What Is Decentralized Finance (DeFi)?

Decentralized finance (DeFi) is an emerging financial technology based on secure distributed ledgers similar to those used by cryptocurrencies.

In the U.S., the Federal Reserve and Securities and Exchange Commission (SEC) define the rules for centralized financial institutions like banks and brokerages, which consumers rely on to access capital and financial services directly. DeFi challenges this centralized financial system by empowering individuals with peer-to-peer transactions.

KEY TAKEAWAYS

Decentralized finance, or DeFi, uses emerging technology to remove third parties and centralized institutions from financial transactions.
The components of DeFi are cryptocurrencies, blockchain technology, and software that allow people to transact financially with each other.
DeFi is still in its infancy, subject to hacks and thefts because of sloppy programming and a lack of security testing before applications are launched.

How Decentralized Finance (DeFi) Works

Through peer-to-peer financial networks, DeFi uses security protocols, connectivity, software, and hardware advancements. This system eliminates intermediaries like banks and other financial service companies. These companies charge businesses and customers for using their services, which are necessary in the current system because it’s the only way to make it work. DeFi uses blockchain technology as a way to reduce the need for these intermediaries.

Blockchain

A blockchain is a distributed and secured database or ledger. In the blockchain, transactions are recorded in blocks and verified through automated processes. If a transaction is verified, the block is closed and encrypted; another block is created that has information about the previous block within it, along with information about newer transactions.

The blocks are “chained” together through the information in each proceeding block, giving it the name blockchain. Information in previous blocks cannot be changed without affecting the following blocks, so there is no way to alter a blockchain. This concept, along with other security protocols, provides the secure nature of a blockchain.