Decentralized Finance (DeFi): A Definitive Guide
Cryptocurrencies have come a long way since making a remarkable history of innovation dating back to the 1980s. Since then, various things have happened that have influenced the crypto sector.
The debut of the original cryptocurrency, Bitcoin, back in 2009 was among the most notable. But even with Bitcoin's spectacular growth, financial services are not so open to Bitcoin, mainly due to its inherent instability and lack of adoption.
Since Bitcoin's price is highly volatile, mainstream institutions won't accept Bitcoin loans. Consequently, Bitcoin is not an asset you can easily use to plan any investment accurately.
In the digital world, things change quickly and the crypto world is not exempted from that. The rise of decentralized finance (DeFi) is paving its way into the cryptocurrency world. But what does it mean in the crypto world?
We'll look deeper into decentralized finance in this blog post and find out how its existence makes the crypto world more exciting.
What is Decentralized Finance?
Decentralized Finance (DeFi) is a financial platform based on blockchain technology. It provides financial instruments without intermediaries like brokers, exchanges, and banks.
In DeFi platforms, users can lend and borrow money, trade cryptocurrencies, insure against risks, speculate on asset price fluctuations via derivatives, and earn interest using decentralized infrastructure, such as public blockchains and smart contracts.
According to Rafael Cosman, CEO and co-founder of TrustToken “Decentralized finance is an unbundling of traditional finance. It gives ordinary people access to the essential components of the activity currently done by banks, exchanges, and insurers, such as lending, borrowing, and trading.”
DeFi removes the function of the intermediaries and transfers that power to everyday people via peer-to-peer exchanges.
The term "DeFi" was coined in 2018 by a group of Ethereum developers and crypto entrepreneurs who wanted to free finance applications from traditional systems. The abbreviation sounds like defy, which is a deliberate move.
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How DeFi Works
DeFi works on the core technologies of cryptocurrency and blockchain. These technologies help connect users without going through a central server and can secure assets and transfer data under the user's watch.
In a conventional transaction, all records of the transactions are in a private ledger managed by financial institutions. But decentralized finance uses blockchain technology to distribute all records of the transactions in a public ledger.
The distributed nature of blockchain is defined as each party possessing an identical copy of the public ledger, which records each transaction in encrypted form for a DeFi application.
A decentralized financial system eliminates gatekeepers and intermediaries. The verification of blockchain transactions and records are through parties using the identical blockchain, solving complex math problems, and adding new blocks.
This process ensures the system's security by providing users with anonymity, as well as authentication of payments and the ability to verify asset ownership (nearly) indefinitely.
A proponent of DeFi claims that the decentralized blockchain provides security and transparency over centralized financial systems that are opaque and private.
Different Uses of Decentralized Finance
There is no doubt that DeFi has already found its way to various financial transactions, whether it's simple or complex.
The good thing about DeFi is that it is readily available for public use (as long as you have access to the internet). There is no fee if you wish to access DeFi and that is probably one of the key factors driving the increase in usage. Moreover, you can modify and enhance it to fit the user's needs.
Though it may be free, for DeFi to work, you need a DeFi app to access it. In these transactions, a virtual wallet is necessary where you can store the "hard currency" in the blockchain.
For example, there are decentralized apps called "dApps" and programs called "protocols" that are useful in the two big players in the cryptocurrencies, Ethereum (ETH) and Bitcoin (BTC).
With these two apps alone, there are so many uses for DeFi:
- Digital wallets (E-wallets) - developers for DeFi are building digital wallets that can operate independently of cryptocurrency exchanges. These developments give investors access to everything from cryptocurrency to blockchain-based games.
- Modern financial transactions - You can borrow and lend money, trade securities, and insurance, and make payments with DeFi.
- Decentralized exchanges (DEXs) - Most cryptocurrency investors today use centralized exchanges such as Coinbase or Gemini. By facilitating peer-to-peer financial transactions, DEXs allow users to retain control over their assets.
- Flash loans - It is a cryptocurrency loan that uses smart contract rules to ensure that the borrower repays the loan before the transaction expires when a flash loan has been given. This function is a blockchain technology that stops money from moving from one account to another until you, as a borrower, can meet specific conditions.
Pros and Cons of Decentralized Finance
DeFi Pros
DeFi's ascent is on an upward trajectory since it has numerous practical applications, many of which are outside the scope of traditional fiat-based financial systems. The following are some advantages of DeFi:
Easy Access
Anyone with an internet connection and a cryptocurrency wallet can use DeFi services. Users also don't have to wait for bank transfers or pay fees to traditional banks in order to swap assets or move them wherever they wish.
Permissionless Transactions
Most financial transactions require the permission of an intermediary in the traditional financial system, but in DeFi, every individual can obtain financial services efficiently and effectively through DeFi. The DeFi approach is quite helpful in democratizing banking and finance.
Transparent Transactions
The majority of DeFi traffic transactions take place on the Ethereum blockchain, where each transaction is broadcast to and validated by all other network members. This level of transaction data transparency allows for the observation of network activity by any user.
Borrowing and Lending Capabilities
You can benefit substantially from such types of lending and borrowing solutions. DeFi borrowing and lending promises advancements in transparency, accessibility, and efficiency. Users who want to serve as lenders can deposit their coins into smart contracts built using the DeFi protocol. They will receive freshly created protocol-native tokens in exchange.
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Faster Transactions
Using DeFi for lending and borrowing would facilitate faster transaction settlement and improved accessibility. As DeFi eliminates intermediaries, verifying lending and borrowing applications is quicker and easier. Moreover, DeFi also protects counterparties in a transaction.
DeFi Cons
There are many advantages to DeFi in the digital world, but it also has some disadvantages. The following are some disadvantages of DeFi:
Scalability
DeFi projects face formidable challenges in scaling because it is dependent solely on blockchain technology. There are limits in terms of capacity to what blockchain technology can handle.
Transaction time and cost are two of the major disadvantages in terms of scalability for DeFi. In times of congestion, transactions can cost a lot of money and take a very long time to confirm.
Unregulated
Due to its decentralized nature,DeFi is unregulated. Traditional financial systems vet personal details to assess a loan applicant's debt level and other aspects. Public keys, however, which do not hold any personal data, represent the "identifier" in blockchain technology. It can be difficult to prevent fraud and other financial crimes because of this.
Liquidity Issues
You can consider liquidity one of the essential factors for DeFi token-based projects and blockchain protocols. For example, DeFi total value locked (TVL) at the end of 2021 went down to $199 billion from around $236 billion.
In light of this, the DeFi market is still less prominent than the traditional financial system. As a result, trusting a sector without a lot of experience can be difficult.
Threats from Hackers
Although hacking can also occur in traditional finance, DeFi's advanced technological design gives skilled hackers access to a larger attack surface with more possible points of failure.
Threats from Global Authorities
Regulators are showing more interest in the DeFi market. Global authorities are looking closely at unhosted wallets and DeFi in general.
To control the market, which is deemed a financial risk by the International Monetary Fund (IMF), they are looking to rein it in. Despite taking preliminary steps, regulators have yet to decide how to control a decentralized market.
Final Thoughts on DeFi
DeFi might be a pillar of the cryptocurrency economy. At the very least, it is one of the crypto industry's busiest segments regarding usage and development activity. However, despite how amazing it may look, it is still in the early stages of development. The ecosystem is still rife with frauds, hacks, and infrastructure failures.
Beyond the fundamentals of cryptocurrency trading, those wishing to begin with DeFi should approach cautiously and make sure they partner with a trustworthy counterparty. Although DeFi's yields are alluring, you shouldn't let the possibility of a return make you ignore the other hazards.
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