Decentralized finance, or DeFi, is defined as an evolving paradigm to arrange and allow transactions related to cryptocurrency, financial services, and exchanges.
In DeFi, the authority is distributed in a decentralized way, as the name says. Transactions related to the purchase, sale, payments, and loans with crypto are possible without the need for a central authority in a P2P approach.
Be it any financial model, the custody of assets is a basic element. When talking about DeFi, each trader has authority over the private cryptographic encryption keys, thus allowing custody of crypto assets.
Here, financial transactions are allowed with smart contracts that are usually supported on blockchains based on Ethereum.
Difference between DeFi and centralized finance
Centralized finance is the financial model in which the world is currently functioning for payments, trading, loans, and other financial solutions. It involves third parties as well as intermediaries who are administered by local regulators.
In centralized finance, not only certain people are denied from opening a bank account but are also deprived of accessing certain financial solutions.
The exact opposite is DeFi, which lets everyone transact via financial apps through blockchain. This way, middlemen like banks are eliminated, and financial services become even more accessible with reduced costs and increased speed.
What distinguishes DeFi from centralized finance prominently is the fact that the former also supports those who are otherwise denied from accessing banking and other financial services.
How does decentralized finance work?
DeFi deploys the distributed ledger technology of blockchain to function like an accessible database and record transactions.
Users engage with the decentralized finance ecosystem via decentralized applications, which use smart contracts for transactions. It is the smart contracts that are behind making peer-to-peer transactions possible without depending on a central controlling authority.
When a smart contract begins, both parties accept the same terms of the transaction followed by which they are hard-coded in the same contract. The transaction completes and is recorded on the blockchain when the accepted terms of the contract are met.
Decentralized finance platforms provide a safe system for the recording of transactions upon using blockchain attributes like encryption and distributed networks. As a result, it is not possible to change or edit the information on the DeFi network, which eventually boosts both its integrity as well as authenticity.
Last but not least, most of the DeFi activity happens on Ethereum.
Uses of DeFi
Decentralized finance has ample uses. Check out some of the best ones below:
Accessibility
A DeFi platform can be easily accessed with only an internet connection and without geographic restrictions.
High interest
Two parties can directly negotiate the rate of interest as well as lend funds through DeFi networks.
Transparency
Anyone can review smart contracts that are based on a blockchain. They can also review records of transactions that are complete.
Security
DeFi platforms are not vulnerable to bankruptcy or trouble. Such risks have negligible chances owing to the decentralized nature of DeFi protocols.
Payments
Peer-to-peer payments are possible without depending on a central authority.
Yield farming
It allows receiving interest income on crypto to those who utilize decentralized finance like an investment.
dApps
Decentralized apps operate on decentralized finance and allow various sorts of use cases, which also include gaming and financial services.
Benefits of decentralized finance
Just as there are multiple uses for DeFi, its advantages are unlimited too. Below are listed some of the prominent ones.
Instant
There’s no need to apply for something or open an account. All that’s required is creating a wallet.
Anonymous
There’s no need to share personal details like names, contact numbers, and email addresses.
Adaptable
Assets can be transferred irrespective of location and time. There’s no need to seek approval, pay hefty fees, or wait for long transfers to end.
Transparent
As compared to private corporations, DeFi allows everyone to view the complete set of transactions.
Downside of decentralized finance
Despite loads of benefits, DeFi is associated with certain disadvantages too.
High cost
The transaction rates are not fixed on Ethereum, which leads to the possibility of expensive active trading.
Volatility
DeFi approaches are volatile due to the absence of a central authority that controls or restricts transactions or the momentum of the market.
Maintenance
For matters of tax, one has to maintain their records, as regulations differ from one region to another.
Complexity
DeFi is complicated, and this is the biggest challenge with it. Not everyone can understand smart contracts and the algorithms used by the technology.
Customer service
Since there’s no authority or service, customer service might not be an easy and pleasant experience.
Security
Attackers have targeted DeFi platforms in recent years, and issues like theft have happened.
Popular DeFi applications
Certain DeFi applications that also happen to be the most popular ones include:
Decentralized exchanges
DEXs are exchanges that link users directly and allow them to trade crypto with each other without depending on an intermediary.
Stablecoins
These digital currencies restrict the volatile nature of cryptocurrency by pegging a coin’s value to some other commodity, asset, or currency.
Lending platforms
By using smart contracts, these platforms replace intermediaries like banks that act as middlemen to handle lending.
Wrapped Bitcoins
It is a way to send Bitcoin to Ethereum; thus, allowing the Bitcoin to be utilized directly in the DeFi system of Ethereum. With WBTCs, users can get interest on the bitcoin they lend through the lending platforms.
Prediction markets
These are markets that enable users to place bets on the results of future events. Prediction markets are based on real-life events, and the focus remains on the price fluctuations of the underlying asset.
Is decentralized finance safe?
DeFi is still a new technology, which is the reason behind the possibility of negative outcomes. Companies depending on decentralized finance might not get the desired output. Also, there are chances of mistakes by programmers, which is something that can benefit hackers.
While the Federal Deposit Insurance Corporation insures centralized financial institutions, there’s no way to recover the lost money in the case of DeFi platforms.
There’s no denying that many people consider DeFi to be the future of finance, and early investment can bring profits. But the fact that the popularity of DeFi has led to many DeFi applications crashing and burning can’t be ignored. As a result, a number of investors have lost ample money.
DeFi bugs are another issue, and since it is impossible to change smart contracts after applying the rules in the protocol, such bugs become sort of permanent and enhance risk.
Investing in DeFi
Investment in DeFi can be done in multiple ways, with the easiest option being the purchase of Ether or another coin that is based on the DeFi technology.
The cryptocurrency can be deposited through a DeFi lending platform, and interest on holdings can be earned. Moreover, depositing funds for a long time will lead to higher interest rates.
Yield farming, a concept mentioned earlier, is another way. What happens is that yield farmers deposit funds on the platform that pays maximum rate of interest or any type of incentive. These farmers keep an eye on the ongoing interest rates as well as incentives that are provided by other platforms.
Once the other platform ensures a better incentive, these farmers transfer their deposits to that particular platform for increased profits.
UNI, the token of Uniswap, is one more way and is meant for those who want to have a role in deciding the future of DeFi protocols. With UNI, they get the decision-making right in proportion to their holdings.
The future of DeFi
Decentralized finance is evolving and currently, is unregulated. Energy requirements, system maintenance and stability, hardware failures, carbon footprint, energy needs, and system upgrades are major concerns of DeFi.
However, decentralized applications have immense potential, as they can act as middlemen between institutions. By doing so, they can make way for an open as well as financially comprehensive marketplace in which pricing is decided on the basis of market forces and transactions happen via a protected technology.
All in all, DeFi has the ability to redefine the world economy. Making the unbanked people a part of the economic system and providing investment opportunities worldwide, decentralized finance is likely to dominate the world.
