what is decentralized finance (DeFi)?

what is decentralized finance (DeFi)?

written by John Murphy | November 12, 2022

Decentralized finance (DeFi) is an emerging financial system that works on secure distributed ledgers like cryptocurrencies. DeFi aims to democratize finance, challenging traditional institutions by shifting control to users. we will further explore and answer the question – what is decentralized finance (DeFi)? The peer-to-peer relationship tends to provide a full spectrum of financial services.

Despite DeFi being an evolving system, it has already gained enough attention from leading global corporations. Many experts rate it as the future of international financial trade. It has grown to manage and provide services, including everyday banking, mortgages, loans, asset trading, and complicated contractual relationships.

Furthermore, DeFi uses complex digital technologies to empower owners to control their assets completely, thus virtually eliminating dependence on traditional financial institutions. 

Without further ado, let’s get started.

Traditional Centralized Finance

To understand DeFi, let us first know the opposite and existing system, centralized finance. Today, almost every financial transaction managed by a centralized system operated by governing bodies acting as gatekeepers.

In a centralized, no individual can bypass the set rules and regulations. Thus, effectively taking away complete control from the users and putting it in the hands of the governing bodies. 

They resultantly leave consumers with no direct access to capital and financial services. They must go through intermediaries like lenders, banks, and exchanges, which earn money by applying commission charges on each transaction. We all pay to play.

The new way: Decentralized Finance

DeFi is changing the financial scene by empowering consumers and removing middlemen and gatekeepers through a peer-to-peer exchange. In other words, decentralized finance is unbundling traditional finance.

Here’s how it works. Today, you can earn 0.5% interest by investing in a bank. On the other hand, a bank lends that money to another customer and gets 3% interest while pocketing 2.5% profit. With DeFi, consumers can bypass banks, lend their money directly to others, and take home that 2.5% interest with them.

However, I already send money through PayPal, Venmo, or CashApp. But you don’t. You still need a bank account or debit card to make such transactions. So even though it seems like a peer-to-peer transaction, it still depends on financial middleman institutions.

Consequently, DeFi jumps in and resolves the external control problems. DeFi applications provide users more control over their finances through personal wallets. You can trade, lend and borrow whenever you have an internet connection through software that verifies and records financial transactions.

Furthermore, DeFi uses advanced security protocols, software, hardware, and connectivity advancements to provide an end-to-end mechanism.

How does DeFi work?

Just like cryptocurrency, DeFi uses blockchain technology. Dedicated applications known as dApps are used to make transactions through a blockchain, which is a distributed ledger or database.

Transactions are in blocks in the blockchain and are then verified by other users. Upon verification, the block encrypts and closes. Subsequently, a new block is created, which contains information about the previous block.

For this reason, it is called a blockchain, as verified blocks chained together and contain information about the preceding block. Further, the data, once recorded, cannot change. The unchangeable feature provides a security protocol, thus making blockchain highly secure.

Uses of DeFi

One of the most vital promises of DeFi is that it delivers peer-to-peer (P2P) financial transactions. A P2P mechanism directly involves only the buyer and seller without the participation of any third party.

P2P can quickly meet individual loan requirements, an algorithm will match peers that agree on the lender’s terms, and a loan can issue. Payments made by a decentralized application (dApp) and work on the same lines as blockchain technology.

A few essential uses of the DeFi system include the following;

  • Accessibility: Anyone with an internet connection can use the DeFi platform, regardless of geographic restrictions. 
  • Security:     Since blockchains are immutable, hence they become highly secure. Smart contracts are complex mathematical algorithms that are difficult to break and hack.
  • Low Fees:    Consumers do not have to pay commission fees while transacting through DeFi. They can mutually agree to interest rates between them, thus avoiding the drainage of finances to a third party.
  • Transparency: DeFi transactions are highly transparent. Any user with a valid account can view details of trades, thus increasing visibility and avoiding any hidden charges scenarios.
  • Autonomy: DeFi platforms are autonomous and do not rely on centralized governing bodies. Thus, they are not at risk of bankruptcy or adversity.

Pros and Cons of DeFi

A few advantages and disadvantages of DeFi are here:

  • Pros
  • High level security
  • Transaction speed is fast
  • No geographical restriction
  • Safe and secure
  • Easy accessibility
  • Cons

  • Highly volatile
  • Risk of fraud and scam
  • Complex mechanism

Future of DeFi

Decentralized finance is an infant idea; it has a fair share of flaws and is prone to infrastructural mishaps, scams, and hacks.

Many financial experts see it flourishing in the future; however, they want it to have a set package of rules and regulations. As otherwise, it may lose control and die an early death.

A few valid questions about DeFi platforms, like who will investigate a crime and who is responsible in case of scam or fraud. Furthermore, there are concerns about system stability, carbon footprints, energy requirements, hardware failures, and system maintenance.

Despite all the concerns, DeFi is flourishing at a rapid pace. 

Frequently Asked Questions

Is Bitcoin a decentralized finance?

Bitcoin is not a DeFi but a part of the broader DeFi system. Since DeFi designs to use cryptocurrency in its ecosystem, they work hand-in-hand.

Who controls the DeFi system?

DeFi does not have a central governing body; it works autonomously. 

What is meant by total value locked (TVL) in DeFi?

TVL is the sum of all cryptocurrencies deposited, loaned, and staked across all DeFi systems.

What are examples of DeFi?

Two known examples of DeFi include Aave (AAVE) and Synthetix (SNX).

Which cryptos are DeFi?

Maker, Compound, Uniswap, Aave, Chainlink, and Ankr are famous cryptos that are DeFi coins.

Parting Thoughts

So, what is decentralized finance (DeFi)? It is an emerging financial system that works against the existing law of a centrally controlled system. 

DeFi is an autonomous system that empowers consumers by neutralizing middlemen and gatekeepers. It aims to shift complete control of finances back to users. Furthermore, the transactions carried out on a blockchain-to-peer mechanism.

In addition, DeFi offers easy accessibility to all those persons who have an internet connection. However, there is still a long way for DeFi to establish itself as the primary financial system.

Please leave your thoughts and enlighten us about your thoughts on what is decentralized finance (DeFi). The comments section is open to you.