What Is Decentralized Finance?
The concepts of cryptocurrencies and DeFi are hot topics in the online financial community. With big names like Ethereum pioneering these exciting new financial systems, the rise of DeFi is one to watch.
But what is DeFi, and how does it work?
We’ll take a look at the exciting world of DeFi and answer all of your most frequently asked questions, including the following: What is DeFi in crypto? What’s the difference between DeFi and crypto? And finally: What is the best DeFi platform?
We’re also going to take a look at some examples of DeFi, along with the pros and cons of this financial system.
Finally, this post will give you a glimpse into the future of DeFi, according to our experts.
What Is DeFi and Why Do We Need It?
What does DeFi stand for in crypto? The answer is “decentralized finance.” It’s essentially an alternative to the regular banking systems that we are used to.
Its users perform transactions in both cryptocurrencies and stablecoins, meaning that no physical cash is ever needed.
Centralized finance refers to institutions such as banks, brokers, and lenders. With DeFi, you take out these middlemen to provide a more streamlined financial service.
Why do we need DeFi? This is subjective, and some may even argue that we simply don’t need an alternative to the normal banking systems.
However, most people agree that financial autonomy offers more positives than negatives. Plus, the option of making transactions outside of the confines of your bank means that banking institutions have less power over people, decreasing their current financial monopoly.
Centralized vs. Decentralized Finance Systems
Most of us have grown up with a centralized banking system. If we need money, we go to a bank and ask to borrow it. If we have money, we tend to store it in a bank account where we perceive that it is always kept safe.
However, banks and lenders involve some pretty major restrictions. Firstly, the government controls banks. This means that your bank could refuse to lend you money at any time or even take away the money you have in your bank account if a government agency deems it necessary.
With centralized finance, we are also at the mercy of banks, their fees, and waiting times. Loans and credit cards feature huge interest rates that we cannot argue with because these banks and lenders are our only choice when it comes to borrowing money. Plus, you get charged for every movement you make, especially if you transfer funds abroad.
Therefore, DeFi is a move to eliminate the need for these third parties, giving you a straight line from A to B when it comes to financial transactions between you and other people.
So what does DeFi mean in crypto circles? DeFi uses blockchain technology similar to cryptocurrency, so everything is done online, completely removing humans from the process. This removes both human error and the risk of tampering.
The 5 Pillars of DeFi
For some, the idea of removing humans and banking systems from financial transactions sounds scary and unpredictable. But although DeFi is still a relatively new concept, it uses solid foundations that you usually find within a centralized system.
You can still borrow and lend funds, exchange currency, take out insurance, and trade. With that in mind, let’s take a look at the five pillars of DeFi and what you can expect from decentralized finance systems.
Stablecoins are a bridge between crypto and fiat currencies. We can describe them as forms of digital coins that are pegged to a fiat currency. Examples of DeFi coins that are also stablecoins include Tether (USDT), Binance (BUSD), and USD Coin (USDC). These are all stablecoins attached to US dollars.
You can consider stablecoins to be a safer asset, as they offer protection for traders and investors during volatile times in the crypto market. Since they are backed by real-world assets, such as USD, GBP, or gold, their value will not fluctuate as cryptocurrencies will.
Borrowing and Lending
Most of us go to our banks to borrow or lend money. Looking for the best crypto loan option and reviewing all associated terms is a tiresome process.
However, with DeFi, you simply need a smart contract, a piece of code set up to perform a particular function.
If you want to borrow or lend crypto, you can use companies such as Compound or AAVE, which will create smart contracts to carry out these financial actions. This means that you don’t need a bank, and you can also say goodbye to the bank’s waiting times and high fees.
Currency exchanges usually involve foreign exchanges. Unfortunately, they also tend to come with high rates of conversion. However, with decentralized exchanges, you are free to trade many different coins and tokens without the outrageous fees attached.
In fact, you could be looking at as little as half a per cent to trade large sums, depending on which exchange you use.
For instance, Coinbase is a centralized exchange that lets you trade around 30 cryptocurrencies. But because it is centralized, each coin is scrutinized before it is allowed onto the platform. Plus, you are subject to the usual government restrictions and higher transaction rates.
One of the most popular examples of decentralized exchanges is UniSwap. Here, users can exchange hundreds, if not thousands, of different coins and tokens as they wish.
When it comes to insurance, this is where DeFi and the real world need a little help to get along together smoothly.
If you want to use DeFi to take out insurance, you can use a smart contract that will write code specific to the insurance deal. But things get more complicated when you need the code to pay out the insurance. For this, you need something called an “oracle.”
Oracles are tools and resources that exist off the blockchain, i.e., in the real world. In the car insurance example, an oracle would be a reliable source to determine whether the insurance claim should be paid out. The oracle then instructs the smart contracts that all terms have been met, in which case the smart contract will pay out the insurance claim.
Margin trading is a whole industry in its own right, consisting of buying and selling shares using leverage. This means that you borrow more money than you have and use it to increase your profits. As a result, you can make money with Bitcoin or alternative coins and boost your current holdings. Be aware that you’ll get access to extra funds, but in exchange, you must pay higher interest rates and possibly other fees.
With centralized trading, you need to prove who you are and have a few thousand dollars in the bank before you’re allowed to enter this market. But with DeFi, the market is open to anyone from anywhere in the world, and the fees tend to be much lower.
How Does DeFi Work?
Now that you know all about the various aspects of DeFi and what you can do using decentralized finance, it’s time to take a look at how DeFi works.
We use the term “blockchain.” regularly to talk about cryptocurrency. DeFi uses the same blockchain technology as crypto to send and receive funds across the world. The blockchain is a peer-to-peer system that eradicates the need for middlemen, such as banks and lenders.
The “blocks” in the chain are collections of data, i.e., details of all transactions carried out. And the “chain” is effectively a list of these blocks, which are stored and protected by cryptography.
Cryptography is basically the process of encrypting all transactions on the blockchain to keep everybody safe. There are a few types of cryptography, but their main purpose is to protect all the information on the blockchain from shady third parties. This is extremely important, especially when no banks act as intermediaries between you and the person you’re sending or receiving money from.
Elements of cryptography include encryption, decryption, cipher, and keys. And each one has a place in the process of sending/receiving money safely using DeFi.
Smart contracts are what you use to make transactions in the DeFi world. Without banks stepping in and facilitating movements, you need another way to send and receive money. That’s where smart contracts come in.
Simply put, smart contracts are pieces of code that contain instructions. Often referred to as “if this, then that” contracts, these pieces of code l carry out transactions when certain terms or conditions are met.
For example, if you agree to give five friends 10 Ethereum coins if they all attend your birthday party, you can create a smart contract for this. All the friends attending will automatically get their coins when they show up. Even if one of your friends has the best excuse in the world for not attending, the smart contract will not send them the Ethereum, as it doesn’t work on the basis of negotiations. After all, it’s computer code and doesn’t care about traffic, illness, or even death!
If you’re wondering how the smart contract would know about your friends’ attendance, this is where oracles come in again. Oracles exist in the real world, so you can set up an oracle to take attendance at your party and tick people off a guest list. The oracle will inform the smart contract and execute its pre-programmed function of paying out the Ethereum coins.
What Is the Difference Between DeFi and Crypto?
A lot of people ask, are DeFi and crypto the same thing? The short answer is no. Cryptocurrencies and DeFi often get lumped in together, as they both use similar processes and technology. But they are not the same thing.
Cryptocurrencies are coins that you can use to carry out transactions, including buying, selling, and trading. In contrast, DeFi is an entire financial system that you can use for peer-to-peer transactions without the need for banks.
In summary, cryptocurrencies are part of DeFi, but DeFi is not a cryptocurrency.
So far, we’ve looked at how DeFi works, as well as its basic structure and potential functions. For a DeFi system to run smoothly, we need three basic components:
- Infrastructure: platforms on which to perform financial transactions
- Software: programs and apps to let us carry out these financial transactions
- Currency: the coins and tokens we use as currency with the DeFi world
Let’s take a look at each of these elements in a little more detail.
DeFi Infrastructure and Software
The first thing you need with any financial system is infrastructure. Without the need for physical institutions, like banks and building societies, DeFi uses online software platforms as a foundation for all transactions.
So what is the best DeFi platform? Currently, the most popular is Ethereum. Using this platform, programmers can write code and create the platforms, smart contracts, and decentralized apps (dApps) needed for users to perform their transactions.
Now that we’ve got our infrastructure in place and the tools to make transactions, we need a currency.
Most people naturally think of ways to buy Bitcoin when they consider DeFi. However, Bitcoin itself is not compatible with many platforms, including Ethereum. Therefore, the next logical step would be to look at Ethereum’s native currency, Ether (ETH). Yet both Bitcoin and Ether are considered highly volatile. This makes them potentially a great currency for buying and trading, but not your daily financial needs. Enter stablecoins.
As we saw earlier, stablecoins are pegged to a fiat currency, such as USD or EUR, meaning their value does not fluctuate as much as volatile currencies.
Popular stablecoins that you can use on platforms like Ethereum include USDCoin, Tether, Binance USD, and DAI.
Regardless of which currency you choose, you can now explore the many benefits of DeFi.
Advantages of DeFi
The potential upsides of using DeFi are pretty evident. However, let’s take a moment to summarize some of our earlier points and look at the advantages of DeFi:
- DeFi eliminates the need for intermediaries, such as banks and building societies
- DeFi users can look forward to more financial freedom of movement
- Without banks, DeFi users avoid high fees and interest rates
- Smart contracts avoid human interference and manipulation
- DeFi can be anonymous; you don’t need a bank account to make transactions
- More opportunities for people to invest and trade with DeFi solutions
Disadvantages of DeFi
DeFi is not a perfect system and has its fair share of possible downsides. Let’s take a look at some of the possible cons of DeFi:
- DeFi systems are more prone to online hacking
- It’s harder to resolve disputes in DeFi, with no central bank, or anything similar, to complain to
- DeFi is generally volatile, particularly when using Bitcoin and Ether
- DeFi is expensive to run, and therefore raises questions of sustainability in the long term
- While still in its infancy, DeFi remains largely a niche environment
Why Is DeFi the Future?
With so many potential upsides of using decentralized finance, there is no doubt that DeFi is here to stay. Freedom of movement, anonymity, and lower transaction fees are all tempting prospects.
However, the systems in place at present are not perfect. It’s difficult to imagine a world without banks in the near future, as the vast majority of the world still sees them as a safe and reliable set of institutions.
That said, with technology moving quickly and more people becoming interested in moving away from centralized finance, the global reach of DeFi and its users is set to widen, and we cannot wait to see what’s in store. The DeFi revolution is here.