What Is Decentralized Finance (DeFi) and How Does It Work?


Table of Contents

  1. What Is Decentralized Finance (DeFi)?
  2. So what is DeFi exactly?
  3. How does DeFi work?
  4. What are the Benefits of Decentralized Finance?
  5. What are the risks and challenges of Decentralized Finance?
  6. What's the Potential Impact of DeFi in the Cryptocurrency Industry?
  7. Final thoughts

What Is Decentralized Finance (DeFi)?

DeFi is the short form of Decentralized Finance. It allows participants to conduct financial dealings directly, eliminating middlemen. With the DeFi policy, it's easy to carry out most of the transactions offered in centralized institutions and traditional banks.

The interesting news about DeFi is that it cuts off bank charges and costs that other financial institutions bill for utilizing their services. And the good thing is anyone with an internet connection can use DeFi.

In the subsequent paragraphs, we'll highlight what DeFi is and how it works, its benefits, risks, and the conceivable influence of this fast-growing sector in the cryptocurrency industry. We shall explore these indices using the Ethereum blockchain system as a premise.

It will interest you to know that Decentralised Finance is not exclusive to the Ethereum blockchain alone. It has only been a prominent ecosystem for the DeFi applications considering its smart contract functionality. Other platforms such as Binance Smart Chain, Polkadot and Solana have also proven to have good ecosystems for DeFi to thrive.

Shall we dive into the captivating realm of DeFi?

So what is DeFi exactly?

Decentralized Finance enables individuals to transact directly with other individuals through blockchain networks instead of using centralized organizations such as banks. This eliminates intermediaries. It also allows for faster, more effective, yet less expensive financial transactions.

With DeFi, there is no centralized authority. Rather, authority is allocated in a decentralized manner to give people more leverage and control. Also, users can store money in a secure digital wallet and transfer money quickly.

How does DeFi work?

Decentralized Finance, or DeFi, utilizes the blockchain technology deployed in cryptocurrencies. The blockchain documents transactions in blocks and is subsequently authenticated by others. The block is closed and encrypted if all of these authenticators agree on a transaction, and an additional block with details of the old block within it is built.

The DeFi model operates with any Layer 1 blockchain, such as Bitcoin, Etherium, and BNB Chain, with the aid of smart contracts. A smart contract is a program that works on a blockchain’s built-in distributed ledger and cryptographic encryption capacities. The conditions for the implementation of a specific operation are laid down in the smart contract.

A smart contract is mechanically equipped to execute the financial transaction described in the contract rather than a central authority. Cryptocurrency investments that can be transferred from one body to another can be stored in a smart contract.

The transaction terms are also available with DeFi smart contracts and are accessible as code, making them perceptible to others for audit and analysis. DeFi operates on a P2P standard. Therefore a central authority is not needed to facilitate a smart contract. As a result, a transaction can be executed without a third-party central authority if two bodies agree on doing so.

The DeFi paradigm and the use of smart contracts underscore empowering the individual user—custody of cryptocurrency assets relies on having access to private and public encryption keys. In a decentralized system, a person holds custody of their own private cryptographic encryption keys.

What are the Benefits of Decentralized Finance?

By leveraging the features of blockchain, Decentralized Finance provides its users with many benefits. These perks icnclude improving financial security and transparency as well as unlocking liquidity and development possibilities. That is not all, it also supports a robust and uniform economic system.

  • Transparency: All transactions are broadcast and validated by other individuals on the network on the public Ethereum blockchain. This grade of transparency regarding transaction data not only enables rich data analysis but also guarantees that all users have access to network activity. The open-source code used to create Ethereum and the DeFi protocols that operate on it is also accessible to anybody to view, audit, and develop.
  • Programmability: Extremely programmable smart contracts can automate the implementation and facilitate the design of new financial tools and digital assets.
  • Interoperability: DeFi protocols and applications are created to incorporate and enhance one another due to Ethereum's comparable software stack. DeFi gives product teams and developers the freedom to develop already-existing protocols, modify user interfaces, and incorporate third-party applications.
  • Permissionless: DeFi, contrary to traditional finance, is characterized by its transparent, permissionless access. Anybody with a crypto wallet and an Internet connection can access DeFi apps developed on Ethereum, irrespective of place and often without any minimum amount of funds.
  • Immutability: Through tamper-proof data management across a blockchain's decentralized structure, transactions that have been executed and recorded become permanent and cannot be altered.
  • Self-custody: Parties in the DeFi market often maintain custody of their assets and management over their data by utilizing Web3 wallets such as MetaMask to ally with permissionless financial apps and measures.
  • Lower costs: With the lack of central authority, DeFi offers parties the guarantee of reduced expenses than transactions carried out in the CeFi paradigm. Also, rather than the total worth of the asset being transferred, costs of transaction basically rely on network charges and computational resources required. What is implied here is that your commission is not based on the volume of the assets being transferred, which further asserts that DeFi is cost-effective.
  • Anonymity: On the blockchain, smart contracts can be shared, but user identification is not essential or required. DeFi does not particularly comply with the Know Your Client criteria typical of centralized and regulated systems.
  • Decentralised Apps: DeFi endorses dApps, enabling users to take advantage of applications for financial services as well as other use cases like gaming and social media.

What are the risks and challenges of Decentralized Finance?

Although Decentralized Finance has several essential benefits, it also has its risk factors and challenges, some of which are highlighted below:

  • Security: DeFi channels have deliberately been the focus of attackers in recent times. Over $1 billion in assets had been taken in three (3) months, the Federal Bureau of Investigation reported in an alert released in August 2022.
  • Private key conditions: In DeFi and cryptocurrencies, you must secure the wallets you employ to keep your cryptocurrency assets. Private keys, which are lengthy, distinct codes learned only by the wallet's owner, are utilized to secure these wallets. If you forfeit the private key for your cryptocurrency wallet by any means, you forfeit access to your funds and can never regain it.
  • Volatility: Since there is no central regulatory authority to manage or restrict transaction or market momentum, there may be increased volatility with DeFi models.
  • Collateralization: Many DeFi lending deals demand collateral equal to 100% of the loan's worth. The requirements seriously limit who is eligible for many of these loans. High-risk borrowers may be required to provide collateral by traditional banks, although many clients can obtain unsecured loans at cheap interest rates.
  • Complexity: DeFi operates under a P2P paradigm using smart contracts and complicated algorithms. This complexity can be challenging for novices to comprehend completely. It is, therefore, commonplace for them to experience confusion over how the service or app functions.
  • Customer service: Customer support with DeFi can mostly be challenging since there is no central authority or service to turn to for assistance.

What's the Potential Impact of DeFi in the Cryptocurrency Industry?

The impact of Defi on the cryptocurrency sector is outstanding, and the potential impact it has cannot be undermined. 

DeFi lending, for instance, is increasingly becoming more popular as decentralized finance companies are beginning to embrace it. You may lend digital assets to others while getting interest with DeFi lending. Using smart contracts, lenders can pool their resources and decide the terms. To secure a loan, borrowers typically have to put digital currency as collateral. This implies that borrowers might obtain funds in a renowned cryptocurrency like Bitcoin while pledging collateral in a less-known cryptocurrency.

You don't have to sell your collateral; if you borrow through DeFi and pay the interest, you can access Bitcoin. In rare circumstances, you may even be able to borrow more money than the collateral you put up.

Final thoughts

Decentralized Finance is an evolving financial technology that threatens centralized financial institutions. It not only allows for easy transfers of capital globally, but it also eliminates intermediaries and centralized banking from financial dealings.

Significant sources:

https://www.investopedia.com/decentralized-finance-defi-5113835 https://www.futurelearn.com/info/courses/defi-exploring-decentralised-finance-with-blockchain-technologies/0/steps/251154

Author: Ganiu Abdurahman

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