What is Decentralized Finance (DeFi)? How DeFi Operates and Impacts Traditional Financial Systems

A key component of cryptocurrencies like Bitcoin is decentralization. However, creating a currency outside of the established banking system is just the tip of the iceberg in the rapidly developing field of decentralized finance, or DeFi.
Jan 5, 2023 3:31 PM

A key component of cryptocurrencies like Bitcoin is decentralization. However, creating a currency outside of the established banking system is just the tip of the iceberg in the rapidly developing field of decentralized finance, or DeFi.

Introducing DeFi

A decentralized type of currency, such as Bitcoin, operates without the need for a governing body like a central bank or a national government. Contrarily, fiat currencies are centralized, which means that governments issue and manage them, as does the Federal Reserve, the central bank of the United States.

In recent years, as the bitcoin ecosystem has expanded, additional players have worked to decentralize other significant components of traditional financial systems. This has led to the emergence of a sizable ecosystem of decentralized financial tools and services, ranging from interest-earning opportunities to lending and borrowing services. Decentralized finance, or DeFi, is the general word for this ecosystem.

What is DeFi?

DeFi, or decentralized finance, is a catch-all word for a variety of financial services that run on open blockchains, most frequently Ethereum. In the DeFi ecosystem, practically every financial transaction that is currently handled by large banks or other institutions has a centralized counterpart. Without the use of a mediator or intermediary, DeFi customers may access borrowing and lending services, buy insurance, earn interest on their investments, and much more through peer-to-peer (P2P) transactions.

How does DeFi function?

DeFi uses blockchain's distributed ledger technology, just like cryptocurrencies, to act as a publicly available database for storing financial transactions. Decentralized apps, or dApps, are how users engage with the DeFi ecosystem. These dApps initiate or finish transactions using self-executing, immutable smart contracts. Without a central regulatory body, P2P transactions are only made feasible thanks to these smart contracts. The identical transaction conditions must be agreed upon by both parties prior to the start of a smart contract, and these terms are then hard-coded into the smart contract. The transaction is only finished and added to the blockchain once the conditions of the contract are met. DeFi systems can provide a safe mechanism to record transactions in a tamper-resistant and anonymous manner by utilizing essential blockchain characteristics including distributed networks and encryption technologies. This increases the integrity and trustworthiness of the information on the DeFi network by making it hard to modify.

The Ethereum blockchain hosts the majority of DeFi activity because of its open-source architecture, which encourages developers to build DeFi applications on the network. The Bitcoin network was built to support peer-to-peer transactions, not for the self-executing smart contracts Ethereum is famous for.

What is DeFi used for?

Users can use DeFi to gain direct access to a vast array of decentralized financial services. In fact, to take part in DeFi, you don't even need a cryptocurrency exchange account. Among the most often used applications for DeFi are:

Participate in DAOs

Decentralized autonomous organizations (DAOs) are groups that are managed by community members that frequently work toward a common objective. Through smart contracts, community members define the guidelines that govern how the DAO functions. This might involve everything from deciding which brand-new initiatives to pursue to how money from its treasury is used. Examples of use cases include collectively held venture capital businesses and charities where members can approve gifts.

Decentralized Exchanges (DEX)

Decentralized exchanges, or DEX, let users utilize smart contracts to purchase, sell, or trade cryptocurrency with other users directly from their crypto wallets. Decentralized exchanges are entirely P2P, in contrast to centralized exchanges like Coinbase and Kraken, which all have some sort of central organization operating behind the scenes. Automated market makers (AMMs) are used by DEXs to maintain price discovery regardless of order size. Users are enticed to contribute liquidity pools by the fee money that liquidity providers receive from users and swaps. In comparison to centralized exchanges, using a decentralized exchange to buy, sell, and trade cryptocurrencies is frequently significantly cheaper and gives access to a wider range of assets. A few well-known decentralized exchanges are Uniswap, 1 Inch, Pancake Swap, and Sushi Swap.

Crypto lending and borrowing

Users can borrow or lend out crypto assets to other users on DeFi lending platforms like Maker, Aave, and Compound. Borrowers secure a loan in stablecoins with a competitive interest rate by pledging the cryptocurrency Bitcoin as collateral. Decentralization benefits all parties involved in the transaction because terms are more flexible and rates are more negotiable than when working with a massive, centralized financial institution. Smart contracts, which are unchangeable and automatically execute whenever all predetermined criteria are satisfied, uphold the terms of the agreement. Due to the fact that DeFi borrowing is available 24/7 from anywhere in the world, these cutting-edge methods of borrowing have provided consumers possibilities to acquire funds much more quickly than through traditional currency finance avenues.

Staking assets to earn interest

DeFi staking, in which cryptocurrency owners "stake" their assets in a smart contract in exchange for interest payments or other benefits, is another well-known application of decentralized finance. These benefits typically outweigh savings account interest rates by a wide margin. Stablecoins, which are dollar-pegged digital assets, have made it possible for users to create income on crypto assets used in these DeFi marketplaces, and they have grown in popularity as a means of doing so while protecting against the volatility of crypto prices. The simplest method for tokenizing holdings so they may be used in DeFi protocols is to convert holdings from fiat currencies like US dollars to stablecoins like USDC. DeFi lending services have grown to be a well-liked substitute for keeping money in conventional low-yield savings accounts.

How safe is DeFi?

It's only normal to be curious about how safe the DeFi space is before becoming involved in anything. With few consumer protections and safeguards in place in comparison to conventional financial systems, regulation around Defi and its numerous applications is still in flux. DeFi investing is still very risky, so it should only be done under extreme caution.

All DeFi wallets are non-custodial, therefore the user is exclusively in charge of keeping their private key secure. Losing or disclosing a private key puts your assets at danger of theft, just like with any other wallet.

Always assume the worst if a project or investment opportunity seems too good to be true. DeFi is nothing short of a revolution in digital assets and has the potential to deliver the financial industry numerous novel and interesting developments. However, despite all of the technological advancements, using common sense is still one of the most effective ways to combat hackers and con artists.