Decentralized finance (or DeFi) is an emerging digital financial system that removes the need to have financial transactions approved by a central bank. Many view DeFi as an umbrella term, that describes a new wave in financial services innovation.
DeFi is closely connected to blockchain, the decentralized public ledger that Bitcoin is based on. Blockchain technology allows all computers on a network to have a copy of the history of transactions, and the underlying idea is that no one entity can alter or have control over the ledger of transactions.
How Does Centralized (Traditional) Finance Work?
Centralized finance means that corporations, and banks hold your money with the overall goal of generating profits. There are countless third parties in the traditional financial system that facilitate money movement between people. Each of these parties charges fees for the services they provide.
Example
Imagine you buy a carton of milk with your credit card. The traditional (centralized) financial system processes the transaction as follows:
1st Step: The merchant passes the charge to the acquiring bank
2nd Step: The acquiring bank forwards the details to the credit card network
3rd Step: The network clears the charge and asks your bank for payment
4th Step: Your bank approves the charge by sending the approval back to the network (through the acquiring bank)
5th Step: The approval ultimately arrives back to the merchant
Therefore, each entity in the chain receives payment for its services. The reason is that merchants are generally responsible (and must pay) for allowing you, and other customers to use credit and debit cards.
How Does Decentralized Finance (DeFi) Work?
Decentralized finance eliminates intermediaries, allowing merchants, individuals, and businesses to transact through this emerging technology. Peer-to-peer financial networks use connectivity, security protocols, and other hardware and software advancements.
You can borrow, lend, and trade from anywhere with an internet connection. Software that records, and verifies financial transactions in distributed financial databases allows you to perform these operations from any location. A distributed database collects and aggregates information from all users, and uses a consensus mechanism for verification.
DeFi uses technology to eliminate centralized finance and allows you to access financial services regardless of where you are. Through personal wallets and trading platforms tailored to individual users, DeFi apps give users greater control over their money.
What Is The Difference Between DeFi and Bitcoin?
Bitcoin is a decentralized digital currency operating on its own blockchain, and users mostly use it to store value. DeFi, on the other hand, is a concept that describes financial services built on public blockchains like Ethereum and Bitcoin. It allows users to borrow against or earn interest on their cryptocurrency holdings. Consequently, DeFi includes a range of financial services applications, such as lending, borrowing, trading, and derivatives.
What Can You Do With DeFi?
DeFi makes it possible to offer financial services through smart contracts, and cryptocurrencies without involving banks. The possibilities for what you can do using DeFi continue to grow with the addition of more decentralized apps. Individuals and organizations typically use DeFi for:
- Sending money worldwide (in a short time and easily)
- Storing money and earning higher yields than in traditional banks through crypto wallets
- Lending and borrowing on a peer to peer level
- Trading cryptocurrencies 24/7 & anonymously
- Trading tokenized versions of investments like funds, stocks, and other financial assets (including NFTs)
- Crowdfunding
The Downsides & Risks of DeFi
DeFi is a new phenomenon with many risks. Decentralized finance is a recent innovation still untested by widespread or long-term usage. National authorities are also taking note of the systems they’re putting in place with an eye toward regulation. Other risks associated with DeFi include:
- Private key requirements. You must protect your wallets that store cryptocurrency assets. Private keys are long, unique codes only known to the owner of the wallet. Losing your private key means you cannot access your funds. Also, such keys are unrecoverable.
- Collateralization. Collateral is an asset of value you use to secure a loan. For example, a mortgage loan’s collateral is the property you are buying. Nearly all DeFi lending transactions require collateral in cryptocurrencies equal to or greater than 100% of the loan’s value. These restrictions severely limit who can apply for DeFi loans.
- Hackers pose a danger. Although a blockchain is nearly impossible to alter, there are other hackable parts of DeFi, potentially resulting in fund theft or loss. All possible uses of decentralized finance rely on software systems, which are hackable by nature.
- There are no consumer protections. DeFi thrived without regulations and rules. However, consequently, users may not have recourse if a transaction goes wrong. On the other hand, there are still DeFi services providers like CEX.IO that understand these concerns. CEX.IO is secure and fully regulated, allowing users to access DeFi services risk-free and with a couple of clicks.
Disclaimer: For information purposes only. Not investment or financial advice. Seek professional advice. Digital assets involve risk. Do your own research.
