DeFi for 10-Year-Olds; What is Decentralized Finance (DeFi) and How Does it Work?
DeFi, an acronym for the term “decentralized finance,” is an umbrella term used to describe peer-to-peer financial technologies and services. These tools and services are built on a secure distributed ledger comparable to those used by cryptocurrencies like Bitcoin.
Decentralized finance (DeFi) is changing the narrative of the financial sector as we know it. DeFi has grown massively within the past 3 years, with a massive explosion in 2021. The growth, which resulted in the TVL (Total Value Locked) across all DeFi platforms going as high as $253 billion, was due to the massive adoption of the services provided by DeFi platforms.
The world of blockchain and cryptocurrency has experienced tremendous transformation, and decentralized finance (DeFi) has altered how we engage with financial instruments. Now let us explore DeFi further and learn more about it as it is being utilized in a variety of unique and innovative ways.
What is DeFi (Decentralized Finance)?
DeFi (Decentralized Finance) can be seen as a fresh perspective on or upgrade to the already existing traditional banking and financial practices. It is a developing technology that uses blockchain technology to enable users to avoid middlemen or third parties (banks and other financial institutions) and conduct financial transactions directly with each other.
DeFi offers a reliable substitute for traditional financial services, with new products and transactions becoming accessible every day.
The DeFi sector is gradually gaining more popularity as it offers the majority of the services provided by traditional banks and centralized financial institutions, and even more unique services and products.
How Does DeFi (Decentralized Finance) Work?
DeFi works by enabling users to utilize cryptocurrencies and blockchain technology to carry out the majority of transactions that are offered by traditional banks. These transactions include lending, borrowing, earning interest, trading assets, purchasing insurance, and more.
In the traditional financial system, intermediaries (middlemen) like banks, stock exchanges, or other financial entities are often required to transfer or receive money. For each transaction to be acceptable, the parties involved need to believe that the intermediary will act with fairness and honesty.
Blockchain technology takes the role of these intermediaries in DeFi. On DeFi, people trade directly with one another using “Smart Contracts” instead of going through banks and stock exchanges. These smart contracts are responsible for creating markets, settling deals, and guaranteeing that the entire process is transparent and reliable.
With a cryptocurrency wallet, a smart device, and an internet connection, everyone can have access to an inclusive, decentralized, uncensorable, transparent, and open-source financial system that DeFi seeks to establish.
What are Smart Contracts?
Smart contracts are computer programs that are built on blockchain technology to execute automatically when certain predefined criteria are met. Typically, smart contracts automate the enforcement of an agreement so that the parties involved may be assured of the outcome of such an agreement without the need for any intermediary or unnecessary delay.
A smart contract, simply put, is a contract that is completely digital and is created entirely in computer code by a computer programmer and stored on a blockchain. It contains all of the contract’s details, including the parties to whom it applies, the deadlines for execution, the dates on which the agreements were signed, etc.
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Decentralized Finance vs. Centralized Finance
One major feature of centralized finance is that, as an investor, unlike in DeFi, where all your assets are controlled by you, you relinquish all the control you have over your assets to banks and other financial entities.
In centralized finance, your funds are controlled by organizations and institutions whose main objective is to generate additional revenue for themselves using your funds. But by using DeFi, your funds are held in your wallet and secured with a private key that grants you exclusive access to such funds.
The entirety of this ultimate control by centralized institutions maintains a significant level of risk and control which builds up in the center and may put the entire system in jeopardy. In the past, we have observed bankers and institutions mismanage market risks. A tragic example of this was the financial crisis of 2008.
Another significant feature of the centralized system is the difficulty and time it takes to access financial instruments. It could take several days and lots of paperwork for a person to secure a loan or any other financial instrument. But with DeFi, the process becomes easier by eliminating third parties and using smart contracts.
The Future of Decentralized Finance
Decentralized finance is currently developing and still in its infancy. For the first time ever, anyone and everyone can influence the direction of the world’s financial system through DeFi. If a person has access to a smart device and an internet connection, they can as well engage in DeFi and use its services from anywhere around the globe to their advantage.
The DeFi sector is increasingly catching up with the established financial system, despite the fact that issues like laws on decentralized finance remain unresolved. It is anticipated that laws would develop over time, reducing the likelihood of infrastructure-related problems, hacks, and fraud.
By providing services that are fast, secure, readily available, decentralized, and easily accessible, DeFi will be able to maintain its current level of success and widespread adoption.
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