Learn what DeFi is, how it works and what it means in this easy-to-read beginner’s guide.
In a nutshell, decentralised finance (DeFi) is like an entire financial system for cryptocurrencies.
While Bitcoin was the first to successfully put money onto the Internet, DeFi aims to create the system for that money to keep moving, working and finding meaningful value.
Just like any currency benefits from being part of a healthy financial system, cryptocurrencies benefit from being part of a DeFi ecosystem.
In coming years, central bank digital currencies, other tokenised assets such as digital gold, real estate or energy, and cryptocurrencies like Bitcoin, will all become digital assets in the DeFi ecosystem.
This guide explains how DeFi works and why it’s important.
How does DeFi work?
A DeFi ecosystem is built on two characteristics of blockchain technology:
- It can be reliably tamper proof and largely automated.
- It can be programmed to interact with cryptocurrency.
With these characteristics it’s possible to create decentralised applications (dApps) that automatically interact with money in many different ways, without needing banks or other intermediaries.
As more dApps are built, and as they increasingly integrate with each other, the DeFi ecosystem becomes more effective.
The key to understanding DeFi is to understand the different types of dApps that make up the DeFi ecosystem, what they can do and how they all fit together.
For example, consider how a simple “swap” dApp, which people can use to trade cryptocurrency with each other, improves as it links up with other elements of a DeFi ecosystem.
| Smart contract types | What it does |
|---|---|
| Swap
A swap program simply allows people to safely trade assets with strangers online. |
Two people can swap cryptocurrency with each other.
It’s slow, inconvenient and extremely limited. You can only trade with others using the same platform. |
| Swap + pricing oracles
Pricing oracles can provide other programs with accurate price feeds and other data. |
Two people can swap cryptocurrency with each other.
It’s more convenient, but still slow and inefficient. You still have to wait for a counterparty to make a trade. |
| Swap + pricing oracles + liquidity pool
Liquidity pools aggregate assets for other dApps to use when needed. |
Two people can swap cryptocurrency with each other.
It’s faster, easier and more convenient. By connecting to liquidity pools, the swap program can make more assets available in greater amounts. |
By itself a swap dApp is very basic and not suitable for large scale use. But by connecting it with other programs, it…
