Decentralized finance, or DeFi, revolutionizes financial transactions through blockchain technology and smart contracts.
DeFi intends to decentralize finance by replacing traditional centralized systems with peer-to-peer networks capable of providing a broad range of financial services. These services include everything from different payments and loans to more advanced transactions and asset trading.
To better explain DeFi, let’s consider the traditional financial system first.
Almost all aspects of traditional financial services are now managed by centralized systems run by government organizations and other entities. To obtain anything from loans to stocks and bonds, ordinary people must deal with various financial middlemen.
As a result, customers don’t have any direct access points to financial services and capital. They are unable to avoid middlemen such as banks and lenders, who profit from every banking and financial transaction.
So what is decentralized finance?
DeFi disrupts the centralized banking system by eliminating middlemen and empowering ordinary people through peer-to-peer trades. It puts crucial components of the job done by insurers and banks in the hands of ordinary people.
Let’s illustrate this with an example. With traditional banking, you put your money in a savings account and receive 0.3% interest. The bank then lends the money to another client at 5% interest, pocketing the 4.7% profit.
People that use DeFi, on the other hand, lend their funds directly to others, avoiding the 4.7% profit loss and obtaining the full 5% interest on their money.
To truly understand what DeFi is, we should learn a thing or two about the blockchain technology that powers it.
When you use a traditional checking account, every transaction is logged in the account’s transaction history and owned by a single financial organization. Blockchain, on the other hand, is a distributed, decentralized public ledger that records financial transactions securely and privately.
When we call it distributed, we mean that every party utilizing a DeFi application has an exact copy of the shared database, which records all transactions in encrypted code. This safeguards the system by giving users anonymity, as well as payment verification and an asset ownership record that’s nearly impossible to modify through fraudulent behavior.
When we call it decentralized, we imply that there is no middleman in charge of the system. Transactions are validated and recorded by parties using the same blockchain by solving challenging math problems and adding fresh transaction blocks to the chain.
DeFi is increasingly being used in both basic and complex financial transactions. It’s powered by dapps which are decentralized apps that manage network transactions.
Now that you know what DeFi is let’s take a look at some current DeFi examples:
- Decentralized exchanges: Platforms for trading different cryptocurrencies and connecting users directly without requiring them to entrust their money to an intermediary.
- Stablecoins: Cryptocurrencies whose prices are tied to assets outside of the blockchain (USD for example) to stabilize their price.
- Lending platforms: These platforms use smart contracts to replace intermediaries such as banks.
- Prediction markets: Markets for betting on the outcome of future events without middlemen.
- Traditional services: Payments, insurance, trading of assets.