UNDERSTANDING DECENTRALIZED FINANCE (Defi) AND HOW IT WORKS

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.

Decentralized Finance aims to provide the same financial services as traditional banking without any central authority or intermediaries. Without a central authority, Defi allows everyone to engage with financial services for payments, lending, borrowing, or investing with high autonomy and fewer barriers.

Key attractions of Defi:

Some of the key attractions of Defi for many consumers include the following:

  • Defi eliminates the fees that banks and other third-party financial institutions charge for using their services.
  • With Defi, you hold your digital money in a secure digital wallet instead of keeping it in a bank.
  • The entry point is having an internet connection, with access to the internet, you can use it without needing any approval.
  • You can transfer and receive funds at the speed of the light.

The essence of this article is to enlighten you about the questions you may have regarding Decentralized Finance and to sharpen your knowledge around this fast-evolving concept:

What is Defi?

Decentralized finance (Defi) is a concept that refers to a new decentralized financial system that is built on public blockchains such as Ethereum, Binance Smart Chain, etc. In order for us to understand Defi, there’s a need to first understand centralized finance or Cefi.

Centralized Finance (Cefi)

In centralized finance, your money is held by banks, corporations whose major goal is to make money. The traditional financial system is full of third parties who facilitate money movement between parties, with each one charging fees for using their services.

For example, say you purchase a cup of coffee using your credit card. The charge goes from the merchant to the bank network, which in turn forwards the card details to the credit card network. The credit card network clears the charge and requests a payment from your bank. Your bank approves the charge and sends the approval to the network, through the acquiring bank, back to the merchant.

Each entity in the transaction process charge for their services, generally because merchants must pay for their ability to use credit and debit cards.

In addition, each and every financial transaction cost money; loan applications can take days before approval and there are limitations of not being able to use a bank’s services while on transit. Therefore, one of the major goals of decentralized finance is to reduce transaction time while increasing access to financial services.

Decentralized Finance

Decentralized finance eliminates middlemen by enabling people, merchants, business owners, etc to conduct financial transactions through evolving technology. This is basically made possible through a peer to peer financial networks that uses security protocols, connectivity, software, and hardware advancements.

Note that while taking control away from third parties, decentralized finance does not provide anonymity. Your transactions are traceable by the entities that have access, which might be law enforcement, government, or others that are authorized to protect people’s financial interests.

There are six vital points that differentiate between public blockchains from private networks managed by governments and the current financial institutions.

  • Programmable: Developers can program applications into low-cost financial services. Assets that are handled on the product have all the native attributes of conventional tokens on a decentralized network.
  • Transparency: Blockchain technology works slightly differently from the typical banking system. Instead of relying on centralized authorities, it ensures the Blockchain features through a collection of nodes. Every node on the system has a copy of the digital ledger. To add a transaction, every node needs to check it’s valid. If the majority think it’s valid, then it’s added to the ledger. This promotes transparency and makes it corruption-proof.
  • Decentralized: the network is decentralized meaning it doesn’t have any governing authority or a single person looking after the framework. This allows users to access it from the web and securely store our assets there.
  • Trustless: as it gets rid of the need for a central authority, no one can just simply change any characteristics of the network for their benefit. Using encryption ensures another layer of security for the system. Every information on the Blockchain is hashed cryptographically.
  • Distributed Ledgers: a public Blockchain is distributed, meaning the ledger provides every information about a transaction and the participants. It’s all open, nothing to hide.
  • Consensus: every Blockchain thrives because of the consensus algorithms. The architecture is well designed, and consensus algorithms are at the core of this architecture. Every Blockchain has a consensus to help the network make decisions. Consensus is a decision-making process for a group of nodes active on the network.

Understanding Defi

As noted earlier, Defi is an abbreviation of decentralized finance, a term for products and services built as open-source financial software on top of blockchain technology that can be pieced together like money legos via shared infrastructure.

One of the most unique parts of Defi is its constituent “smart contracts”, which power everything from programmable digital assets to decentralized applications (DApps). Smart contracts are publicly accessible and highly interoperable. So like lego pieces, projects in Defi can easily connect together to create powerful new innovations.

Accordingly, decentralized finance is exciting because it’s leading to a constant influx of novel opportunities that can financially empower users across the globe in unprecedented ways. This, Defi is creating an alternative financial system that’s open to everyone and minimizes one’s need to trust and rely on centralized authorities.

Technologies such as the internet, cryptography, and Blockchain give us the tools to collectively build and control a financial system for the users, by the users; resulting in financial democracy. Defi is the culmination of these tools and the effects of global communities of early builders and users, all collectively committed to pushing beyond the limits of mainstream finance.

Almost all Defi applications today are built on the Ethereum Blockchain, the world’s most popular programmable Blockchain. Ethereum is a network technology that maintains a shared ledger of digital value. Instead of a central authority, the participants that comprise the network control the issuance of ether (ETH), the native cryptocurrency, in a decentralized manner.

Developers can program applications on Ethereum using smart contracts that can create, store and manage digital assets on the Blockchain. Smart contracts come in many varieties, and you can connect them to create different kinds of decentralized applications (DApps). There are smart contract standards like ERC-20 and ERC-721 that provide easy templates for creating tokens and NFTs, respectively.

How does Defi work?

Decentralized finance is an open and global financial system built for the internet age; an alternative to a system that’s opaque, tightly controlled, and held together by decades-old infrastructure and processes. It gives you control and visibility over your money.

Defi uses cryptocurrencies and smart contracts to provide services that don’t need intermediaries. In today’s financial world, financial institutions act as guarantors of transactions. This gives these institutions immense power because your money flows through them. In addition, billions of people around the world do not have access to financial services or bank account.

In Defi, smart contracts replace the financial institutions in the transaction. Smart contracts are lines of code that are programmed to hold funds or tokens, and can also send or receive under certain conditions.

Furthermore, Defi is built on blockchains as stated earlier, and in blockchains; transactions are recorded in blocks and then verified by other users. If these verifiers agree on a transaction, the block is closed and encrypted; another block is created that has information about the previous block within it.

The blocks are “chained” together through the information in each proceeding block, giving it the name blockchain. Information in previous blocks cannot be changed without affecting the following blocks, so there is no way to alter a blockchain. This concept, along with other security protocols, provides the secure nature of a blockchain.

What can you do with Defi?

With Defi, you can do most of the things that banks support; earn interest, borrow, lend, buy insurance, trade derivatives, trade assets, and more; but it’s faster and doesn’t require paperwork or a third party.

Users typically engage with Defi through decentralized apps (DApps), most of which currently run on the Ethereum Blockchain. Unlike a conventional bank, there is no application to fill or account to open.

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

  • Lending: Lend out your crypto and earn interest and rewards every minute; not once per month.
  • Getting a loan: Obtain a loan instantly without filling in paperwork, including extremely short-term “flash loans” that traditional financial institutions don’t offer.
  • Trading: Make peer-to-peer trades of certain crypto assets; as if you could buy and sell stocks without any kind of brokerage.
  • Saving for the future: Put some of your cryptos into savings account alternatives and earn better interest rates than you’d typically get from a bank.
  • Buying Derivatives: Make long or short bets on certain assets. Think of these as a crypto version of stock options or futures contracts.

Why is Defi important?

Defi takes the basic premise of Bitcoin Blockchain technology, expanding on it through the Ethereum Blockchain, therefore creating an entire digital alternative to the traditional financial institutions, but without all the associated costs (like office buildings, banker salaries, trading floors, etc). This has the potential to create more open, free, and fair financial markets that are accessible to anyone with internet access.

The Future of Defi

There’s a quantum leap in the new possibilities of the functionalities of money through the innovation of distributed ledger technologies. For the first time in history, a global financial system for a worldwide population is being shaped by that very population. Everyone can take part in the governance of Defi protocols and get a seat at the table where the world of decentralized finance is actively created.

The Defi space is gradually catching up with the traditional financial system and despite some of the obstacles which are certain while operating on the bleeding edge of innovation, the world of decentralized finance is on the path to prosperity.

Over time, it’s difficult to predict how this space will shape when the power to build financial services will democratize. Thus, at the point where Defi and Fintech map and merge, we’ll have an inflection where an incipient financial technology is just part of a new financial system. One that realizes that dream of being swift, secure, open, and classless.

What are the downsides?

Discussions around Decentralized finance in the present times largely focus on the advantages of Defi. It is also important to discuss the potential downsides of the technology. The challenges with Blockchain are generally responsible for fueling the downsides of Defi. Here are some of the critical setbacks that you can encounter with the Defi adoption.

  • Scalability: Defi projects are undoubtedly suitable for enabling financial inclusion for a broader population. However, Defi projects encounter formidable difficulties in the scalability of host Blockchain from various perspectives.

First is the Defi transactions require undoubtedly extended periods of time for confirmation.

Furthermore, the transactions on Defi protocols could become highly expensive during the period of congestion.

  • Uncertainty: in the event of instability in a Blockchain hosting a Defi project, the project could automatically inherit instability from the host Blockchain. As of the time of writing this article, the Ethereum Blockchain is going through various changes. For instance, the mistakes committed during the transition from the “Proof of Work” consensus to the new Eth 2.0 “Proof of Stake” system can lead to risks.
  • Concerns of liquidity: liquidity is also undoubtedly a critical factor in Defi-based projects and Blockchain protocols. According to CoinQuora, the Total Value Locked in Defi chains tops $200 billion as of December 2020, though a big raise from $12.5 billion as of October 2020. Thus, it is very clear that the Defi market is not as big as the traditional financial systems. But the good news is, the sector is growing very rapidly.
  • Shared Responsibility: Among all the advantages and disadvantages of Defi, the shared responsibility factor works negatively for users. The Defi projects do not take responsibility for your mistakes. All they do is take away the intermediaries, and it is the users who have to take responsibility for their funds and assets. Therefore, Defi space needs tools that could prevent possibilities of human mistakes and errors.

The advantages of Defi outshines its disadvantages by a very wide margin. Defi has become a promising favorite for transforming the conventional benchmarks of financial services.

Defi could foster the application of Blockchain in the financial services sector. With the value benefits of transparency, immutability, and decentralized, permissionless, etc., Defi space has to encounter obstacles as scalability.

In conclusion, Decentralized finance is not just a hype that people will forget after a few days. With all its Blockchain features and applications, we can safely conclude that it’s here to stay. All these important Blockchain features are making a whole new level of impact on the web.

Freelance Blockchain & Metaverse Writer | Cryptocurrency | NFT & Defi Whitepaper | Writer | Press Release & Articles