What is DeFi? Is that the future of Finance?
DeFi stands for decentralized finance, this is a popular term today, it refers to peer-to-peer financial services on public blockchains, mainly Ethereum. DeFi is completely different from the traditional financial model, in this article, let’s take a deep dive into DeFi with Tech Town.
What is Decentralized Finance (DeFi)?
DeFi is a financial technology trend based on secure distributed ledgers, which are similar to those used in cryptocurrencies (crypto). The emergence of DeFi could remove the control of banks and financial institutions, financial products and services.
Some advantages of DeFi for users:
● Eliminate service fees charged by banks or financial institutions.
● Users keep their money in personal electronic wallet – it is safer than keeping money in a bank.
● Anyone with an internet connection can use it without approval.
● Ultra-fast currency transactions in seconds.
To better understand DeFi, let’s learn the difference between it and the concept of centralized finance.
For this type of finance, the user’s money is held by a bank or financial institution. The financial system now has the presence of third parties to facilitate the flow of money between the parties, with each party charging their own service fee. Example: You buy an item with a credit card, the money goes from the seller to the bank, the bank forwards to the credit card network. Every transaction in the chain incurs a service fee, in short, you will have to pay for the ability to use your credit/debit card.
All financial transactions cost money, loan applications can take days to be approved, and users cannot even use banking services if they are traveling.
DeFi eliminates middlemen by allowing all users, merchants and businesses to conduct financial transactions using new technology. This is done through peer-to-peer financial networks, using modern security protocols, connections, software and hardware.
No matter where there is an internet connection, users can lend, trade and borrow using software that records and verifies financial activities in a distributed database. This database is accessible in various locations, it collects and aggregates all data from users and verifies it via consensus mechanism.
DeFi uses this technology to eliminate centralized financial models, by allowing users to use financial services anywhere. DeFi applications allow users to control their own funds through personal digital wallets and personalized transaction services.
How does DeFi work?
In the past, people called DeFi “open finance”, bypassing intermediaries in financial transactions. So, instead of letting a bank or credit company act as an intermediary in the middle of transactions between buyers and sellers, users will now use cryptocurrency, having the right to own it for direct use. DeFi is mainly based on Ethereum – the top famous cryptocurrency next to Bitcoin.
And here are the key tenets of DeFi:
● There are no intermediaries, no financial institutions or banks that can monitor an individual’s money.
● Wide coverage across geographical borders.
● There are many applications for users, mainly based on Ethereum.
DeFi is mentioned by many people in crypto conversations. But not only that, it goes beyond creating an alternative digital currency or value. DeFi will replace the role of traditional financial systems with its smart contracts.
“DeFi is code. With the help of things called smart contracts, your coins are programmed to perform a variety of functions. It creates an opportunity for anyone with a computer and a connection. internet participates in the global economy,” said Anton Mozgovoy, Co-Founder of Mover, a DeFi Savings platform.
One of the biggest advantages of DeFi is that it removes the barrier to entry for many financial transactions. Users will now not need a government or a bank to manage their money, nor will they need to qualify for certain financial products.
Thanks to Ethereum’s smart contracts and application creation capabilities, DeFi can be used to:
● Make a lending network, providing loans and peer-to-peer lending.
● Convert currencies through decentralized exchanges. Example: Convert Eth to US Dollar.
● For betting purposes, this is where a user can place a bet on the possible outcome of a certain event.
● Making stablecoins – connecting a cryptocurrency to a traditional currency for reduced price volatility and economic stability.
Peer-to-peer (P2P) financial transactions are one of the core premise behind DeFi. A P2P DeFi transaction is where two parties agree to exchange cryptocurrencies for goods or services with a relevant third party.
To help you understand better, let’s take the example of you getting a loan in a centralized financial system. You need to go to your bank or financial institution to apply. If approved for a loan, you must pay interest and service charges in order to have access to the lender’s services.
In DeFi, on the other hand, you will use a decentralized finance application (dApp) to input your loan requests, an algorithm will match your loan request to the person who meets it. You must then agree to the lender’s terms and receive the loan.
In DeFi, you will use a decentralized finance application (dApp) to input your borrowing needs, and an algorithm will help you match peers who meet your needs. You then need to agree to one of the lender’s terms and get your loan.
The transaction will be recorded in the blockchain, you get your loan after the consensus mechanism verifies it. The lender will then collect your payments at the agreed time (or intervals). When you make a payment through your dApp, it follows the same process in the blockchain, and the funds go to the lender.
Benefits of DeFi
● Users do not need to register or open an account. Everyone has access to their digital wallet.
● Users do not need to provide their name, email address or any other personal information.
● Users can move their assets anywhere and at any time without approval, long waits and paying transaction fees.
● Interest rates and rewards are usually updated quickly (as fast as every 15 seconds), which can be significantly higher than on traditional Wall Street.
● Every participating user can see the entire transaction in the most transparent way.
Disadvantages of DeFi
Since transaction rates fluctuate on the Ethereum blockchain, it means that active transactions can get expensive.
Depending on the dApps used and how they are used, this can cause fluctuations in investments.
Users need to maintain their profile for tax purposes. Regulations may vary from region to region.
The future of DeFi
DeFi is still in the early stages of development, which means it’s unregulated, the ecosystem still has potential risks of infrastructure, hacks, and scams.
Existing laws build on the idea of separate financial sectors, each of which will have its own set of laws and rules. DeFi’s cross-border transaction capabilities will be the issues to deal with for these regulations. For example: Who will enforce the regulations, how will they be enforced, who will be responsible for investigating cross-border financial crimes, etc.
Overall system stability is also a top concern today, including energy requirements, carbon footprint, system upgrades, and hardware maintenance and debugging.
There are many issues that need to be resolved before DeFi becomes safe for users. Financial institutions will not give up their forms of money. So if DeFi is successful, it is likely that banks and financial institutions will find ways to participate in the system, they will definitely find ways to make money from this potential system.
Hope the information Tech Town brings above will be useful to you.
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