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What is Decentralized Finance (DeFi)?

Co-written by Raphael Bustamante, James de Jesus, and Gabriel Paningbatan
Key Takeaways
  • The Traditional finance (TradFi) system is the mainstream financial system that has been operating for decades.
  • Decentralized finance (DeFi) emerged as a protest against the problems of TradFi. It refers to a set of financial services and applications that work in a decentralized way and typically operate on blockchain technology.
  • The easiest way to get into DeFi is through decentralized applications (DApps) which are software applications that operate on decentralized networks.

Ever found yourself curious about what goes on with the money you deposit in banks like BPI or BDO? Are your funds just there for you to withdraw them anytime? Maybe for a few people, that might be the case. But what if every single user of Bank A decided they wanted to withdraw their money all at once? Unfortunately, Bank A wouldn’t be able to accommodate such a mass withdrawal, which is known as a bank run. 

Actually, most banks operate on something called a fractional reserve system. In simpler terms, they only keep a fraction of deposits as cash reserves while putting the rest to work by lending it out. Here’s an example!

So, imagine Pedro deposits Php 1,000.00 into Bank A. Now, Bank A would only need to keep, say, 10% (Php 100.00) in their reserves, and the rest, Php 900.00, can be loaned out to someone like Darna. Here’s the interesting part: when Bank A lends money, it doesn’t actually take it from Pedro’s initial deposit, instead, it creates “new money” by simply adding a new entry to Darna’s account. 

Darna could then deposit the Php 900.00 into Bank B, which only has to keep 10% as well (Php 90.00), and could lend out the remaining Php 810.00 elsewhere. This process goes on, creating more money seemingly out of nowhere. 

The catch is, the majority of the money in circulation is essentially credit. Therefore, if every user of Bank A decides to withdraw their cash at once, the bank might struggle to cover it all. 

Fortunately for the banks, they can halt transactions whenever necessary to prevent all the built-up credit from being exposed. Let’s go over why this happens!

Traditional Finance (TradFi) vs Decentralized Finance (DeFi)

Banks operate under the traditional finance (TradFi) system, which is the mainstream financial system that has been operating for decades. Institutions in TradFi are centralized, meaning a single entity or a small group of people make all the decisions. When you put money in a bank, the bank gets to decide what to do with it. If lots of people start withdrawing at once, the banks can simply choose to temporarily suspend operations. While this is useful for protecting TradFi institutions, this is not always beneficial for its users. 

Now, the catch is, in TradFi, you don’t have control over your funds. Users of TradFi are also reliant on the security of its large institutions. They have to trust TradFi to safeguard their assets. 

TradFi is also highly regulated and monitored. All transactions made are viewed by intermediaries and reported to necessary governing bodies. Did you know that banks can also block your account should you be suspected of illicit activity? 

And let’s talk about the costs – the fees to participate in TradFi can be pricey and there are geographical and economic barriers that prevent some people from joining in. It’s not always the most accessible option for everyone.

Aside from the banks, governments, stock markets, and insurance companies also operate under TradFi.

On the other hand, decentralized finance (DeFi) emerged as a protest against the problems of TradFi. DeFi refers to a set of financial services and applications that work in a decentralized way and typically operate on blockchain technology.

If you’re curious about blockchain, read our full module here: https://www.bitskwela.com/en/blockchain

In contrast to TradFi, DeFi has no central authority governing transactions, and users are responsible for holding their own funds. Transactions here happen directly and are peer-to-peer, with no need for middlemen like banks. 

DeFi also allows a more transparent and trustless system. Instead of trusting people or institutions to facilitate transactions, we trust the power of cryptography and the code behind its service. This code is generally open-source, meaning that anyone can audit them to check their security. 

Interested in cryptography and Bitcoin? Check out our past lessons here: https://www.bitskwela.com/en/digital-signature 

DeFi is also much less regulated than TradFi, giving you more privacy. No need to share your ‘know your customer (KYC)’ information. It also typically offers way cheaper transaction fees than TradFi services. As a result, almost anyone can join DeFi regardless of race, gender, or economic status. All you need is a device with an internet connection! 

Examples of DeFi include self-custody cryptocurrency wallets, staking services, lending and borrowing platforms, and decentralized exchanges (DEXes).

Here’s a quick look at the differences between TradFi and DeFi.

Something to take note of: The DeFi movement hopes to utilize blockchain technology to offer a more transparent and inclusive financial system that can act as an alternative to TradFi. Doesn’t this sound so exciting?

How to participate in DeFi?

If you’re interested in what you’ve learned so far and wondering, “How exactly can I join in on this DeFi thing?” – don’t worry, it’s simpler than you think!

The easiest way to get into DeFi is through decentralized applications (DApps). These are software applications that operate on decentralized networks. These networks are often blockchain platforms. Think of your usual mobile applications, but instead of the App Store or Google Play Store, it’s decentralized applications on platforms like Ethereum, BNB chain or Solana. DApps offer different types of services such as lending, borrowing, gaming, social media, music and video streaming, supply chain management, and decentralized storage.

For the purposes of this course, we’ll explore how to use a specific type of DApp. Let’s dive into decentralized exchanges (DEXes) as we enter the next module!

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