What is decentralized finance?
Decentralized finance (DeFi) is an emerging financial technology based on secure distributed ledgers similar to those used in cryptocurrencies. The system eliminates the control of banks and institutions over money, financial products and financial services.
The main goal of decentralized finance is to become an alternative to the banking sector and replace the traditional technologies of the current financial system with open source protocols. Most of the existing DeFi is built on the Ethereum blockchain.
The main function of DeFi is to give you undeniable control over your own assets.
The decentralized finance (DeFi) movement includes digital assets, smart contracts, decentralized applications, and protocols built with reference to the blockchain.
Here are some of the key benefits of DeFi for many consumers:
- This eliminates the fees that banks and other financial companies charge for using their services.
- You keep your money in a secure digital wallet, not in a bank.
- Anyone with an internet connection can have a digital wallet.
- You can transfer funds in seconds and minutes.
Key Takeaways
Decentralized finance, or DeFi, uses new technologies to eliminate third parties in financial transactions. The components of DeFi are stablecoins, software and hardware that enable application development. The infrastructure for DeFi and its regulation are still under development and discussion.
Understanding DeFi
To understand decentralized finance and how it works, it is helpful to understand how centralized finance differs from DeFi.
Centralized finance
In centralized finance, your money is kept in banks, corporations whose main purpose is to make money. The financial system is full of third parties that facilitate the movement of money between parties, each of whom charges fees for using their services. For example, let's say you buy a gallon of milk using a credit card. The payment is received from the merchant to the acquiring bank, which transmits the data cards to the credit card network.
The network clears the fee and requests payment from your bank. Your bank approves the payment and sends a confirmation online via the acquiring bank back to the merchant. Each organization in the chain receives payment for its services, typically because merchants must pay for your ability to use credit and debit cards.
All other financial transactions cost money; approval of loan applications may take several days; You may not even be able to use a bank if you are traveling.
Briefly
Two of the goals of DeFi are to reduce transaction times and increase financial inclusion.
Decentralized finance
Decentralized finance eliminates intermediaries, allowing people, merchants and businesses to conduct financial transactions using new technologies. This is achieved through peer-to-peer financial networks that use security protocols, connectivity, software and hardware.
From anywhere you have an internet connection, you can lend, trade and borrow using software that records and verifies financial activity in distributed financial databases. A distributed database is accessible from different locations; it collects and aggregates data from all users and uses aconsensus mechanism to check them.
Decentralized finance uses this technology to eliminate centralized finance models, allowing anyone to use financial services anywhere, no matter who or where they are.
Important
DeFi applications give users more control over their money through personal wallets and trading services designed for individuals. By taking away control from third parties, decentralized finance does not provide anonymity. Your transactions may not have your name on them, but they are tracked by those with access. These organizations may be governments, law enforcement agencies, or other organizations that exist to protect people's financial interests.
How does DeFi work?
Decentralized finance uses blockchain technology (such as Ethereum), which uses cryptocurrencies. Blockchain is a distributed and secure database or ledger. Applications, called dApps, are used to process transactions and run the blockchain.
In a blockchain, transactions are recorded in blocks and then verified by other users. If these verifiers agree to the transaction, the block is closed and encrypted; another block is created containing information about the previous block within it.
Blocks are "linked" together by information in each ongoing block, giving it its name "blockchain". Information in previous blocks cannot be changed without affecting subsequent blocks, so it is impossible to change the blockchain. This concept, along with other security protocols, ensures the secure nature of the blockchain.
Ethereum platform is an ideal option if you want to run a DeFi application, but this means you can't apply it to other platforms. You can think of DeFi as a financial ecosystem that is open to everyone. You will be able to create your own effective financial instruments and services at your discretion. They are decentralized and have no single point of failure.
DeFi Financial Products
Peer-to-peer (P2P) financial transactions are one of the core prerequisites of DeFi. A P2P DeFi transaction is when two parties agree to exchange cryptocurrency for goods or services involving a third party.
To fully understand this, consider how you obtain credit in centralized finance. You will need to go to your bank or other lender and apply for one. If you were approved, you would pay interest and a service fee for the privilege of using that lender's services.
Briefly
Peer-to-peer lending within DeFi does not mean there will be no interest or fees. However, this means that you will have many more options since the lender can be located anywhere in the world.
In DeFi, you use your decentralized finance application (dApp) to input your lending needs, and the algorithm will match you with peers who match your needs. You will then need to agree to one of the lender's terms and conditions and receive the loan.
The transaction is recorded on the blockchain; you receive your credit after the consensus mechanism verifies it. The lender can then begin collecting payments from you at agreed intervals. When you make a payment through your dApp, it follows the same process on the blockchain; the funds are then transferred to the lender.
DeFi currency
DeFi is designed to use cryptocurrencies for transactions. The technology is still evolving, so it is difficult to determine exactly how existing cryptocurrencies will be implemented, if at all. Much of the concept revolves around a stablecoin, a cryptocurrency backed by an institution or pegged to a fiat currency such as the dollar.
The Future of DeFi
Decentralized finance is still in its early stages of development. First, they are unregulated, which means the ecosystem is still riddled with infrastructure failures, hacks, and scams.
Current laws were developed based on the idea of separate financial jurisdictions, each with its own set of laws and regulations. The possibility of borderless DeFi transactions raises important questions for this type of regulation. For example, who is responsible for investigating financial crime that occurs across DeFi borders, protocols, and applications? Who will enforce the rules and how will they enforce them?
Important
The open and distributed nature of the decentralized financial ecosystem may also pose challenges to existing financial regulation.
Other concerns include system stability, energy requirements, carbon footprint, system upgrades, system maintenance, and hardware failures.
Many questions need to be answered and progress must be made before DeFi can become safe to use. Financial institutions aren't about to give up one of their primary ways of making money - if DeFi succeeds, it's more than likely that banks and corporations will find ways to infiltrate the system; if not to control how you access your money, then at least to make money in the system.
What does decentralized finance do?
The goal of DeFi is to get rid of third parties who are involved in all financial transactions.
Is Bitcoin Decentralized Finance?
Bitcoin is a cryptocurrency. DeFi is being developed to use cryptocurrency within its ecosystem, so Bitcoin is not so much DeFi as it is part of it.
What is the total value locked in DeFi?
Total Value Locked (TVL) is the sum of all cryptocurrencies staked, lent, deposited in a pool, or used for other financial activities across all DeFi. It can also represent the amount of specific cryptocurrencies used for financial activities, such as Ether or Bitcoin.
Author: Rakesh Sharma Updated December 30, 2021
Source: https://www.investopedia.com/decentralized-finance-defi-5113835