Decrypting DeFi: The Blockchain Financial Revolution from Beginner to Expert

What is DeFi? And Why Is It Changing Finance

In traditional financial systems, intermediaries like banks and fund companies control most of the wealth flow. But Decentralized Finance (DeFi) presents a completely different vision — enabling everyone to participate directly in financial activities without any intermediaries.

DeFi is essentially an ecosystem of financial applications built on blockchain technology. It leverages smart contracts, liquidity pools, stablecoins, and other financial primitives to create an open, transparent, permissionless financial system for users.

At its peak in December 2021, the total value locked (TVL) in DeFi protocols reached an astonishing $256 billion, nearly four times higher than the previous year. This not only reflects market enthusiasm but also indicates that DeFi is gradually becoming the choice for millions of users.

Why Is DeFi So Important? The Root of the Issue

Trust Crisis Caused by Centralization

Historically, we have witnessed numerous financial crises and inflation events that affected billions worldwide. The root cause lies in — centralized institutions holding absolute power without checks and balances.

Unfair Monopoly in Finance

A harsher reality is: 1.7 billion adults worldwide still lack access to basic banking services. They are excluded from traditional financial systems, unable to open savings accounts or obtain loans. This is a global injustice.

DeFi Breaks Monopolies

Blockchain technology allows money to escape control by central banks and governments, and DeFi does the same for traditional finance — enabling anyone worldwide to access financial services within minutes:

• Loan approval in just 3 minutes (no documents needed)
• Real-time virtual savings accounts
• Cross-border transfers completed in minutes (compared to days in traditional banks)
• Investing in global companies through tokenized securities

How Does DeFi Work? Technical Underpinnings

All DeFi applications run on blockchain platforms supporting smart contracts. Smart contracts can be understood as self-executing digital agreements — once preset conditions are met, they execute automatically without human intervention.

Ethereum pioneered smart contracts, providing a Turing-complete virtual machine (EVM). Developers write contracts in languages like Solidity, which are compiled and executed by the EVM. Solidity has become the universal language for blockchain development.

This innovation made Ethereum the second-largest crypto asset globally, with its flexibility attracting a vast developer community. However, smart contract platforms are not limited to Ethereum — Cardano, Polkadot, TRON, EOS, Solana, Cosmos, and others are strong competitors, each offering unique architectural innovations to address scalability, interoperability, and other issues.

Although some platforms surpass Ethereum technically, due to network effects and first-mover advantage, Ethereum remains dominant. According to DeFiPrime, out of 202 DeFi projects, 178 operate on Ethereum. This concentration reflects the power of ecosystem lock-in.

DeFi vs Traditional Finance vs Centralized Exchanges: The Three Pillars

Traditional Finance (TradFi) and Centralized Finance (CeFi) provide services through intermediaries like banks, while DeFi adopts a peer-to-peer architecture. The differences are more than one:

Transparency and Security

DeFi apps are inherently transparent due to the absence of intermediaries — all processes and fee structures are determined collectively by users, not hidden behind black boxes. This eliminates single points of failure, and any manipulation attempts are visible to the entire network. In contrast, centralized platforms are more vulnerable to hacking.

Transaction Speed and Cost

Peer-to-peer DeFi models accelerate transaction processing. Cross-border transfers on DeFi can be completed in minutes, with significantly lower fees. Traditional banks require multi-country coordination and regulatory procedures, which can take days.

User Control

In DeFi, users have full control over their assets, bearing their own security risks. This removes the central authority as an attack target and also saves huge costs that traditional financial institutions spend on asset protection and insurance.

24/7 Operation

Traditional financial markets are limited by business hours, whereas DeFi markets operate 365 days a year, 24 hours a day. This ensures liquidity stability and prevents fluctuations caused by market closures.

Data Privacy and Immutability

DeFi protects user data through blockchain’s immutable features, while traditional institutions are more prone to internal fraud or external breaches.

The Three Core Financial Primitives of DeFi

The DeFi ecosystem consists of three core components — we call them the “financial Lego blocks”:

1. Decentralized Exchanges (DEX)

DEXs enable users to trade crypto assets in a fully decentralized manner, without KYC or regional restrictions. Currently, the total locked value in global DEXs exceeds $26 billion.

DEXs are divided into two types:

• Order Book DEXs: mimic traditional exchange order book mechanisms
• Automated Market Maker (AMM) DEXs: facilitate token swaps via liquidity pools, trading only one trading pair at a time

2. Stablecoins

Stablecoins are the foundational assets of DeFi, pegged to stable assets like the US dollar, limiting price volatility. Over the past five years, stablecoin market cap has surpassed $146 billion.

Stablecoins are categorized into four main types:

Fiat-collateralized Pegged 1:1 with fiat currencies like USD. Examples: USDT, USDC (market cap $76.01 billion), PAX, BUSD

Crypto-collateralized Supported by over-collateralized crypto assets. Examples: DAI (market cap $4.24 billion), sUSD, aDAI, aUSD

Commodity-collateralized Supported by physical assets like gold or silver. Examples: PAXG (market cap $1.63 billion), DGX, XAUT, GLC

Algorithmic Maintained purely by algorithms without collateral. Examples: AMPL, ESD, YAM

Many modern stablecoins use a hybrid approach. For example, RSV combines crypto and fiat collateral assets (USDC, DAI) to achieve greater stability.

A unique feature of stablecoins is “chain agnosticism” — since they are pegged to external assets, they can exist across multiple blockchains. Tether operates on Ethereum, TRON, OMNI, and other platforms.

3. Lending Markets

Lending is a core component of traditional banking, and DeFi replicates and improves this model. Currently, lending protocols lock over $38 billion, accounting for nearly 50% of the entire DeFi market (total TVL of DeFi is $89.12 billion as of May 2023).

The advantages of DeFi lending are clear:

• No complex paperwork or credit checks
• Only requires sufficient collateral and a wallet address
• Peer-to-peer lending opens new markets, with lenders earning interest
• Platforms profit from net interest margin (NIM), similar to traditional banks

The entire DeFi ecosystem is built upon these three primitives. Combining them enables the creation of an open, transparent, trustless, and borderless financial service system.

How to Profit from DeFi?

DeFi opens new doors for investors seeking passive income. Let’s explore the main ways to earn:

Staking

Staking involves locking up PoS-based crypto assets to earn rewards. DeFi staking pools function similarly to savings accounts — users deposit assets into designated pools and earn percentage-based rewards over time. These rewards come from protocol issuance and are distributed to participating investors.

Yield Farming

Compared to staking, yield farming is a more advanced strategy. It is one of the most popular ways to earn in DeFi. Protocols incentivize liquidity through farm rewards to ensure sufficient liquidity for platforms like DEXs.

Yield farming is supported by Automated Market Makers (AMMs) — smart contracts that facilitate DEX trading using mathematical algorithms. In farm mode, AMMs maintain pools via liquidity providers, ensuring ample liquidity.

Liquidity Mining

Although often confused with yield farming, there are subtle differences. Liquidity mining involves maintaining trading liquidity through smart contracts and liquidity providers, while yield farming relies on AMMs.

In farms, users earn APY rewards by locking assets; in liquidity mining, users receive liquidity provider tokens (LP tokens) or governance tokens.

Crowdfunding

While crowdfunding has existed for a long time, DeFi significantly lowers the barriers. The combination of decentralized power and crowdfunding has spawned new financing and earning models.

DeFi projects allow users to invest crypto assets in exchange for future rewards or project shares. Users can also initiate community-supported social projects, enabling P2P crowdfunding with transparent profit sharing.

Risks of DeFi: Unavoidable Challenges

Despite promising prospects, DeFi involves risks alongside opportunities:

Smart Contract Vulnerabilities

DeFi protocols run on smart contracts, which may contain exploitable bugs. According to Hacken, in 2022, DeFi hacks caused losses exceeding $4.75 billion, much higher than $3 billion in 2021. Hackers exploit critical software flaws to carry out attacks.

Fraud and Scams

High anonymity and lack of KYC make DeFi a breeding ground for scams. “Rug Pulls” and “Pump-and-Dump” schemes were frequent in 2020-2021, scaring off many investors. Recent trends show scammers stealing funds through mainstream DeFi protocols, which is a major obstacle for institutional investors.

Impermanent Loss

Due to high volatility in crypto assets, token prices in liquidity pools may change asynchronously. For example, if one token’s price surges while another remains stagnant, user returns can be severely impacted or even result in losses. While historical price analysis can mitigate some risks, extreme market volatility makes full risk elimination impossible.

Over-Leverage

Some DeFi derivatives and futures platforms offer leverage up to 100x. While high leverage can be attractive for successful trades, it also amplifies losses in volatile markets. Fortunately, reputable DEXs often provide reasonable leverage levels to prevent excessive borrowing.

Token Risks

Every token involved in DeFi investments should be carefully scrutinized, but this is often overlooked. Many users jump into new tokens without proper due diligence. High reward tokens carry high risk. Investing in tokens lacking developer credibility or community support can lead to significant losses.

Regulatory Risks

Although DeFi’s TVL reaches billions of dollars, current financial regulators have limited oversight. Many governments are still understanding this market and considering introducing regulations to protect investors. However, most DeFi users are unaware of this vulnerability. Investors harmed by fraud lack legal recourse and must rely on the security mechanisms of DeFi protocols themselves.

The Future of DeFi: Innovation and Competition

DeFi has the potential to serve billions worldwide. The ecosystem has evolved from a few applications into a complete, open, trustless, borderless, and censorship-resistant financial infrastructure.

These core applications lay the foundation for developing more complex services like derivatives, asset management, and insurance.

Ethereum holds an absolute advantage in DeFi due to network effects and flexibility, but alternative platforms are gradually emerging, attracting top talent. The ETH 2.0 upgrade, with sharding and PoS consensus, is expected to significantly improve Ethereum. We may see fierce competition between Ethereum and other smart contract platforms in the DeFi ecosystem.

Summary of Key Points

1. DeFi Definition: An open financial system built on blockchain, democratizing finance by removing intermediaries

2. Core Value: Solving trust issues in centralized systems, providing financial services to everyone globally

3. Technical Foundation: Smart contracts automatically execute preset conditions, enabling full decentralization

4. Competitive Advantages: Compared to TradFi and CeFi, DeFi offers greater transparency, faster speeds, more user control, 24/7 availability, and better privacy

5. Core Applications: DEX, stablecoins, and lending services form the ecosystem backbone

6. Earning Paths: Multiple options like staking, yield farming, liquidity mining, and crowdfunding

7. Risk Checklist: Code vulnerabilities, scams, impermanent loss, leverage risks, token risks, regulatory uncertainty

8. Development Outlook: DeFi will continue to innovate and expand, but users should understand risks and conduct due diligence

Decentralized finance represents a new paradigm in financial services — more inclusive and transparent. With technological progress, DeFi is poised to reshape the global financial landscape, providing unprecedented access to financial tools for people around the world.