, all trades are publicly viewable on blockchain explorers, further boosting the transparency of these protocols.

Borrowing and lending

Some DeFi protocols, like Aave and Compound, let anyone deposit crypto to lend or take out a crypto loan using their self-custodial wallets. Since there are no credit checks or lengthy applications on the blockchain, crypto loan dApps make taking out money more accessible. However, many DeFi loan sites rely on “overcollateralization,” where borrowers have to deposit more crypto than they intend to take out to avoid margin calls and liquidation.

Yield farming

When traders talk about yield farming in DeFi, they aren’t referring to a specific practice on one protocol. Instead, this strategy focuses on earning passive rewards on one or multiple dApps through whatever opportunities the user feels have the most attractive risk-to-reward profiles.

For example, a trader might contribute to liquidity pools on a DEX to earn trading fees, then move their crypto to a loan to earn interest. It’s also common for crypto yield farmers to stake their crypto on DeFi platforms, which involves locking their digital assets on blockchains that use the proof-of-stake (PoS) consensus algorithm to earn rewards. Some popular DeFi protocols like Lido offer a new form of “liquid staking,” where yield farmers earn staking rewards while using tokenized versions of their deposits to access even more yield opportunities.

What are the benefits of DeFi?

With billions of dollars in crypto already locked in DeFi protocols, more developers and users recognize the potential positives of bringing financial services on-chain.

Permissionless access and global reach

DeFi does away with institutional and geographic barriers that would otherwise restrict access to basic financial services. All that you need to interact with DeFi is a compatible self-custodial wallet and cryptocurrencies, which helps create a more inclusive financial system for unbanked and underbanked populations.

Transparency and user control

Since DeFi protocols are on public blockchains, all transactions take place on transparent and globally distributed payment ledgers. Many DeFi platforms release third-party audits and offer democratic voting through decentralized autonomous organizations (DAOs) to build even more trust with their online communities. Plus, DeFi users link their self-custodial wallets to dApps, so they always retain ownership over their crypto assets.

Yield opportunities and financial innovation

The programmability of smart contracts creates possibilities beyond what’s possible in traditional finance, including tokenized real-world assets (RWAs) and liquid staking protocols. These DeFi innovations offer new ways to invest and earn passive income.

Risks and considerations before using DeFi

As a new, intermediary-free technology, DeFi doesn’t have the same safeguards as more established centralized platforms. Anyone considering using a DeFi dApp needs to weigh the real risks before linking a wallet:

• Software risk: A drawback of DeFi’s reliance on smart contracts is that any code vulnerability could completely undermine a protocol’s security. It only takes one bug or hack to trigger irrecoverable financial losses and completely erode trust in a dApp.
• User error: DeFi users have more autonomy than other crypto traders thanks to the control they maintain over their self-custodial wallets. However, that freedom in DeFi also increases the risk for irreversible errors, like mistaken transactions or losing all your assets after misplacing a wallet’s private key.
• Regulatory risk: Currently, there’s no clear, unified legal framework for interacting with DeFi, and people in different jurisdictions may face restrictions on their activity. Research the latest laws and tax policies surrounding DeFi where you live so you know if your trading is compliant with local authorities.
• Token risk: DeFi lacks the same vetting procedures as centralized trading platforms, increasing the risk of scams and fraudulent tokens. But even if a project has a solid reputation, its DeFi tokens are inherently prone to volatile price swings and software risks due to their reliance on smart contracts.

How to get started with DeFi

Using DeFi may seem daunting for first-time users, but you don’t have to be a crypto expert to test the waters of Web3. With the right foundations and tools, anyone can start exploring what DeFi has to offer and take advantage of its opportunities:

• Review crypto basics: Before experimenting with DeFi, be sure you feel confident with foundational concepts like protecting your wallet’s private keys and transferring cryptocurrencies between wallet addresses. It also helps to read up on the potential risks of DeFi and install tools to protect yourself, like two-factor authentication (2FA).
• Set up a self-custodial wallet: Many crypto traders use browser extension software wallets like MetaMask that link to their preferred DeFi dApps to make trading more convenient. Take time to review the safety profile and accessibility of different wallets and choose one that fits your needs.
• Fund your wallet with crypto: If you already have crypto on a CEX account, transfer it to the address associated with your wallet. In some cases, you could buy crypto directly through a wallet’s interface. Note that you need to pay network fees (aka gas fees) in the blockchain’s native cryptocurrency (e.g., ETH on Ethereum) to use DeFi, so make sure you have enough to cover these variable transaction costs.
• Explore and choose a DeFi dApp: Visit the official pages for DeFi dApps to see the latest offerings and yield rates for different services. If you don’t have a DeFi protocol in mind, you can research the largest dApps by trading volume and total value locked (TVL) on third-party aggregator sites.
• Execute your first transaction: When you’re ready to use a DeFi service, click the button “Connect My Wallet” (usually on the top-right-hand corner) and agree to the Terms and Conditions. After linking your wallet, you can confirm transactions on the DeFi protocol as long as you have enough crypto in your account.
• Track and manage DeFi transactions: For tax purposes, you need to keep a detailed log of all your DeFi transactions throughout the year. The simplest way to complete this task is to link your self-custodial wallets to a DeFi-friendly crypto tax software like CoinTracker that organizes all of this data.

Stay compliant and confident with CoinTracker

DeFi offers exciting possibilities for both traders and developers, but keep in mind it’s still an experimental field prone to risks, like bugs and online scams, without anyone ready to help if things go wrong. And just because DeFi doesn’t have intermediaries doesn’t mean you don’t need to account for crypto taxes when using DeFi platforms. Anyone involved in DeFi should use crypto tax software like CoinTracker so they can link to all their self-custodial wallets and smart contracts to instantly calculate gains, losses, and cost basis in a comprehensive report.

Worried about reporting your crypto taxes? CoinTracker makes it simple. Join over three million users who trust us for hassle-free tax reporting and start for free today.

Disclaimer: This post is informational only and is not intended as tax advice. For tax advice, please consult a tax professional.