What is Decentralized Finance (DeFi)?

Published by Sten Ivan on

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Decentralized finance (DeFi) refers to a wide range of blockchain-based financial solutions, primarily built on the Ethereum network. Just like typical cryptocurrencies like Bitcoin, DeFi is a network that is global, peer-to-peer, pseudonymous, and open for all. But the technology utilized in decentralized finance is more advanced, and the potential applications of DeFi seem unlimited.

Not to be confused with centralized finance (CeFi), DeFi has its own characteristics that set it apart from its CeFi counterparts. In this article, you will find all you need to know about decentralized finance: you will get to know what is DeFi, how it works, what are its advantages and disadvantages, and what are some of the most popular DeFi solutions on the market.

What is DeFi?

The term “DeFi” was created in August 2018 among a group of blockchain developers, including Blake Henderson of 0x, Inje Yeo of Set Protocol, and Brendan Forster of Dharma Labs. They discussed how to call the innovative financial decentralized applications (dApps) they were building, and someone in the chat suggested the name “DeFi.” At the time, nobody could have predicted how massively popular that word will become.

The full name of DeFi – Decentralized Finance – explains the main idea behind it quite well. Simply put, DeFi uses decentralized technologies, such as blockchain and smart contracts, to create innovative financial solutions.

DeFi takes traditional financial world concepts – like banking, lending, or insurance – and enhances them through decentralization. Removing centralized intermediaries such as banks, investment firms, and insurance companies make time-tested financial mechanisms quicker, cheaper, and more secure. 

How Does it Work?

DeFi works by applying advanced blockchain technology and smart contracts to the world of finance.

All the DeFi projects on the market utilize blockchain. The most widely used blockchain for building DeFi applications is Ethereum, and initially, all DeFi projects were created on ETH. Nowadays, some decentralized finance projects use the TRON network or Binance Smart Chain (BSC) instead of Ethereum.

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Smart contracts are the central part of the DeFi architecture. Smart contracts are pieces of computer software similar to typical computer programs or smartphone applications; only instead of being stored on a single device they are distributed on many devices connected through the blockchain.

Decentralized smart contracts are what makes DeFi solutions so efficient. Centralized servers have a high maintenance cost; they are unreliable and not as secure as blockchain-based alternatives.

In other words, using smart contracts stored on the blockchain instead of traditional servers significantly improves the asset protection and transaction speed of financial operations, all while massively reducing the fees.

The potential use cases of DeFi are almost unlimited because smart contracts can do everything that typical computer programs can do. While banks and other financial institutions still use outdated technology based on centralized servers, DeFi removes the need for banks altogether and replaces them with decentralized, open-source smart contracts.

The Advantages

The use of advanced smart contracts and blockchain technology allows DeFi applications to improve almost every aspect of conducting financial transactions. The main advantages of DeFi include increased security, faster transaction times, and lowered fees.

Security

All DeFi platforms operate on the blockchain, which means that each part of the underlying DeFi infrastructure is secured with powerful, military-grade cryptographic algorithms. On top of that, most DeFi solutions are open source so that the source code can be independently audited, making the risk of any bugs being occurring in the code extremely small.

Faster Transactions

Fast transactions are one of the most significant advantages of DeFi. Opening an account at an investment firm or using the services of an insurance company is a long and tiresome process, but automated smart contracts can do all the work almost instantly.

Low Fees

The reason why DeFi got so popular so quickly is how accessible it is to everyone due to the low fees of decentralized finance platforms. For example, the fee of Uniswap – the largest DeFi exchange – is just 0.3%, which allows trading digital assets at an extremely low cost.

The Downsides

Although the benefits of decentralized finance are tremendous, DeFi also has some downsides. The two most significant problems with DeFi are the lack of regulations and the unfriendliness towards crypto beginners.

Lack of Regulations

The DeFi ecosystem is not regulated in the same way as traditional crypto platforms such as Binance or Coinbase. Because of that, the world of DeFi is troubled with a large number of scams, so it’s always essential to carefully pick the DeFi project to invest in.

Not Very Beginner Friendly

DeFi platforms don’t accept traditional currency like the dollar or euro. On Ethereum-based DeFi platforms, you need to own some ETH before you can purchase other DeFi projects. This means that you need to already own some cryptocurrency to enter the DeFi ecosystem, as using debit or credit cards on DeFi platforms is impossible. 

What Are the Examples of DeFi Solutions?

The most popular use cases of DeFi include decentralized exchanges (DEXs), stablecoins, and non-fungible tokens (NFTs).

Decentralized Exchanges

Decentralized exchanges like Uniswap are the most widespread example of DeFi platforms. DEXs enable people to trade many digital assets efficiently, securely, and with very low fees.

Stablecoins

Stablecoins like DAI (you can earn 8.3% on your DAI with Hodlnaut) use DeFi technology to solve one of the most significant crypto issues: high market volatility. Stablecoins are pegged at a one-to-one ratio to a traditional asset such as the US Dollar, which means they are immune to drastic price movements.

Non-Fungible Tokens

Non-Fungible Tokens are currently the fastest-growing DeFi market. NFTs use intelligent contracts to create digital collectibles and virtual works of art that can be quickly sent, received, and stored on the blockchain. 

Is DeFi the Future of Finance?

Decentralized technologies revolutionized the world. The Internet allowed people to communicate with anyone, anywhere in the world, instantly. Blockchain enabled everyone to make secure financial transactions. DeFi is the next step in the evolution of decentralized solutions: can applying the power of blockchain to the world of finance be the most significant technological breakthrough of our time?


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