Decentralized Finance (DeFi): An Introduction

October 26, 2022

What is Decentralized Finance (DeFi)?

Decentralized Finance (DeFi) is a financial ecosystem created as an alternative to traditional financial systems. Decentralized finance uses blockchain technology to perform different transactions such as buying, selling, financing, and investing without needing any intermediaries. 

"Decentralized" means that no single entity has power over the user's funds such as in traditional financial systems. Only the users of DeFi may control their digital assets, unlike banks and other traditional financial institutions that may freeze your assets and bind you to only make transactions during their dictated operating hours. 

How does Decentralized Finance (DeFi) work?

Decentralized finance offers services in which the transfer of data and assets can occur without a centralized entity controlling everything. In other words, there will be no central servers that will be used to connect users. DeFi is comprised of "smart contracts" that are programmed using Blockchain to hold or transfer digital assets. These smart contracts are what run decentralized apps (DApps) and protocols. DeFi apps offer many services to their users such as lending, investing, saving, trading, and market-making. 

Anyone can have access to decentralized finance as it uses an open source. So, anyone on the Internet can create and offer services, or build on pre-existing applications to adapt to their own needs, free of charge. To operate in DeFi apps, you will have to own tokens in your virtual wallet. These tokens are the currency in blockchain and can be bought with dollars, euros, and some other legal tenders. 

DeFi app users may create smart contracts to sell cryptocurrencies at specific prices to gain a return on investment in tokens. Users can make a smart contract to automatically buy tokens when they reach a certain value. These transactions are done without any intermediaries.

By not depending on only one location or center for data storage, DeFi takes away a lot of risks that come with the storage of data. If data is stored in only one location, it is more prone to theft by hackers and is at great risk. Security is greatly improved in DeFi by dispersing data across several locations.

What is the difference between Decentralized Finance (DeFi) and Centralized Finance (CeFi)?

To compare decentralized finance with centralized finance, let's take the example of banks. In traditional financing systems, people go to banks to borrow loans, store money, make transactions, and earn interest. Banks have long and thorough procedures to ensure security against theft and other crimes against stored property. Since you have stored your assets in the bank, they do have some control over them. Banking hours can also limit your activities and transactions. Some of them may even be complicated and take a lot of time, requiring authorization and security checks. One must have their complete details and the proper documentation when dealing with banks.

There is only one entity that handles the assets and monitors the processes and transactions. This means that customers are dependent upon the entity. 

All that means that traditional finance or centralized finance users must share their personal data with the entity in power and transfer the security risk to them. The traditional system is slow and complicated and is operational only for limited hours. Payments in traditional systems can be intercepted as well.

However, in DeFi, anyone can have access to financial services and products if they have the Internet. They do not need any third parties for approvals or permissions. There is no limitation on time in DeFi, transactions can happen 24/7 in almost real-time. You may store your cryptocurrencies in virtual wallets and access them whenever you want, just like a normal cash wallet. Because of the blockchain technology used in decentralized finance, you can now make transactions much faster and safer. You do not even need to pay any intermediaries. In decentralized finance, the assets and processes are managed by smart protocols. 

People who do not have access to traditional financial services can easily use decentralized finance for services such as borrowing, lending, trading cryptocurrencies, and earning an income from yield farming. Smart protocols and distributed ledger technology handle the assets and procedures, allowing users to interact in a peer-to-peer (P2P) manner. Users do not have to provide any authorizing documentation; they can just connect to a digital wallet and can make transactions from all over the world. They have custody of their own digital assets hence, there is less risk of theft of funds.

The foundations of this decentralized financial system are built on programmed rules. In the traditional system, you would borrow money from the bank. In decentralized finance, if users want to loan an amount, they would store an amount of a certain cryptocurrency at a secure digital location that would be locked and kept as collateral for the loan, and claim it back once the loan amount has been paid in full. The main goal of decentralized finance is to operate using technology that is not under the control of a central entity.

Is investing in DeFi risky?

Investments in tokens that have smaller market capitalization can be riskier. Before investing our funds in tokens, check their liquidity. See how many total deposits a DeFi protocol has before investing and check for how long it has been operating. Make sure to do some research on whether the protocol was ever hacked on the Internet and check if it has taken preventive measures ever since. You can find information on its website to see any steps they have taken to minimize its risks. 

Most investments come with a risk. If you make these precautionary steps before investing, you may reduce your risks. There are no regulations in the decentralized financial system. So, users need to be careful of security risks and financial crimes.