What Is DeFi? Decentralized Finance Explained
Crypto Guides
Crypto Guides
May 25, 2023

What Is DeFi? Decentralized Finance Explained

Bitcoin at its core is a payment system in which anyone on planet earth can send money to anyone else. This simple premise was the foundation of the cryptocurrency revolution. Those building Decentralized Finance, or DeFi for short, hope to create applications which take that simple idea further than Satoshi Nakamoto could’ve ever imagined.

What Is DeFi?

Decentralized finance is an umbrella term for financial services on public blockchains. DeFi offers financial instruments without relying on intermediaries such as brokerages, exchanges, or banks by using smart contracts on a blockchain. No centralized authority can block payments or restrict your access to anything, so the market is always open. Previously time-consuming and vulnerable to human error, services have been automated and made more secure due to the code's openness.

In addition to lending, borrowing, trading, and earning interest on cryptocurrencies, there are many other options. Argentinians who are well-versed in the cryptocurrency have used DeFi to avert a currency crisis. Employees are increasingly being paid in real-time at their workplaces. Millions of dollars in loans have been secured and repaid by borrowers who have not disclosed any personal information.

The Old Way Of Finance

In order to fully comprehend how DeFi works, one must first understand how it differs from traditional centralized finance models.

Banks are for-profit corporations whose primary objective is to maximize shareholder value. While money moves through the financial system, third parties collect a fee for their services. Banks that accept credit cards send their customers' personal information to third-party credit card networks for onward transmission to merchants.

Your bank is contacted by the network to collect payment for the cleared charge. After your bank has approved the charge, your acquiring bank will email you. Because merchants have to pay for the use of credit and debit cards, every organization in the chain is compensated for its services.

A New Age

Consumers, businesses, and merchants can now transact money directly through new technologies. Private financial networks employ a wide range of technologies to protect their customers' personal information.

Software that records and verifies transactions in distributed databases enables anyone with an internet connection to lend, trade, or borrow from anywhere. All user data is gathered and aggregated using consensus-based verification in a distributed database.

Virtually anyone can access financial services, regardless of their identity or location. With the help of DeFi apps, customers can access personal wallets and trade services.

How Does DeFi Work?

DeFi uses cryptocurrencies and smart contracts to provide financial services, eliminating the need for intermediaries such as guarantors and other third parties. Loaning (where users can lend their cryptocurrency and earn interest in minutes rather than once a month), receiving a loan instantly, making peer-to-peer trades without using a broker, saving cryptocurrency . Earning a higher interest rate than a bank, and purchasing derivatives such as stock options and futures contracts are all examples of services that fall into this category.

Decentralized applications (dApps) allow users to conduct peer-to-peer business transactions. The Ethereum network hosts the majority of these applications. Coins (Ether, Polkadot, Solana), stablecoins (whose value is tied to a currency such as the US Dollar), tokens, digital wallets (Coinbase, MetaMask), DeFi mining (a.k.a. liquidity mining), yield farming, staking, trading, and borrowing, lending, and saving using smart contracts are just a few examples of DeFi services and dApps.

The term "open source" refers to DeFi's protocols and applications being theoretically available for users to inspect and improve. As a result, users can combine protocols to create unique combinations of opportunities when creating their own decentralized applications (dApps).

Here are some of the ways people are engaging with DeFi today:

  • Lending: Lend your cryptocurrency and earn interest and rewards every minute, not just once a month.
  • Getting a loan: Get a loan right away without having to fill out any paperwork, including extremely short-term "flash loans" that traditional financial institutions do not provide.
  • Trading: Make peer-to-peer trades of specific crypto assets, just as you would if you were buying and selling stocks without the use of a brokerage.
  • Saving for the future: Put some of your cryptocurrency in a savings account alternative to earn higher interest rates than you would typically get from a bank.
  • Buying derivatives: Place long or short bets on specific assets. Consider these to be the cryptocurrency equivalent of stock options or futures contracts.

Why DeFi Will Change The World

DeFi expands on Bitcoin's basic premise — digital money — to create an entire digital alternative to Wall Street without all of the associated costs (think office towers, trading floors, banker salaries). This can create more open, free, and fair financial markets that anyone with an internet connection can access.

So what are the benefits?

  • Openness: You do not need to submit an application or "open" an account. You simply need to create a wallet to gain access.
  • Pseudonymous: Your name, email address, or other personal information is not required.
  • Flexible: You can move your assets wherever you want, whenever you want, without having to ask permission, wait for long transfers to complete, or pay exorbitant fees.
  • Fast: Interest rates and rewards are frequently updated (as often as every 15 seconds) and can be significantly higher than those found on traditional Wall Street.
  • Transparent: The entire set of transactions is visible to everyone involved (private corporations rarely grant that kind of transparency)

DeFi Weaknesses

Given that Ethereum is the most popular DeFi blockchain, fluctuating transaction rates can make active trading on the Ethereum blockchain very costly.

Your investment may experience high volatility depending on which dapps you use and how you use them – after all, this is new technology.

For tax purposes, you must keep your own records. Regulations differ from one region to the next.

There are fewer middlemen in DeFi, which means a new, active financial sector with the potential to be highly successful. Overall market effect may be considerable in the near future as well. Don't get carried away with the prospect of these assets; they're still in the early phases of development. It's now possible to access a broad range of functionality depending on the many alternatives that are accessible, and many of these programs may be obtained online.

The Future Of DeFi

While still in its infancy, the development of the Decentralized financial ecosystem can be clearly seen. There are still a few areas that need to be filled up. The new technology is on the approach of becoming as mainstream as bank cards and fiat cash, if not more so.

What if you don't have to pay fees or take custody risk because you own your assets? That's a potential that DeFi developed from Dexes, and it's something that might be possible in the future. Due to the success of various platforms designed specifically for this purpose this year, DeFi has already surpassed it as the second-largest category.

As a matter of fact, the daily volume traded on Coinbase Pro has already eclipsed the daily amount traded on DeFi and has become a primary conduit for the launching of new currencies and protocols.

Creating payment methods without middlemen is the third major use of DeFi. As today's primary asset (Bitcoin) accomplishes exactly that, this is nothing new to the cryptocurrency world. Even yet, it's fascinating to consider how these apps are even addressing the Bitcoin issue. Despite how bizarre it may sound, Bitcoin has a scalability and performance issue in its transactions.

People may exchange synthetic BTC-backed tokens without utilizing the BTC blockchain, making blockchain transactions quicker and cheaper while also improving the value of BTC as a payment mechanism. For example, on the Ethereum Blockchain, renBTC and WBTC account for 0.5 percent of all Bitcoin in existence.