It’s difficult for people to do without financial operations. Because of that (but not only that) we use banks to center the world of finance around, participating in a traditional, centralized system. However, there’s an alternative called decentralized finance (DeFi).
Decentralized finance (DeFi) proposes the same banking and financial services as traditional finance, but does it using decentralized technology or blockchains. The purpose of decentralized finance is to eliminate the intermediary, which in conventional finance are banks, and promote the ability to perform financial operations directly between users.
Decentralized finance (DeFi) is undoubtedly interesting, and we will view everything DeFi-related in this article.
What is Decentralized Finance?
Decentralized Finance (DeFi) is somewhat of an umbrella term for a distinct sector of the cryptocurrency market that seeks to revolutionize traditional financial services through blockchain technology.
Through integrating blockchain networks like Ethereum, DeFi can offer a new technical and regulatory approach to lending, borrowing, saving, trades, insurance, and asset management. DeFi solutions reduce intermediary fees and make financial services more accessible to people worldwide.
To think about decentralized finance (DeFi) as exclusively cryptocurrency-focused would be an understatement because, ultimately, DeFi is meant to replace different types of assets, financial tools, and contracts.
In the case of traditional banks, there’s not enough privacy emphasis. Customers must provide their legal documentation to prove their identity to start using banking services. As a result, banks get access to information about all transactions, which they have the right to block for a multitude of reasons. Besides, banks are not interested in reducing commissions.
Decentralized finance (DeFi) fights the drawbacks of the traditional banking system such as high fees, third-party involvement, and insufficient privacy.
To better understand decentralized finance (DeFi), here are the differences between DeFi and traditional finance:
- With DeFi, everything runs on code instead of institutions and employees.
- You can actually check the DeFi code for yourself, which contributes to unmatched transparency.
- With DeFi, you can utilize DApps accessible from any location.
- You, the user, completely control your funds with DeFi.
Those are just a few main differences between DeFi and traditional finance systems. Let’s dive deeper.
The Architecture of DeFi
The significant component of Decentralized Finance (DeFi) architecture is, of course, blockchain. With blockchain being the foundation of DeFi, transactions are recorded in code instead of a private ledger, like in the case of banks. Blockchain, in turn, is a distributed public ledger, meaning that every user running a DeFi app has the exact full copy of the ledger that records every transaction made through the blockchain. It’s worth mentioning that transactions are encrypted, which provides increased privacy and serves as a preventative measure against fraudulent activity.
Besides the blockchain, DeFi has other essential components to it, including:
- Smart contracts. Smart contracts are settlements executed on the blockchain when the specific conditions are met. In DeFi, smart contracts are most commonly used as a tool for transactions. Smart contracts can be considered an automatic “intermediary” within transactions, helping to verify them within the blockchain. DeFi utilizes smart contracts for landing, DEXs, and more areas.
- Decentralized exchanges (DEXs). Decentralized exchanges (DEXs) are marketplaces where cryptocurrency trades can be issued. DEX is a “temple” of decentralization philosophy since it serves as a place for direct peer-to-peer trading without needing third-party involvement. DEXs use smart contracts to issue transactions.
- Options for lending and borrowing. Specific DeFi platforms provide users with significant crypto options to lend digital assets and earn interest. Such an approach to landing is much more transparent than the one practiced by traditional financial institutions since it reduces the steps one needs to follow to get to the actual financial part of it.
- Stablecoins and stablecoin trades. Stablecoins, being digital assets that hold value, consistently provide alternatives for storing and investing in crypto. Stablecoins participate in DeFi lending, borrowing, and insurance protocols.
The DeFi Advantage
DeFi becomes increasingly popular each day, and not without a reason. It has certain advantages many users appreciate. Here’s why people use decentralized finance:
Since DeFi makes it possible for people to issue direct transactions with one another, no intermediary is needed; hence, the fees are much lower than in traditional economic settings.
Higher interest rates
Those lending money through DeFi networks have witnessed much higher interest rates than the fees set by conventional banking.
In traditional finance, certain people are denied loans or experience issues keeping their bank accounts active based on regulatory nuances. DeFi gets rid of such complications. Anybody who has internet access can become a part of decentralized finance in an instant. This is a much more democratic approach that ensures that people who need access to financial platforms get it.
Security and transparency
Every transaction made within decentralized finance (DeFi) is recorded within the blockchain with the help of smart contracts that serve as storage for such records. Anyone on the blockchain can view smart contracts. At the same time, a higher level of security is provided through smart contract encryption while using the base-level encryption of the blockchain itself.
The great things that come with DeFi are often wrapped in its difference from the traditional finance system.
For example, if you want to borrow money from a conventional bank, you cannot just go and receive the money; you should be approved for a loan first. Then, the bank sets a rate and charges a fee for managing the loan. A bank basically controls the whole process.
DeFi makes the services available for everybody without the “approval” process to start using DApps. In turn, DApps charge much lower fees to maintain their functionality than banks. Rates are set based on market supply and demand.
Besides, DeFi is open 24/7, unlike banks.
DeFi in Action – Real-World Applications
There are many real-world applications for DeFi. We’ll briefly mention some of them.
DeFi can be used for asset management utilizing DeFi-based DApps – applications for managing digital funds. With DApps, only you have the access to your data.
Decentralized Autonomous Organizations
The DAO ecosystem is profoundly based on DeFi; without decentralized finance, DAOs wouldn’t exist.
With smart contracts that DeFi uses, one can create tokenized derivatives from other assets, the value of which will be tied to the original token. Things like fiat currency and commodities can also be subject to tokenization.
DeFi can provide the insurance market with minimal paperwork and a secure process of insurance claims.
Lending and borrowing
DeFi’s lending and borrowing protocols enable the lending and borrowing operations on a peer-to-peer basis. DeFi structure provides higher interest rates and much less paperwork.
Decentralized finance allows the use of digital assets as an in-game currency alternative to fiat assets.
The Envisioned DeFi Future
The preference for a decentralized finance system has grown in recent years. According to estimated statistical data, at least 20% of businesses will utilize DeFi technology for payments and resource storage in the following years. More DApps are expected to be developed since developers are currently working on creating more DeFi products and services.
The adoption rate of DeFi seems to be increasing due to blockchain’s regulatory specifics and enhancements and the high demand for digital economic ecosystems. Decentralized exchanges, landing platforms, and asset management tools have become increasingly popular since they are accessible to a broader audience.
Overall, the DeFi future is likely to be bright due to increased interest in blockchain technology, the need for regulatory changes within traditional finance, and the streamlined expansion of DeFi’s landscape.
To Sum Up
Decentralized Finance (DeFi) is here to shape a new economic structure and a more user-friendly and transparent financial system. While DeFi’s technology has its challenges, it is ever-evolving and has excellent potential to lessen the regulatory limitations of traditional finance systems.
We hope you got an idea of what DeFi is all about so it is easier to join the financial revolution if you wish to.