Decentralized Finance: From Basic Financial Principles to Financial Revolution

Definition and Nature of DeFi

DeFi – short for Decentralized Finance – is a financial ecosystem built on blockchain platforms, operating on a peer-to-peer (P2P) model without intermediaries. Completely different from traditional finance, DeFi leverages blockchain technology combined with fundamental financial principles such as credit, payments, derivatives, and exchanges to create an open, transparent, and borderless financial system.

Financial primitives – or basic building blocks of finance – serve as the foundation for the entire DeFi ecosystem. These financial principles, when combined through smart contracts, generate complex and flexible financial applications, allowing users to access financial services that were previously only available through large institutions.

In December 2021, the total value locked (TVL) in DeFi protocols across leading blockchains exceeded $256 billion, nearly quadrupling compared to a year earlier, reflecting the sector’s rapid growth.

Why DeFi Is Important: Solving Global Issues

Centralization and Lack of Trust

Traditional finance relies on centralization – financial institutions act as intermediaries between buyers and sellers. However, financial history shows that centralization often leads to crises, hyperinflation, and market manipulation affecting billions. DeFi offers an alternative – removing intermediaries and empowering users with direct control.

Unequal Financial Access

The numbers show: 1.7 billion adults worldwide still lack bank accounts and cannot access basic financial services like savings or borrowing. Strict KYC requirements, high banking fees, and geographical limitations of traditional finance create significant barriers. DeFi breaks down these barriers by providing open access for everyone – all you need is a wallet address and an internet connection.

With DeFi, a user anywhere in the world can borrow money in under 3 minutes, open a savings account almost instantly, send international payments at high speed, or invest in favorite companies through tokenized securities.

How It Works: Smart Contracts and Blockchain

DeFi is based on smart contracts – self-executing programs stored on the blockchain. When conditions are met (for example: sufficient collateral), the contract automatically executes without third-party intervention.

Ethereum pioneered the concept of smart contracts with the Ethereum Virtual Machine (EVM). EVM allows developers to write code in Solidity or Vyper, compile it into bytecode, and run it on the network. Thanks to this flexibility, Ethereum has become the second-largest blockchain after Bitcoin.

However, Ethereum is not the only platform. Alternatives like Cardano, Polkadot, TRON, EOS, Solana, and Cosmos also support smart contracts with different approaches to address scalability, interoperability, and transaction throughput issues.

Practical data shows Ethereum dominates: out of 7,250 smart contracts deployed across various platforms (as of November 2022), 4,900 contracts (67.5% market share) are on Ethereum. Among 202 DeFi projects, 178 (88%) operate on Ethereum.

DeFi vs Traditional Finance: Core Differences

Transparency

By removing intermediaries, DeFi offers a new level of transparency. Processes, interest rates, and mechanisms are clearly defined in smart contracts – everyone can verify. In contrast, centralized (CeFi) operates as a “black box,” where users must trust organizations.

Speed and Cost

An international bank transfer can take days and involve multiple intermediary fees. With DeFi, similar transactions can be completed in minutes at significantly lower costs, as there are no middlemen taking a cut.

User Control

DeFi gives users full control over their assets via private keys. This is both an (advantage)—not worrying about theft by organizations—and a responsibility (to protect your keys).

24/7 Operation

Traditional financial markets close on weekends and during business hours. DeFi operates nonstop, allowing users to trade anytime, maintaining more stable liquidity.

Blockchain Security

Smart contracts use blockchain encryption, making data tamper-proof. The P2P model ensures all participants can monitor and verify, preventing internal manipulation as seen in traditional financial institutions.

Basic Financial Primitives of DeFi

Decentralized Exchanges (DEX)

DEXs enable users to trade crypto assets P2P without KYC or geographical restrictions. Unlike centralized exchanges, DEXs only support crypto-to-crypto trading.

There are two main models:

• Order book-based DEX: operates like traditional exchanges, where buyers and sellers meet via order books
• Liquidity pool-based DEX: uses AMM (Automated Market Maker), allowing token pair trades without direct counterparty

DEXs have accumulated over $26 billion in TVL, becoming a vital part of DeFi.

Stablecoins – Stable Digital Assets

Stablecoins are cryptocurrencies pegged to a stable external asset (USD, EUR) or other assets, aiming to limit price volatility. Stablecoins are the backbone of DeFi, with a total market cap exceeding $146 billion over five years.

There are four main types:

• Fiat-backed: USDT, USDC, PAX, BUSD – backed by fiat currency
• Crypto-backed: DAI, sUSD – collateralized by over-collateralized cryptocurrencies
• Commodity-backed: PAXG, DGX, XAUT – backed by gold, silver
• Algorithm-backed: AMPL, ESD – controlled by algorithms, no collateral required

Many stablecoins now use hybrid models, combining multiple sources for higher stability. A unique feature: “chain-agnostic” stablecoins, as their value is pegged to external assets, allowing Tether to exist on Ethereum, TRON, OMNI, and other platforms simultaneously.

Credit: Lending and Borrowing

The lending market is the largest in DeFi, accounting for over 50% of total TVL (39.25 billion USD out of 77.32 billion USD).

Unlike traditional banks, DeFi lending does not require:

• Complex credit assessment
• Detailed financial history
• Lengthy processing times

All you need is: sufficient collateral + a wallet address. Lenders earn interest, borrowers get quick access to funds. Profits are distributed based on net interest margin (NIM), similar to traditional banks but fully decentralized.

How to Earn Income from DeFi

Staking

Users hold tokens using Proof of Stake (PoS) mechanisms and receive rewards. Staking pools function like savings accounts, allowing you to deposit crypto to earn interest over time. DeFi protocols put tokens into use and distribute rewards to the investor community.

Yield Farming (Khai Thác Lợi Suất)

This is an advanced staking strategy. Users provide liquidity to DEX pools, earning trading fees and governance tokens as rewards. AMM (Automated Market Maker) uses algorithms to facilitate trading without intermediaries.

Liquidity Mining (Khai Thác Thanh Khoản)

Although often confused with yield farming, liquidity mining focuses on providing liquidity directly via smart contracts and liquidity providers ###LP###, rather than through AMMs. Rewards can be LP tokens or governance tokens.

Community Fundraising (Huy Động Vốn Từ Cộng Đồng)

Users can invest crypto into projects seeking funding in exchange for rewards or equity. This method also enables fundraising for social activities, creating transparent rewards without third-party permission.

Risks Facing DeFi

( Software Vulnerabilities

Smart contracts can contain bugs. According to ImmuneFi, over $3.2 billion in crypto was stolen from DeFi projects in 2021, and over $1 billion in the first three months of 2022 due to exploits.

) Fraud and Scams

High anonymity and lack of KYC create opportunities for scams like rug pulls ###sudden liquidity withdrawal### and pump-and-dump ###artificial price increases then dumping###. Recently, many scam projects have stolen funds from investors.

( Loss Risks

Due to high price volatility, providing liquidity to a DEX pool can result in losses if one token rapidly increases while another grows slowly, compared to just holding the original tokens. This risk is hard to eliminate entirely due to market unpredictability.

) High Leverage

Some derivatives platforms offer leverage up to 100x. While high leverage can lead to big wins, it can also cause devastating losses, especially during volatile markets.

( Token Risks

Many investors buy new tokens without proper due diligence. Tokens without reputable developers or backing can lead to total loss of investment.

) Legal Risks

Although DeFi TVL reaches billions of USD, regulatory authorities have not yet established clear rules. If scammed, investors have no legal recourse to recover funds – they can only rely on protocol protections.

Future Outlook of DeFi

DeFi has evolved from just a few DApps to a truly alternative financial infrastructure – open, trustless, borderless, and free from centralized control. Basic financial primitives are combined to create more complex applications: derivatives, asset management, insurance, etc.

Ethereum currently dominates due to network effects, but competition from other platforms will continue. The ETH 2.0 upgrade with sharding and Proof of Stake (PoS) will improve scalability. Meanwhile, other platforms will continue technological advancements to gain market share in the emerging DeFi ecosystem.

Summary: Key Points About DeFi

1. DeFi is a blockchain-based financial system aimed at democratizing finance by removing intermediaries and increasing accessibility.

2. The importance of DeFi lies in addressing distrust in centralized systems and expanding financial access to 1.7 billion unbanked people.

3. DeFi operates through smart contracts on blockchain – self-executing programs triggered by conditions.

4. Compared to traditional finance, DeFi offers higher transparency, faster transactions, better control, 24/7 operation, and blockchain security.

5. Main financial primitives include: DEX (decentralized exchanges), stablecoins stable assets, and credit lending/borrowing.

6. Income opportunities: staking, yield farming, liquidity mining, community fundraising.

7. Main risks: software bugs, scams, temporary losses, high leverage, token risks, regulatory uncertainty.

8. Future prospects: DeFi will continue to grow with more complex applications, competition among blockchain platforms, and technological improvements to expand global financial access.

Decentralized finance offers a new approach to financial services – transparent, efficient, and more accessible. As technology advances, DeFi has the potential to reshape the global financial landscape and bring financial tools to everyone, regardless of location or economic status.