What Is DeFi?
DeFi is an abbreviation for “decentralized finance,” a collective term for blockchain-based applications that disrupt the legacy financial system. It eliminates the control and monopoly of central banks and other financial institutions imposing on people’s finances by championing peer-to-peer (P2P) settlements.
Summary of Important Points
- DeFi leverages blockchain technology to eliminate third parties from financial settlements.
- It champions financial inclusion by giving access to anyone with an internet connection and a digital wallet.
- It brings power back to the people by allowing them to hold their financial assets in digital wallets.
The Key Features of DeFi
- Permissionless DeFi leverages an open, permissionless access system instead of the standard access model common in the legacy financial system. People from all walks of life can access DeFi products and services through the internet.
- Programmability Smart contracts are programmed into DeFi applications, facilitating the automatic execution of established terms and conditions. This streamlines financial settlements and opens up new wealth generation avenues.
- Transparency All DeFi transactions are available and accessible for other network users to verify. This advanced transaction transparency increases the security and trust of DeFi users.
- Immutability The sharing of transactional data in DeFi applications calls for data integrity. For this reason, it is essential to have an incorruptible data coordination system on P2P networks.
- Interoperability The compassable software stack of most public blockchains allows DeFi products and services to integrate and complement each other easily. Developers can build new solutions and incorporate functionalities into existing contracts. Besides, they can customize interfaces and integrate more applications.
- Non-custodial Lastly, DeFi users enjoy total control of their finances and data. Decentralized wallets like Metamask helps users to utilize permissionless apps and protocols.
How Does DeFi Work?
As mentioned earlier, DeFi products and services are built on blockchain technology (the technology behind digital currencies). DeFi applications process transactions automatically and in a permissionless way.
In a blockchain network, every transaction is recorded in a block format and then confirmed by network users or miners. When the miners verify a transaction, the block is secured and encrypted before mining the next block.
The verified blocks are “chained” together using the data in every scheduled block; thus, the name "blockchain." It is essential to point out that information in the chained blocks can’t be altered without affecting the subsequent blocks, making blockchain data immutable.
The Common DeFi Use Cases
The above features make DeFi ideal for numerous applications, such as:
- Decentralized exchanges (DEXs) Online marketplaces enable users to trade various cryptocurrencies. DEXs are crypto marketplaces that allow peer-to-peer trading without the help of an intermediary.
- Stablecoins These are digital currencies pegged to tangible and intangible assets like commodities or fiat money in order to stabilize their price. They are the solution to the needs of crypto users looking for a cryptocurrency equivalent to fiat money, like the US dollar.
- Lending platforms Decentralized applications that leverage smart contracts to offer financial lending and borrowing services online.
- Prediction markets These are markets for predicting upcoming events, like sports. DeFi prediction markets aim to provide the same function as traditional prediction markets without third parties.
Centralized vs. Decentralized Finance
In centralized finance, client money is controlled by financial institutions, like banks, whose main objective is generating profits. This monetary system utilizes intermediaries who process and approve transactions between parties and then impose transaction charges on its services. For instance, assume you use your credit card to buy pizza from your favorite restaurant. After the restaurant cashier initiates the deduction, it is sent to your bank and forwarded to the corresponding credit card company.
On the other hand, decentralized finance eliminates third parties by enabling users to carry out transactions via blockchain technology. This is achieved via P2P applications that employ security protocols. Users can trade, borrow, lend, and stake digital cryptocurrencies from any part of the world. DeFi apps give users more power over their assets via decentralized wallets and exchanges by eliminating third parties.