DeFi, short for Decentralized Finance, is a new financial system that makes use of blockchain technology to enable transactions while removing the need for intermediaries such as banks or other central authorities.
The keyword “decentralized” means that there is no single entity or central governance that controls it. What this means is that each user will be able to have full access and control to their funds, and it removes all middlemen from transactions. For example, when you use your VISA or Mastercard to pay for your meals, the bank acts as a middleman between you and the restaurant. This gives them the authority to pause or stop your transactions, and it also requires you to pay a middleman fee. With decentralization, there will be no more middleman between the customer and the merchant.
How does DeFi work?
DeFi works with the use of smart contracts, which are contracts that can automatically execute transactions when certain pre-determined conditions are met.
With smart contracts, it makes transactions much more faster and safer, as the smart contracts are able to ensure that both parties of the transaction have fulfilled their ends of the agreement, and the automation is also able to handle more complex tasks.
Centralized Finance includes the banks that we all know, as well as other third party platforms or financial institutions that facilitates the movement of money between parties. These institutions charge a middleman fee when we use their services.
Centralized Finance is much slower due to the intermediate step of having the middleman. When a transaction is initiated, it will have to be passed through a middleman to be verified and cleared before the transaction goes through for the other party to receive the money.
Centralized Finance has been the backbone of the global economy for a long time, but it is often criticized for being exclusive and inefficient due to the high fees and long processing times. It also lacks transparency, which makes it hard for individuals to find out how their money is being used by these financial institutions.
Decentralized Finance (DeFi)
DeFi makes use of peer-to-peer (P2P) financial transactions as their core working mechanism to remove intermediaries from the equation. P2P transaction is where two parties will agree on the exchange of goods or services for a set amount of money and execute the transaction among themselves.
In DeFi, these P2P transactions are executed using smart contracts as mentioned before, and can occur much faster compared to Centralized Finance. DeFi is designed to be more inclusive, efficient and transparent compared to Centralized Finance, as it is built on the blockchain where all transactions are available for everybody to see.
Applications of DeFi
Ethereum is the most popular blockchain network for developing DeFi, as not only is it just the second largest cryptocurrency platform, it also offers greater flexibility for developing smart contracts. This is because Ethereum has a programming language called Solidity that is designed just for creating smart contracts.
Some of the most popular DeFi applications include Decentralized Exchanges (DEXs), Stablecoins and Lending Platforms.
Decentralized Exchanges (DEXs) are platforms that allow currencies, or more specifically cryptocurrencies, to be exchanged without the need for an intermediary. These platforms operate on the decentralized network and enable P2P trading. Examples include Sushiswap and 1inch.
Stablecoins are a type of cryptocurrency that is pegged to an asset, such as US dollar, to ensure the price stability. This allows cryptocurrency investors to tell how much their cryptocurrency holdings are worth due to the high volatility and price fluctuations of cryptocurrency. Examples of stablecoins include USDT, USDC and DAI.
Lending platforms such as Aave, Compound and MakerDAO allows users to lend and borrow cryptocurrencies. Those who lend are able to make money through the lending interests. In contrast to CeFi lending platforms, DeFi lending platforms do not require any identification in order for a user to take a loan, and all they have to do is to provide a collateral.
To sum it all up, DeFi is a new revolutionary financial system that grants users with greater control of their own financial assets as well as providing greater transparency and efficiency compared to traditional financial systems that we are all familiar with. The use of P2P transactions also allows DeFi to reduce or eliminate the fees that banks would normally charge for transactions.