| ASK VIV |
This is Ask Viv.
| Q. | What is DeFi, and why do people say it could change the way we use financial services? |
5 min watch · Always free
The short answer
DeFi stands for decentralized finance. It's an attempt to provide some of the financial services people already use, such as borrowing money, exchanging currencies, earning interest and trading, with blockchain technology and software instead of financial institutions and intermediaries. Some of the work an institution does, like managing accounts, recording transactions and applying the rules, can be handled by smart contracts, which are software running on a blockchain that executes predefined rules. Relying less on intermediaries changes where the risk sits. Smart contracts can contain vulnerabilities, protocols can be hacked or exploited, prices can move sharply, and mistakes can be extremely difficult to reverse. When a platform advertises a very attractive yield, the question to ask is where that return is actually coming from.
Viv's answer
For education only, not financial advice. Crypto assets are volatile and you can lose all the money you invest.
Transcript4:47 · lightly edited
Today's question
Hi, and welcome to Ask Viv, where I answer your cryptocurrency questions simply and honestly.
Today's question is: what is DeFi? And why do people say it could change the way we use financial services?
Start with the services you already use
DeFi stands for decentralized finance. The simplest way to understand that is to think about the financial services you already use.
You might borrow money from a bank. You might exchange one currency for another. You might earn interest on savings. You might trade an investment.
Traditionally, these activities rely on financial institutions and intermediaries. DeFi is an attempt to provide some of these services using blockchain technology and software instead.
How DeFi handles a loan
So how is DeFi different? Let's take a simple example.
Imagine you want to lend someone money. In traditional finance, a bank or lending platform might sit between the lender and the borrower. The institution manages the accounts, records the transactions, assesses the risk, and applies the rules.
In DeFi, some of these functions can be handled by smart contracts running on a blockchain. A smart contract is essentially software that executes predefined rules.
So instead of saying "trust this institution to carry out the agreement," the idea is closer to "the rules are encoded in software and executed by the blockchain." That's one of the fundamental ideas behind DeFi.
Exchanges, lending and liquidity
So what can you actually do with DeFi? There are several different types of DeFi application.
You can have decentralized exchanges, where users can trade digital assets without a traditional centralized exchange operating the entire marketplace. There are lending and borrowing protocols, where users can potentially lend assets or borrow against collateral. There are also systems that allow people to provide liquidity to markets and potentially earn fees. And there are increasingly complex financial applications that combine these different functions.
The important point is that these aren't just websites. Underneath them are blockchain networks and smart contracts that determine how the systems operate.
Where the yield comes from
So where does the yield come from? Now this is where I think people need to be particularly careful.
You may see DeFi platforms advertising very attractive yields. But whenever someone says you can earn 20%, 50%, or even more, the first question should be, how do I get it? It should be, where is that return actually coming from?
It could be generated from trading fees or borrowing activities, incentives, token emissions, or other mechanisms. And each of course comes with different risk.
A high yield is not free money. The higher the potential return, the more important it becomes to understand the risks behind it.
Risks of a different kind
DeFi introduces risks that are different from traditional finance. Smart contracts can contain vulnerabilities. Protocols can be hacked or exploited. Digital assets can experience significant price movements. There can be liquidity risk. There can also be governance and counterparty risks, depending on how the protocol is designed.
And because many DeFi systems operate globally and digitally, mistakes can sometimes be extremely difficult to reverse.
So while DeFi can remove or reduce reliance on certain intermediaries, it doesn't remove risk. It changes where the risk sits.
How many services need an intermediary?
And that's ultimately why I think DeFi is worth understanding. It's asking a very interesting question. How many financial services actually need a traditional intermediary?
If software and blockchain networks can perform some of those functions securely and efficiently, we could potentially create financial services that are more accessible, programmable, and globally connected. But we're still relatively early in that evolution.
So don't think of DeFi as simply a way to earn returns. Think of it as an experiment in building financial infrastructure with software and blockchain technology. And understanding that distinction is critical, because the opportunity may be significant, but so are the risks.
Closing
With that, remember, if you've got a cryptocurrency question you'd like me to answer, I'd love to hear it. Please leave it in the comment section below.
Thanks for watching, and I'll see you in the next Ask Viv.
Worth knowing
Ask where the yield comes from. An advertised yield could be generated by trading fees, borrowing activity, incentives, token emissions or other mechanisms, and each comes with different risk. A high yield is not free money, and the higher the potential return, the more important it becomes to understand the risks behind it.
Think of DeFi as an experiment in building financial infrastructure with software and blockchain technology, rather than simply a way to earn returns. It's still relatively early in that evolution, and the opportunity may be significant, but so are the risks.
Got your own question? Ask it.
There's no separate Ask Viv email. Subscribing gets you The Crossover, free, every weekday, and you can put your question to Viv any time.
Related questions
| Q. | What is blockchain? |
| Q. | What is tokenization? |