[Crypto 4NE1] Understanding Decentralized Finance (DeFi)
Decentralized finance, also known as DeFi, uses cryptocurrency and blockchain technology to manage financial transactions. DeFi aims to democratize finance by replacing legacy, centralized institutions with peer-to-peer relationships that can provide a full spectrum of financial services, from everyday banking, loans and mortgages, to complicated contractual relationships and asset trading.
What Is Decentralized Finance (DeFi)?
Decentralized finance (DeFi) is an emerging financial technology based on secure distributed ledgers similar to those used by cryptocurrencies. The system removes the control banks and institutions have on money, financial products, and financial services.
Some of the key attractions of DeFi for many consumers are:
- It eliminates the fees that banks and other financial companies charge for using their services.
- You hold your money in a secure digital wallet instead of keeping it in a bank.
- Anyone with an internet connection can use it without needing approval.
- You can transfer funds in seconds and minutes.
How is centralized finance different from DeFi?
Centralized Finance
In centralized finance, your money is held by banks, corporations whose overarching goal is to make money. The financial system is full of third parties who facilitate money movement between parties, with each one charging fees for using their services.
The network clears the charge and requests a payment from your bank. Your bank approves the charge and sends the approval to the network, through the acquiring bank, back to the merchant. Each entity in the chain receives payment for its services, generally because merchants must pay for your ability to use credit and debit cards.
All other financial transactions cost money; loan applications can take days to be approved; you might not even be able to use a bank’s services if you’re traveling.
Decentralized Finance
Decentralized finance eliminates intermediaries by allowing people, merchants, and businesses to conduct financial transactions through emerging technology. This is accomplished through peer-to-peer financial networks that use security protocols, connectivity, software, and hardware advancements.
From anywhere you have an internet connection, you can lend, trade, and borrow using software that records and verifies financial actions in distributed financial databases. A distributed database is accessible across various locations; it collects and aggregates data from all users and uses a consensus mechanism to verify it.
Decentralized finance uses this technology to eliminate centralized finance models by enabling anyone to use financial services anywhere regardless of who or where they are.
DeFi applications give users more control over their money through personal wallets and trading services that cater to individuals.
How Does DeFi Work?
Decentralized finance uses the blockchain technology that cryptocurrencies use. A blockchain is a distributed and secured database or ledger. Applications called dApps are used to handle transactions and run the blockchain.
In the blockchain, transactions are recorded in blocks and then verified by other users. If these verifiers agree on a transaction, the block is closed and encrypted; another block is created that has information about the previous block within it.
The blocks are “chained” together through the information in each proceeding block, giving it the name blockchain. Information in previous blocks cannot be changed without affecting the following blocks, so there is no way to alter a blockchain. This concept, along with other security protocols, provides the secure nature of a blockchain.
DeFi Financial Products
Peer-to-peer (P2P) financial transactions are one of the core premises behind DeFi. A P2P DeFi transaction is where two parties agree to exchange cryptocurrency for goods or services with a third party involved.
To fully understand this, consider how you get a loan in centralized finance. You’d need to go to your bank or another lender and apply for one. If you were approved, you’d pay interest and service fees for the privilege of using that lender’s services.
In DeFi, you’d use your decentralized finance application (dApp) to enter your loan needs, and an algorithm would match you up with peers that meet your needs. You’d then need to agree to one of the lender’s terms and receive your loan.
The transaction is recorded in the blockchain; you receive your loan after the consensus mechanism verifies it. Then, the lender can begin collecting payments from you at the agreed-upon intervals. When you make a payment via your dApp, it follows the same process in the blockchain; then, the funds are transferred to the lender.
DeFi Currency
DeFi is designed to use cryptocurrency for transactions. The technology is still developing, so it is difficult to determine precisely how existing cryptocurrencies will be implemented, if at all. Much of the concept revolves around stablecoin, a cryptocurrency backed by an entity or pegged to fiat currency like the dollar.
