Decentralized finance (DeFi) is an emerging financial technology based on secure distributed ledgers similar to those used by cryptocurrencies. The system removes the control banks and institutions have on money, financial products, and financial services. With DeFi, the markets are always open and there are no centralized authorities who can block payments or deny you access to anything. Services that were previously slow and at risk of human error are automatic and safer now that they’re handled by code that anyone can inspect and scrutinize.
DeFi Vs Traditional finance
Some of the key attractions of DeFi for many consumers are:
- It does away with the usage fees that banks and other financial institutions impose.
- Instead of depositing your money in a bank, you keep it in a secure digital wallet.
- It can be used by anyone with an internet connection without authorization.
- Money transfers can be made in seconds or minutes.
Understanding Decentralized Finance (DeFi)
Understanding the differences between centralized finance and decentralized finance (DeFi) is helpful in understanding how DeFi functions.
In centralized finance, banks—companies whose main objective is to make money—hold your money. There are several third parties in the financial system that let people move money between parties, and each one charges for doing so. Consider buying a gallon of milk with your credit card as an illustration. An acquiring bank receives the charge from the merchant and sends the card information to the credit card network.
The network authorizes the charge and asks your bank to make a payment. Your bank authorizes the charge and relays the authorization to the network and back to the merchant through the acquiring bank. Because retailers are required to pay for your ability to use credit and debit cards, each link in the chain is paid for its services.
All other financial transactions are expensive, the loan approval process might take several days, and if you’re abroad, you might not even be able to use a bank’s services.
By enabling individuals, businesses, and merchants to perform financial transactions through new technologies, decentralized finance eliminates middlemen. Peer-to-peer financial networks that make use of connectivity, software, hardware improvements, and security protocols enable this.
You can lend, trade, and borrow using software that logs and validates financial transactions in distributed financial databases from any location with an internet connection. A distributed database allows access from multiple places, gathers data from all users, and verifies it using a consensus process.
This technology enables everyone to use financial services everywhere, regardless of who they are or where they are, eliminating centralized finance models.
Through individual-focused trade services and personal wallets, DeFi applications provide consumers with more control over their finances.
How does it work?
Blockchain technology, which underpins cryptocurrencies, is utilized by decentralized finance. Blockchains are decentralized, secure databases or ledgers. The blockchain is operated by programs known as “dApps,” which manage transactions.
Transactions on the blockchain are recorded in blocks and subsequently validated by other users. The block is closed and encrypted if these verifiers concur on a transaction, and a new block is formed with details about the old block inside of it.
The term “blockchain” refers to the way the blocks are “chained” together by the data in the blocks that come before them. There is no way to update a blockchain because doing so would have an impact on the blocks that came after. The secure aspect of a blockchain is provided by this idea in combination with other security methods.
One of the main tenets of DeFi is the use of peer-to-peer (P2P) financial transactions. When two parties agree to exchange cryptocurrencies for goods or services without the involvement of a third party, this is known as a P2P DeFi transaction.
Think about how you obtain a loan in centralized finance to completely comprehend this. You would have to apply for one at your bank or another lender. If accepted, you would pay interest and service charges in exchange for the right to use that lender’s services.
In DeFi, an algorithm would connect you with peers who may provide the loans you need after you entered your loan requirements in your decentralized financial application (dApp). To get your loan, you would then need to accept one of the conditions set forth by the lender.
The loan is disbursed to you following the consensus mechanism’s verification of the transaction, which is recorded in the blockchain. The lender will then be able to start getting payments from you at predetermined intervals. The same procedure is followed in the blockchain when you pay using your dApp, after which the lender receives the funds.
What can you do with DeFi?
- Trade tokens
- Grow your portfolio
- Fund your ideas
- Buy insurance
- Start crypto savings
- Send money around the globe
- Access stable currencies
- Borrow without collateral
- Manage your portfolio
What are the downsides?
Fluctuating transaction rates on the Ethereum blockchain means that active trading can get expensive.
Depending on which Dapps you use and how you use them, your investment could experience high volatility — this is, after all, new tech.
You have to maintain your own records for tax purposes. Regulations can vary from region to region.