DeFi stands for Decentralized Finance. It is a financial system that allows for smooth transactions without the help of financial intermediaries like brokerages, exchanges, or banks. The Defi instead makes use of smart contracts on a blockchain.
Platforms that use DeFi allow users to trade cryptocurrencies, trade derivatives, and trade assets. Such platforms also provide regular banking services like lending funds from other people and even earning interest from their savings- but at a much faster rate.
This technology is based on the Blockchain and removes third parties from transactions. It means no financial institutions control your transactions, and no fees will be charged on whatever business you carry out.
The renowned speed of DeFi is due to its global Peer-to-Peer trading also allows users to:
• keep their funds in secured digital wallets
• access funds from anywhere in the world
• transfer funds instantly
How does DeFi work?
DeFi makes use of the blockchain technology, which is a layered architectural structure with highly composable building blocks.
Blockchain technology allows the implementation of an essential feature known as smart contracts, which can be used to program your funds.
Strange right? Programming funds? Let me explain to you. First, let’s take Bitcoin, a regular cryptocurrency, and Ethereum, a DeFi enabled crypto, into comparison.
With Bitcoin, you get to keep and trade your funds on the Blockchain. However, Ethereum’s DeFi feature allows for much more like lending and borrowing, scheduling payments, and investing in index funds.
Smart contracts are very crucial to such diverse transactions. Ethereum accounts are used to deploy these smart accounts, which code for a specific set of rules and are irreversible.
You can then deploy the smart contracts after it’s been programmed into the network and run the program, which other users can interact with via their own accounts.
These interactions are various transactions which are allowed by the smart contract. All smart contracts are made public on the network and can even be quoted by other contracts.
It is not at all hard to create these smart contracts. All you need is knowledge of coding in the smart contract language and enough Eth available to deploy your contract for transactions.
Solidity and Vyper are two languages used to code smart contracts in ethereum. These languages are very developer-friendly and not hard to master for even novices.
For example, you can use Solidity or Vyper to code a smart contract that dictates the yearly payment of 0.02 Eth from your account, A, to another account, B. It is that straightforward.
Other developers can publicly view the smart contract by reading the code used. Still, nobody, including you, can change or disrupt the smart contract in the running. Thus, a yearly payment of 0.02Eth will continuously be paid as long as there is enough Ethereum in your wallet.
The framework of Decentralized Finance is mainly made of four components, these include:
- The Blockchain – helps to store all data of activities and transactions.
- The assets- Stablecoins, Ethereum and other crypto tokens used for transactions in the DeFi systems.
- The protocols- these are smart contracts which provide the technical compliance for transactions.
- The applications- these are dApps used to implement DeFi across several platforms.
With a basic knowledge of these components, anybody, including you, can cut out the third-party-based Centralized Finance (corporations, government & people) oversight.
Replacing Centralized Finance
DeFi is the polar opposite of much more common Centralized Finance. Banks and financial corporations are custodians of all funds in the Centralized Finance system. These corporations permit and facilitate all your transactions but with direct charges for their services.
For example, you use credit cards and bank apps for your daily business to pay other people. The credit card contacts your bank, which allows your payment and deducts their own service charge in this timespan.
However, DeFi bypasses all sorts of foreign charges and control, which means you can do transactions directly. Although there are many distinctive features, this is the major difference between both systems.
With DeFi systems, you have total control over your funds, unlike when your money is in the hands of corporations. These corporations may use them for investments and loans that may affect your wealth.
DeFi also allows for pseudonymous transactions(I.e. without verified names & identity), unlike Centralized Finance which requires your identity for whatever transaction you wish to make. This means DeFi will always be an open market for everyone without interference or control from the financial corporations.
In the blockchain model of DeFi, you can directly view your transaction history and the usage of your funds. However, the Centralized Finance system is based on a closed book operational model, which is at the mercy of the corporations.
Unlike the Centralized Finance, which is rigid, DeFi allows several flexible and innovative ways, which have been mentioned earlier; let’s take an in-depth look at them:
Lending and borrowing have always been a pillar of finance that financial institutions thrive on. In Traditional finance, getting a loan is no easy task. First, you have to present your verified identity to the bank along with a couple dollars for collateral. Even then, your access to these loans is still at the mercy of the banks; annoying, right? It is even more challenging if you intend to gain some interest off your own money. Banks only approve such transactions through direct deposits or stock investments for a significantly lesser profit margin.
However, this is not the case with DeFi; crypto allows for anonymous payments among several parties. All you need to do is use a crypto loan platform (like AAVE or Compound) for this. To borrow, you can go to these websites and deposit your coins in an over-collateralization agreement on the smart contracts created by Compound or AAVE. This means that if you want to borrow $100, you should put in $120 worth of crypto. Funny, right? I know.
This is because crypto loans are not necessarily the usual loans from banks, and the system is set up so that the lender will never be at a loss. As the borrower, you may need money for business or other dealings. Selling your crypto for such dealings may not be a good idea since it will likely increase in value. Crypto loans are a great option in such a case since your crypto assets remain intact as collateral. They will also be returned to your possession after repaying the loan with whatever profit you make. Furthermore, you can do this instantly without going through any lengthy process of verifications and applications at the mercy of banks.
As a lender, it is even more straightforward; all you have to do is deposit your money into the crypto platform (Compound or AAVE), which gives you tokens. These tokens are put in the smart contract for others to borrow. Once the contract period is up, you get back your money with interest. Simple, right?! You can do all these in the comfort of your home or office or garden without having to notify the banks, deposit your money and hope for small interest returns while they do whatever they wish with it.
• Decentralized Exchanges
Several cryptocurrency exchanges allow you to trade your coins for others at a minute rate of about 0.05%. However, many are centralized publicly-traded corporations (like Coinbase & Binance). This means they control the cryptos you can trade and are regulated by the government, which means taxes measures and bank control is also heavily involved.
On the other hand, decentralized crypto exchanges (like Uniswap & Pancake swap) host several thousand coins that can be traded by their users. This allows you to pick a variety of several cryptocurrencies. Furthermore, such DeFi exchanges are not regulated by governments and are open to everyone- they are strictly regulated by the smart contracts that have already been coded by the platforms and cannot be changed by ANYONE EVER.
As in the everyday setting, you pay an insurance fee called premium to protect your assets (like cars, houses and more). When your home is insured, the insurance company will cushion your financial fall when something happens to your house. Let’s say it is destroyed in a fire accident, the insurance company will pay you. However, they will do so through conventional centralized systems like banks.
In DeFi systems, you can also get insurance through smart contracts. For example, you can also pay continuous amounts of money to insure your house.
If your home is subject to catastrophe, you get paid directly without interference from centralized systems. Straightforward, right? This is how it works: you pay a premium fee on a regular basis (yearly or monthly). This fee goes into the smart contract, delegated to the insurance provider. Once your insured asset is subject to damage, the insurance platform depends on Oracles to verify the events in the real world. An oracle is another verified trusted user in your local area that can attest to the damage done to your assets. Once the oracle gives their approval, you get paid. Through this, you get to bypass all the lengthy applications, investigations, requirements, and charges that Insurance companies use to gatekeep their services and any sort of control from the banks and government.
The future of DeFi
Although Decentralized finance is still growing, the DeFi world is set for mindblowing evolutions in the years to come.
The case of its regulation still poses some problems since the Defi ecosystem may get cramped by hacks, scams, and system issues. Moreover, the borderless nature of DeFi transactions means regulations will be an uphill journey.
There are also separate concerns about the crypto world’s general worries, such as energy requirements, carbon footprint, system upgrades, system maintenance, and hardware failures.
However, the future of DeFi looks bright for all those involved as it will only get better. The success of DeFi is followed closely by Financial institutions worldwide, who will come for their piece of the pie.