Decentralized Finance (DeFi): What Is It and How Does It Work?

DeFi is influenced by blockchain, the technology that underpins the virtual currency bitcoin. It enables many parties to each maintain a copy of a transaction history, preventing a single, centralized source from controlling it. This is significant because human gatekeepers and centralized systems may restrict the sophistication and speed of transactions while giving users less direct control over their funds.
Dec 8, 2022 3:56 PM

Decentralized Finance (DeFi): What Is It?

A new financial system called decentralized finance (DeFi) is built on safe distributed ledgers that are similar to those used by cryptocurrencies.

The Securities and Exchange Commission (SEC) and Federal Reserve set the rules for centralized financial institutions like banks and brokerages in the U.S., where customers go to directly access capital and financial services. By giving people access to peer-to-peer digital exchanges, DeFi challenges this centralized financial system.

DeFi is influenced by blockchain, the technology that underpins the virtual currency bitcoin. It enables many parties to each maintain a copy of a transaction history, preventing a single, centralized source from controlling it. This is significant because human gatekeepers and centralized systems may restrict the sophistication and speed of transactions while giving users less direct control over their funds. DeFi stands out because it broadens the application of blockchain beyond straightforward asset transfers to more intricate financial use cases.

DeFi does away with the usage fees that banks and other financial institutions impose. Anyone with an internet connection can use DeFi, and users can store money in a safe digital wallet and transfer money quickly.

Key Takeaways:

  • Decentralized finance, or DeFi, eliminates third parties and centralized institutions from financial transactions by using developing technologies.
  • Stablecoins, software, and hardware that supports the creation of applications are the elements that make up DeFi.
  • DeFi's regulatory framework and infrastructure are always changing.

Decentralized Finance (DeFi) vs Centralized Finance

Decentralized finance is distinct from conventional, centralized banking and financial institutions.

Decentralized Finance

By enabling individuals, businesses, and merchants to perform financial transactions through new technologies, decentralized finance eliminates middlemen. DeFi makes use of connection, software, hardware, security protocols, and peer-to-peer financial networks.

People can lend, trade, and borrow using software that logs and validates financial transactions in distributed financial databases from anywhere there is an internet connection. A distributed database collects and aggregates data from all users and utilizes a consensus process to verify it, making it available from different locations.

By enabling anyone to utilize financial services wherever they are, regardless of who they are or where they are located, decentralized finance eliminates the necessity for a centralized finance model. Through individual-focused trade services and personal wallets, DeFi applications provide consumers more control over their finances.

Note: Financial decentralization does not completely guarantee anonymity. Although transactions do not contain a person's name, they can be tracked by the authorities who have access, such as governments and the legal system, who are there to safeguard a person's financial interests.

Centralized Finance

In centralized finance, banks and other third parties hold the funds and enable the transfer of funds between parties; each party charges a fee for its use. An acquiring bank receives the card information from the merchant and passes it on to the credit card network to complete the credit card transaction.

The network authorizes the charge and asks the bank for payment. Because retailers typically have to pay for the usage of credit and debit cards, each link in the chain is paid for the services it provides.

Centralized finance oversees all financial activities, including loan applications and local bank services.

Fun Fact: Reducing transaction times and expanding access to financial services are two of DeFi's objectives.

DeFi Runs on Blockchain

Decentralized finance is made possible by key technologies like blockchain and cryptocurrencies.

Your banking transaction history is kept in a private ledger, which is owned and controlled by a sizable financial institution, when you make a transaction in your standard checking account. Blockchain is a distributed, decentralized public ledger where digital records of financial transactions are kept.

The public ledger, which records every transaction in encrypted code, is what we mean when we say that blockchain is distributed. This means that any party utilizing a DeFi application has an identical copy of the public ledger. By giving users anonymity, payment verification, and a record of asset ownership that is (almost) impossible to change through fraudulent conduct, this secures the system.

Blockchain is described as being decentralized when there is no mediator or gatekeeper in charge of overseeing the system. By resolving challenging math problems and adding fresh blocks of transactions to the chain, parties who utilize the same blockchain can verify and record transactions.

Decentralized blockchain, according to proponents of DeFi, makes financial transactions safer and more transparent than the private, secretive systems used in centralized finance.

How DeFi is Used Today

DeFI is becoming more prevalent in both straightforward and intricate financial activities. It is driven by decentralized applications, or "dapps," or other software, or "protocols," which manage transactions in the two most popular cryptocurrencies, Bitcoin (BTC), and Ethereum.

Despite the fact that Bitcoin is the most widely used cryptocurrency, Ethereum is far more flexible and is used by a large portion of the dapp and protocol landscape.

Here are some examples of current uses for dapps and protocols:

  • Conventional financial transactions. With DeFi, everything is already possible, including payments, the trading of stocks and insurance, as well as lending and borrowing.
  • Decentralized exchanges (DEXs). At the moment, the majority of bitcoin users trade on controlled exchanges like Coinbase or Gemini. DEXs enable peer-to-peer financial transactions while allowing users to maintain ownership of their funds.
  • E-wallets. Digital wallets are being developed by DeFi developers that can function independently of the biggest cryptocurrency exchanges and allow users access to everything from cryptocurrencies to blockchain-based games.
  • Stable Coins. Since cryptocurrencies are notoriously volatile, stable coins link their values to currencies that are not cryptocurrencies, such as the U.S. dollar, in an effort to stabilize their prices.
  • Yield harvesting. DeFi, also known as the "rocket fuel" of cryptocurrency, enables speculative investors to lend cryptocurrencies with the potential to make significant profits when the proprietary coins that DeFi borrowing platforms pay them for accepting the loan appreciate quickly.
  • Non-Fungible tokens (NFTs). NFTs turn non-tradable assets, such as YouTube recordings of slam dunks or the very first tweet on Twitter, into digital assets. NFTs make commodities out of things that weren't before.
  • Quick loans. These are cryptocurrencies loans where the funds are borrowed and repaid in one transaction. That seems counterintuitive. Here's how it works: Borrowers can earn money by signing a contract that is encoded on the Ethereum blockchain, executes a transaction, and immediately repays the loan. There is no need for attorneys to do this. The money will immediately be returned to the lender if the transaction cannot be completed or will result in a loss. If you do make a profit, you can keep it after subtracting any fees or interest. Flash loans can be compared to decentralized arbitrage.

The "locked value" metric, which determines how much money is currently operating in various DeFi protocols, is used by the market to measure DeFi adoption.

Blockchain's ubiquity, which makes dapps accessible everywhere the instant they are encoded, is what drives the adoption of DeFi. Dapps operate outside of these rules, enhancing their potential benefit, whereas most centralized financial instruments and technologies spread out gradually over time and are subject to the norms and regulations of respective regional economies.

The Future of DeFi

The world of decentralized finance is always changing. It is unregulated, and its ecosystem is full of frauds, hacks, and infrastructure errors.

The current legal framework was developed with the idea of distinct financial jurisdictions, each with its own set of regulations. The ability of DeFi to conduct borderless transactions raises crucial issues for this kind of regulation.

Who is in charge of looking into financial crimes that take place across boundaries, protocols, and DeFi apps? Who and how would carry out the regulations' enforcement?

System stability, energy usage, carbon footprint, system upgrades, system upkeep, and hardware failures are some additional issues.

What is the purpose of decentralized finance?

DeFi wants to undermine the widespread use of centralized financial institutions and middlemen in all financial transactions.

Is Bitcoin a Decentralized Finance?

Bitcoin is a cryptocurrency. DeFi is being designed to use cryptocurrency in its ecosystem, so Bitcoin isn't DeFi as much as it is a part of it.

How Much Total Value Is Locked in DeFi?

Total value locked (TVL) is the total amount of all cryptocurrency staked, loans made, deposits made into pools, and other financial transactions made across the whole DeFi network. It may also be used to denote the whole value of a particular cryptocurrency, like ether or bitcoin, which is used for monetary transactions.

Closing Thoughts

An developing financial technology called decentralized finance (DeFi) poses a threat to the current centralized banking system. DeFi encourages the usage of peer-to-peer, or P2P, transactions by eliminating the fees that banks and other financial institutions charge for using their services.

Disclaimer: This article was provided “as is” without the intention to provide any investment advice. This article is intended for informational purposes only. Be diligent and always do your own research.