Bitcoin, ethereum and the blockchain technology behind decentralised finance

Ethereum is the world’s second largest cryptocurrency platform. Photo: Budrul Chukrut/SOPA/LightRocket via Getty

Decentralised finance, also known as DeFi, is a fast-growing sector of the cryptocurrency industry. It’s a blockchain-based form of finance that doesn’t rely on central financial intermediaries such as brokerages, exchanges or banks to offer services.

Instead, DeFi offers a more open alternative that is accessible to anyone with a smartphone and good internet connection. As of January 2021, approximately $20.5bn (£15bn) was invested in DeFi. But what exactly is it – and why is it transforming financial services?

What is DeFi?

“DeFi, a rapidly growing sector within financial services, is a technology that uses the blockchain and cryptocurrencies to remove financial intermediaries from transactions. This creates a quicker, cheaper, more efficient and more secure way of providing financial services,” explains Mike Edwards, the CEO of Dispersion Holdings, the second DeFi investment firm to list in the UK. Edwards is the co-founder of the LSE-listed Argo Blockchain (ARB.L). 

“A decentralised financial system at its core allows for buyers, lenders and borrowers – among others – to interact with each other without involving themselves with any intermediaries such as banks, companies and institutions,” he explains.

Read more: Record-breaking Bitcoin tumbles on Yellen warning

Most DeFi applications are built on top of ethereum, the world’s second largest cryptocurrency platform. Decentralised applications use smart contracts, which are digital programmes operating autonomously to facilitate contracts and transactions.

“DeFi is transparent and accessible to everyone, allowing users to keep full control over their assets and interact with each other through decentralised technology and applications,” adds Edwards.

Watch: What are the risks of investing in cryptocurrency?

How does DeFi work?

DeFi services are carried out on a blockchain – a decentralised account of all transactions between two parties – and essentially cut out the ‘middleman’ in financial transactions.

“Usually in any transaction your money will be controlled externally by a bank or institution,” Edwards says. “With DeFi, smart contracts cut out the intermediaries. Smart contracts are essentially ‘computer codes’ or programmes which execute all parts of a financial agreement. This means that transactions carried out with DeFi are faster and do not involve any intermediary costs.

“Funds are also entirely in the user’s custody which reduces the risk of security issues,” he adds. “Ethereum allows for complete financial autonomy as it is not owned by anyone and you are always in control of your funds.”

Crucially, much of the interest in DeFi is linked to giving people more control over their money and what they do with it.

Read more: Bank of England’s Bailey on crypto: ‘Be prepared to lose all your money’

“DeFi is a pioneering force with regards to accessibility and is, in my opinion, set to create one of the most significant changes in the financial sector,” says Edwards.

Most DeFi platforms take the form of decentralised apps, otherwise known as ‘dapps’. These use a series of smart contracts to automate financial transactions. “This automation enables faster, cheaper and more efficient transactions within the financial world and avoids any potential human biases,” Edwards explains.

“Another major benefit is that anyone with an internet connection and personal device will be able to use DeFi technology to access financial services,” he adds. “DeFi can provide innovative financial services which are tailored to the needs of individual users as opposed to institutions, presenting consumers with greater control over – as well as bespoke opportunities for – using their money.”

DeFi is also entirely transparent and all transaction activity is public for anyone to view as contracts are open sourced. Privacy is also retained as transactions are not linked to any real-life identities. “As such, DeFi boasts an incredibly high level of user trust, something which traditional FinTech still struggles to achieve,” Edwards says.

What are the challenges facing the DeFi sector?

That being said, DeFi is still in its infancy. There are still challenges to overcome, including a lack of understanding around DeFi and how it operates.

“Moreover, there are an array of decentralised platforms which differ in quality and reliability,” says Edwards. “Users have also been subject to ineffectual platforms, regressive technologies and in some cases, scams.”

However, he adds, companies like his own are well-suited to address these challenges. “We have assembled a highly qualified team with an established track record and deep expertise in the DeFi, crypto and digital asset management sectors,” Edwards says.

“Using our contacts and expertise we will successfully identify and invest in projects that we deem to be reliable and efficacious. As such, we are not only helping innovate the DeFi ecosystem, but we are also providing investors with a safe, reliable and effective route to invest in DeFi.”

Watch: What is bitcoin?