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What is decentralized finance?

Understanding DeFi

Decentralized finance — DeFi for short — refers to a complex financial ecosystem on the blockchain

DeFi in a nutshell

DeFi stands for decentralized finance, an umbrella term that includes all financial networks, platforms, applications, and assets built on a blockchain that don’t rely on a single institution or organization to work.

The main difference between DeFi and TradFi — traditional finance, also called “legacy finance” — is the absence of intermediaries or third parties. Indeed, where TradFi needs a bank, a broker, or a payment service provider, DeFi relies on computer code, blockchain technology, and smart contracts.

As a result, decentralized finance applications enable their users to transact with each other in a trustless, direct, and private manner, saving them time and money along the way.

Photo by Shubham Dhage on Unsplash

How DeFi works

Decentralized finance relies on three pillars: cryptocurrency, blockchain technology, and smart contracts.

Firstly, cryptocurrency enables the tokenization of any asset or commodity. In turn, tokenization makes these assets liquid, easily exchangeable, and transferable on the blockchain.

On the other hand, Blockchain technology records all data and transactions on a public ledger, enforcing transparency and decentralization. Instead of an overseeing institution, like a bank or a broker, it’s the blockchain’s nodes that validate and confirm the transactions between users.

Photo by Shubham Dhage on Unsplash

Finally, smart contracts add automation functionality. They are self-executable computer programs between two or more parties that contain specific rules and conditions. The former establish the agreement’s terms, which the contract automatically enforces when the latter are met.

By combining these three technologies, developers can build all kinds of platforms and applications that allow users to access several financial products and options without any third parties.

DeFi applications: dApps

As we mentioned, decentralized finance refers to an ecosystem of platforms in which users transact with no intermediaries. We refer to these platforms as “decentralized applications” or dApps.

Decentralized applications are built on blockchain networks and use smart contracts to bring various financial products to their users. There are many types of dApps depending on their functionality and use-cases.

The most popular types of decentralized applications are:

DEXs, or decentralized exchanges

DEXs are cryptocurrency trading platforms that allow users to swap one cryptocurrency for another. Users connect to DEXs directly from their wallets, meaning they don’t need to trust their assets to a third party.

Besides exchanging, most DEXs allow other forms of participation, like liquidity providing or staking. These functions improve the platform’s performance and grant users a reward in return for contributing.

Lending and borrowing protocols

These loan applications connect lenders and borrowers through smart contracts.

Lenders “lock” their assets in the platform’s smart contracts and earn yield in return for their deposit. Meanwhile, borrowers can take these assets as a loan after pledging a certain amount of funds as collateral.

As a result, smart contracts enable secure, trustless, and direct loans between two parties without intermediaries, saving them considerable fee costs.

Synthetic assets

Many dApps focus on creating synthetic financial products through tokenization. These platforms allow exchanging and transacting real-world or physical assets on the blockchain.

Many protocols have created crypto tokens with a 1:1 peg to fiat currencies — called stablecoins — securities, company stocks, commodities such as gold, oil, or other cryptocurrencies.

As a result, users can invest in these types of assets directly from their crypto wallet, saving on broker fees and cumbersome bureaucratic processes and paperwork.

Various financial instruments

Some decentralized applications don’t specialize in a single function but offer different financial options in addition to the ones named above, including:

  • Yield aggregators: Protocols that automatically reinvest your revenue, aiming to maximize your return from other platforms.
  • Staking pools: These platforms allow you to provide security to proof-of-stake networks without running a validator node.
  • Lottery: Decentralized gaming sites that offer different games and contests in which users can participate to win prizes.
  • Prediction markets: Platforms for users to speculate and bet on the outcome of certain situations or the direction of a particular asset’s price.

Risks and opportunities of DeFi

Decentralized finance offers several advantages for users.

First of all, removing intermediaries streamlines the transaction process and saves the interacting parties considerable fees and costs.

Additionally, smart contracts and blockchain technology ensure security and transparency. All parties involved can verify the terms of the transaction before committing their funds and access all transaction information immediately after it happens.

On a global scale, DeFi enables people from all over the world to access financial products that otherwise would be impossible for them to reach.

Photo by olieman.eth on Unsplash

However, interacting with DeFi applications requires an enormous responsibility from users. Being decentralized and unmediated, the security and safekeeping of assets rely exclusively on their owners.

Users are responsible for any losses resulting from hacker attacks, getting involved in fraudulent platforms, or any other risks involved in DeFi. That is why it is vital to do your own research and consider safety best practices.

Final considerations

Decentralized finance expands the reach of individuals when it comes to transacting with each other in a private, direct manner and accessing a wide range of financial opportunities, but it comes not without risk.

As a consequence, one of the most fundamental aspects of experimenting with DeFi is security. Before approving any smart contracts or connecting your wallet to a website, always do your own research to avoid scams and losses.

DeFi can be intimidating at first, but it gets easier as you explore and learn about it. We hope this article helps you get started!

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