What Is DeFi? Understanding Decentralized Finance

DeFi is a decentralized finance platform that uses cryptocurrencies and blockchain to facilitate financial transactions.?

The goal of DeFi is to replace traditional, centralized financial institutions with peer-to-peer relationships that offer a wide range of financial services. These services range from traditional banking, loans, and mortgages to complex contractual agreements and asset trading.

Centralized Finance

In today’s world, almost all banking, lending, and trading activities are centralized systems, managed by governing bodies and controlled by gatekeepers.

Regular consumers have to deal with numerous financial intermediaries to access everything ranging from auto loans to mortgages, to stock and bond trading.

This means that there are few ways for consumers to directly access capital and finance services. They can’t bypass middlemen such as banks, exchanges, and lenders who make a cut of every financial transaction as a fee. We all pay to play.

Decentralized Finance (DeFi)

?removes the middleman and gatekeepers from the financial system, empowering everyday people through peer-to-peer exchanges.

"DeFi takes the core functions of traditional finance, such as lending, borrowing, and trading, and puts them in the hands of ordinary people."

For example, today, depositing money into an online savings account would earn a bank a 0.5% interest rate. The bank would then lend that money to another depositor at a 3% interest rate, pocketing the 2.5%. With DeFi, depositors lend their money directly to others, eliminating this 2.5% loss and earning the full 3% interest.

Defi runs on blockchain

which is a decentralized public ledger that records financial transactions in computer code. Blockchain and cryptocurrency are the fundamental technologies that make decentralized finance possible.

When a transaction is made in your traditional checking account, it is recorded in your bank’s private ledger—your bank’s history of transactions. This ledger is owned and controlled by a major financial institution.

In contrast, when a transaction is recorded on a decentralized blockchain, it is verified and recorded by multiple parties who all use the same blockchain. This process involves solving complex mathematical problems and adding new transactions to the blockchain.

DeFi advocates claim that decentralized blockchain technology makes financial transactions more secure and transparent than private, opaque systems used in centralized finance. When we say “distributed” in DeFi, we mean that all parties using the DeFi app have an “exact same copy” of the public ledger. Each transaction is recorded in encrypted code and provides users with anonymity, as well as verification of payments and record of asset ownership, which is (almost) impossible to change by fraudulent activity.

How Defi is Currently Being Used

DeFi is being used for a variety of straightforward and intricate financial transactions. It is being used through decentralized applications called "apps" or other programs called "protocols." apps and protocols are used to process transactions in the two major cryptocurrencies, Bitcoin and Ethereum. Bitcoin is the more widely used cryptocurrency, but Ethereum is much more flexible and can be used for a wide range of purposes, so much of the decentralized application and protocol landscape is based on Ethereum code.?

Here are some examples of how DeFi is already being used:

DeFi enables traditional financial transactions such as payments, securities trading, insurance, lending, and borrowing.

DEXs: Most cryptocurrency investors currently use centralized exchanges such as Coinbase. DeXs enable peer-to-peer financial transactions and allow users to maintain control over their funds.

E-Wallets: Developers of DeFi are developing digital wallets that operate independently from the biggest cryptocurrency exchanges and provide investors with access to cryptocurrency and blockchain-based gaming.

Stable Coins: While cryptocurrencies are known for their volatility, stablecoins try to stabilize their value by linking them to other currencies, such as the US dollar.

Yield Harvesting: DeFi is often referred to as “the ‘rocket fuel’ of crypto. For speculative investors, DeFi enables lending crypto and potentially yields big returns when proprietary coins that DeFi lending platforms pay for agree to lend appreciate rapidly.

NFTs (Non-Fungible Tokens): NFTs are digital assets created from typically non-transferable assets, such as “slam dunk” videos or “first tweet on Twitter.” NFTs convert the previously non-transferable asset into a commodity and commodify it.

Flash loans: Flash loans are a type of cryptocurrency loan that borrows funds and pays them back in one transaction. Does this sound counterintuitive? The short answer is yes. Borrowers can make a profit by entering into an Ethereum blockchain-encoded contract—no lawyers required—that allows them to borrow funds, execute a transaction, and pay the loan back immediately. In the event that the transaction cannot be executed or is a loss, funds automatically return to the borrower. If the borrower makes a profit, they pocket the money minus interest charges and fees. Consider flash loans decentralized arbitrage.

The DeFi market is measured by what’s known as ‘locked value’, which is the amount of money currently working in various DeFi protocols. The total locked value of DeFi protocols currently stands at nearly INR 3,000,000,000.

The adoption of DeFi is driven by the ubiquity of blockchain technology. As soon as an app is coded on a blockchain, it becomes available all over the world. Most centralized financial tools and technologies are slowly rolled out over time, regulated by the rules and regulations of the regional economies. Dapps, on the other hand, exist outside of those rules, which increases their potential reward—as well as their risks.

DeFi’s Risks and Downsides

DeFi is a relatively new phenomenon that comes with a number of risks. As a new innovation, decentralized finance hasn’t been stress-tested by extensive or widespread use. Furthermore, national authorities are increasingly scrutinizing the systems it is implementing, with an eye to regulation.

Here are some of the other risks associated with DeFi:

No Consumer Protection

DeFi has flourished in the absence of any rules and regulations. However, this also means that users may not have much recourse if a transaction goes wrong. For example, in centralized finance, banks have to hold a set amount of capital as reserves to maintain stability and to cash you out from your account whenever you need it.

Hackers

While a blockchain may be almost impossible to change, other aspects of decentralized finance are at high risk of being hacked. Hackers can steal or lose funds, and all of the potential use cases of decentralized finance rely on vulnerable software systems.

Collateralization: Collateral is an item of value that is used to guarantee a loan. For example, when you take out a mortgage, the collateral is the home you are buying. Almost every DeFi lending transaction requires collateral that is at least equal to, or greater than, the loan amount. These requirements significantly limit the number of people who can get a DeFi loan.

Private Key Requirements: When using DeFi and cryptocurrencies, you need to secure the wallets you use to store your crypto assets. These wallets are secured using private keys. Private keys are long, one-of-a-kind codes that are only known to the wallet owner. If a private key is lost, you lose the ability to access your funds. A lost private key cannot be recovered.

How do I get involved with DeFi?

To get started with DeFi, there are a few things you'll need to know. First, you'll need to set up a crypto wallet. Cosman recommends starting with an Ethereum wallet such as Metamask. Once you have a wallet, you can use it to trade digital assets.

However, it's important to remember that you'll need to keep both your private and public keys safe. If you lose your private key, you won't be able to access your assets again.

Once you have a crypto wallet set up, you can trade digital assets. For example, you can trade a few small amounts of two assets to a decentralized exchange like Uniswap.

This is a great way to get a feel for the current market, Cosman says, but be aware that you may lose everything if you don't manage your risk.

Take a look at Stablecoins

"Stablecoins (dollar-backed tokens that aren't subject to price movements) are a great way to get started with DeFi without exposing yourself to the volatility of an underlying asset," Cosman says. "The key to any new financial venture is to start small, stay humble, and don't get carried away. Digital assets traded in the crypto and DeFi worlds move quickly and there is always a risk of loss."

What the Future of DeFi Looks Like

"DeFi has the potential to revolutionize the way investors deploy assets in ways that seem impossible now, such as by removing the middleman and turning digital assets into monetary value.