8.1 What is DeFi and Does It Replace Banks?

DeFi stands for Decentralized Finance. It refers to a system of financial services built on blockchain networks, primarily Ethereum, using smart contracts to automate financial transactions without needing centralized intermediaries such as banks, brokers, or payment processors.

Key components include:

Smart Contracts
These are self-executing programs written on blockchains. They automatically carry out actions when certain conditions are met (e.g. "If user deposits collateral, then issue loan"). Once deployed, they operate without needing trust in a third party—no bank or human needs to approve the transaction.

Blockchain / Distributed Ledger
This is the underlying technology that records all transactions in a permanent, transparent way. Public blockchains like Ethereum allow anyone in the world to see transaction history, verify activity, and audit protocols—no central authority controls or edits the record.

Tokens / Crypto-assets
These are digital assets used within DeFi for a variety of purposes:

• Currency: Used for payments or trading (e.g. ETH, USDC).
• Collateral: Locked in smart contracts to back loans.
• Rewards: Given as incentives to participants (e.g. liquidity providers).
• Governance: Allow users to vote on protocol changes (e.g. through DAOs).

How DeFi Replaces / Challenges the Role of Banks

Traditional Bank Functions

• Custody: Banks hold customer funds and manage access to them.
• Intermediation: Act as middlemen—taking deposits, issuing loans, processing payments, clearing trades.
• Regulatory Compliance: Follow government laws (KYC, AML) to monitor customers and prevent illegal activity.
• Limited Access: Operate during business hours, charge fees, require documentation, and may exclude users due to location or income.

How DeFi Differs

• User Custody: Users control their own funds using crypto wallets and private keys. No bank or third party holds your money—you're responsible for it.
• No Traditional Intermediaries: Smart contracts automate services like lending, borrowing, or earning interest. Trust is placed in open-source code and the security of blockchain consensus, not a human-run institution.
• Permissionless Access: Most DeFi platforms are global and open 24/7. Anyone with a crypto wallet and internet connection can use them—there's usually no need to provide an ID or go through credit checks (although this may change as regulation grows).
• Transparency and Auditability: All transactions and protocol rules are visible on the blockchain. Users can see how funds are managed, how much collateral is held, and where fees go. This level of transparency is rare in traditional finance.

Limitations vs Banks

• Lack of Legal Protections: There is typically no government-backed deposit insurance (like FDIC), and limited legal recourse if something goes wrong—whether it’s a hack, scam, or lost funds.
• Smart Contract and Security Risks: Bugs in the code or poorly written contracts can be exploited. Price volatility and sudden drops in collateral value can lead to automatic liquidations.
• Technical Complexity: Users need to understand how to use wallets, sign transactions, manage private keys, and interact with dApps. Mistakes (like sending funds to the wrong address) are often permanent and unrecoverable.
• Service Gaps: Some traditional financial services—like long-term mortgages, handling of physical assets (e.g. property), or legal enforcement—are hard to replicate or enforce purely through code.

DeFi doesn't fully replace banks, especially when it comes to regulation, consumer protection, and ease of use. However, it offers powerful alternatives for certain services—like lending, trading, and earning yield—especially for people who are tech-savvy, globally connected, or underserved by traditional banks. As the space evolves, DeFi may continue to grow alongside or even integrate with traditional financial systems.