What is DeFi (Decentralized Finance)? An In-depth Explanation from Mechanisms and Key Services to Usage and Risks

In recent years, alongside the development of cryptocurrencies, the concept of 'DeFi (Decentralized Finance)' has garnered global attention from investors and technologists. This is not merely a financial technology trend, but an innovation with the potential to fundamentally overturn the centralized financial systems in place.

DeFi is notable for its structure that allows even those without bank accounts to access financial services, provided they have an internet connection and a wallet to store and manage cryptocurrencies. Traditionally, roles filled by banks and brokerage firms are being replaced by blockchain technology and smart contracts, which is the essence of DeFi.

This article will introduce the concept, mechanisms, and representative services of DeFi.

DeFi, short for 'Decentralized Finance', translates to '分散型金融' in Japanese. True to its name, it refers to a system where users can conduct transactions and manage assets directly with each other, without the need for centralized intermediaries. This not only eliminates the fees typically earned by intermediaries but also allows for more flexible transactions.

At the core of this system are 'smart contracts'. These are programs that automatically execute transactions and contracts based on predefined conditions and operate on blockchains like Ethereum (ETH) and Solana (SOL).

Furthermore, one of DeFi’s strengths is its transparency, derived from operating without centralized intermediaries. This transparency not only ensures reliability but also fosters a community-driven development culture.

DeFi (Decentralized Finance) encompasses a variety of use cases. Below are some of the services that represent these applications.

DEX (Decentralized Exchanges)

Examples: Uniswap, SushiSwap
Unlike traditional cryptocurrency exchanges, users do not deposit their assets with the exchange but connect their wallets to conduct transactions directly. The price determination and liquidity provision are automated through the use of Automated Market Makers (AMM).

Lending

Examples: Compound, Aave
Users can earn interest by depositing cryptocurrencies or borrow funds by providing collateral. Smart contracts automatically manage repayment and liquidation terms, ensuring fair financial transactions.

Liquid Staking

Traditional staking involves earning rewards by participating in the management and operation of a blockchain. Liquid staking, on the other hand, allows users to deposit specific cryptocurrencies into DeFi services and receive alternative tokens in return.

These alternative tokens can typically be received in a 1:1 ratio with the deposited cryptocurrency, allowing for flexible trading and management.

Yield Farming

Yield farming is a method of asset management in DeFi (Decentralized Finance) that earns rewards by providing liquidity for transactions. It is known for offering high returns through the use of DeFi.

Providing liquidity generally involves depositing two types of cryptocurrencies. For example, if one holds Ethereum (ETH) and USD Coin (USDC), they would choose the 'ETH/USDC' pair and deposit both to participate.

The greatest advantage of DeFi (Decentralized Finance) is the realization of 'Financial Inclusion'. Even people in emerging countries who do not have bank accounts can access financial services such as savings, loans, and remittances through a smartphone and a cryptocurrency wallet.

Additionally, the reduction of fees and the improvement of transaction speeds are not to be overlooked. In traditional financial systems, numerous intermediaries contribute to high fees, but DeFi significantly reduces these costs. Moreover, because it operates 24/7, it offers the convenience of being usable anytime and from anywhere, without being limited by time zones or national borders.

Furthermore, its censorship resistance is a notable feature. Smart contracts executed on the blockchain cannot be arbitrarily halted by any specific nation or organization, enabling free financial transactions.

However, DeFi (Decentralized Finance) also entails significant risks.

Firstly, the prevalence of bugs and vulnerabilities in smart contracts has led to incessant hacking incidents. The DeFi market has witnessed several incidents of fund outflows amounting to hundreds of millions of dollars, constantly threatening the safety of user assets.

Additionally, fraudulent activities known as 'Rug Pulls' are a major concern. This involves developers launching a project and issuing tokens, only to suddenly disappear with the invested funds. Although not exclusive to DeFi, the difficulty in detecting such schemes continues to result in ongoing losses.

Moreover, the relationship with legal regulations is complex. Many services struggle to fit within the current legal framework, and governments worldwide are in the process of developing regulations for DeFi. Future regulatory measures might include licensing requirements and mandatory KYC (Know Your Customer) processes, potentially compromising user anonymity.

Another significant concern, especially for beginners, is the absence of a centralized authority, making all actions a matter of personal responsibility. There is generally no support for transactions or operations, and users must handle any unforeseen situations themselves, making it essential to be aware of the relatively high difficulty level of using these services.

Currently, DeFi is evolving into what is often referred to as 'DeFi 2.0'. This phase represents a shift towards addressing past issues and challenges, with emerging DeFi projects proposing new models such as Protocol Owned Liquidity.

In the era of Web3.0, DeFi is being redefined as part of the financial infrastructure. It envisions a future where finance, identity, and data are integrated on a network that does not require centralized management.

To adapt to these changes, it is crucial for investors to understand the mechanics of protocols and enhance their literacy in assessing risks. Decisions should be based on a deep understanding of decentralized philosophies and development backgrounds, rather than being swayed by high yields alone.

DeFi is not just an investment opportunity; it embodies a new paradigm in finance. Indeed, there are risks such as hacking and regulatory challenges, but this field still holds significant social importance and potential.

It is crucial not to take information at face value but to continuously update oneself and maintain an awareness to protect one's assets. Understanding the essence of DeFi and mastering its use can potentially bring substantial benefits to both individuals and society.

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