People curious about cryptocurrencies sooner or later come across the term DeFi, which is used to describe so-called decentralized finance. What are they? What impact do they have on the transparency and security of investments? We explain!
DeFi, decentralized finance
DeFi, short for decentralized finance, is a term used to describe financial services using a system of smart contracts embedded in a blockchain network. The system is based on peer-to-peer (P2P), understood as a peer network where all users participate on an identical basis. DeFi’s market capitalization has grown from $3 billion in July last year to an impressive figure of over $100 billion in October 2021.
How does decentralized finance (DeFi) work?
The way decentralized finance works is an alternative to the traditional financial system. This one operates on a centralized infrastructure managed by central authorities, institutions and intermediaries. Decentralized finance extends the basic idea behind cryptocurrencies – no trust in third parties – to a wide range of democratized financial services. These services, implemented on public blockchains, bypass central financial intermediaries such as banks, exchanges or brokerage firms. This means that market participants can make all transactions without submitting their data to verification or comply with a range of other procedures.
What are the characteristics of decentralized finance (DeFi)?
DeFi provides free access to financial services, including people who are isolated from the existing financial system. Decentralized finance uses the key principles of the Ethereum blockchain to increase transparency and financial security.
There are many advantages to this system – the most significant are outlined below.
On the public, Ethereum blockchain, each of the transactions are transmitted and verified by other users on the network. Furthermore, Ethereum and the DeFi protocols running on it are built using open-source code freely available to anyone.
The DeFi sector operates without oversight. Participation in a decentralized system, unlike a traditional system, does not require users to go through various regulatory verification systems. Decentralized finance allows financial services to eliminate prominent players who can manipulate the market for their benefit.
DeFi applications, although they mimic the operation of these traditional financial systems, provide users with complete anonymity and operations security. Data in DeFi is recorded in chains, which reduces the risk of censorship or service closure. Decentralized finance, which is still a relatively new product, is constantly being improved to protect better the assets entrusted to it.
The traditional system, which relies on intermediaries, is only available to a select group of people with certain incomes. With DeFi, the costs of financial services are much lower, so that low-income people can also freely use them. Thus, decentralization reduces the costs associated with the use of financial products and creates a more efficient financial system.
Despite the apparent advantages, DeFi is not without disadvantages. Key ones include:
- Relatively limited scalability,
- Low system efficiency and regulation,
- The most critical challenges for decentralized finance.
DeFi – how can decentralized finance be used?
DeFi’s capabilities can be used to streamline all financial systems in the world entirely. This is because blockchain technology allows replicating all the traditional financial instruments we know in a decentralized way.
The most popular DeFi projects currently include lending and credit platforms. Open, decentralized services of this type have many advantages over the traditional credit system. First, they allow transactions to be settled, and digital assets to be secured instantly and do not require credit checks. DeFi also solves the problem of expensive and time-consuming mortgages by eliminating intermediaries. In addition, the use of smart contracts reduces the fees associated with the service. Similarly, insurance on the blockchain can eliminate the need for intermediaries and allow risk-sharing among multiple participants.
Another of DeFi’s use cases are decentralized Exchanges (DEX), an alternative to a centralized stock exchange, whereby users retain control over their assets. Smart contracts automatically connect buyers and sellers. DeFi is also being used to operate assets – tools such as asset wallets are not connected to banking services and help cryptocurrency holders manage their funds efficiently.
With the development of blockchain, there is growing interest in creating stablecoins. They are a type of cryptocurrencies that retain their value relative to traditional currencies, most commonly the US dollar. Given the fluctuating prices of cryptocurrencies, stablecoins could be adopted as digital cash for everyday use that is not subject to issuance and monitoring by central authorities.
In summary, DeFi is creating an alternative financial infrastructure based on blockchain technology. They are decentralized equivalents of the financial services we know very well and a broad spectrum of new services separate from the traditional financial system.