What is Decentralized Finance (DeFi)?
Decentralized Finance (DeFi) is an emerging financial technology based on secure distributed ledgers similar to the technology used by cryptocurrencies.
In the United States, centralized financial institutions like banks and brokerages are regulated by entities such as the Federal Reserve and the Securities and Exchange Commission (SEC), with consumers relying on these institutions to directly access capital and financial services. DeFi challenges this centralized financial system by empowering individuals with the ability to conduct peer-to-peer transactions.
Key Points
- Decentralized Finance (DeFi) utilizes emerging technologies to remove third parties and centralized institutions from financial transactions.
- The components of DeFi are cryptocurrencies, blockchain technology, and software that allows people to conduct financial transactions with each other.
- DeFi is still in its early stages and is susceptible to hacks and theft due to rushed programming and the lack of security testing before application launches.
How Decentralized Finance (DeFi) Works
Utilizing peer-to-peer financial networks, DeFi leverages advancements in secure protocols, connectivity, software, and hardware. This system eliminates intermediaries such as banks and other financial services companies, which charge fees for using their services, a necessity in the current system because it’s the only way to make it work. DeFi uses blockchain technology to reduce the need for these intermediary institutions.
Blockchain
A blockchain is a distributed and secure database or ledger. In a blockchain, transactions are recorded in blocks and verified through an automated process. If a transaction is verified, the block is closed and encrypted; another block is created containing information about the previous block and information about new transactions.
These blocks are “linked” together through information in each ongoing block, hence the name blockchain. Information in previous blocks cannot be changed without affecting subsequent blocks, making the blockchain immutable. This concept, along with other security protocols, provides the security nature of blockchain.
Using wallet applications that can send information to the blockchain, individuals hold private keys to tokens or cryptocurrencies, functioning similarly to passwords. These keys enable them to access virtual tokens representing value. Ownership of tokens is transferred by “sending” a certain amount from one wallet to another entity, whose wallet generates a different set of private keys for them. This ensures their ownership of the tokens, and the blockchain design prevents the transfer from being reversed.
Applications
DeFi applications are designed to communicate with the blockchain, allowing people to use their money for purchases, loans, gifts, trades, or any other way they desire without a third party. These applications are programs installed on devices such as personal computers, tablets, or smartphones, making them easier to use. Without these applications, DeFi would still exist, but users would need to be familiar and comfortable with using the command line or terminal in the operating system running their device.
DeFi applications provide an interface by automating transactions between users and offering financial options for users to choose from. For example, if you want to lend money to someone and charge them interest, you can select options on the interface and enter terms such as interest or collateral. If you need a loan, you can look for providers, ranging from banks to individuals who can lend you some cryptocurrency after you agree to the terms.
Some applications allow you to enter the parameters of the service you’re looking for and match you with other users. Since the blockchain is a global network, you can offer or receive financial services from anywhere in the world.
Goals of Decentralized Finance
Peer-to-peer (P2P) financial transactions are one of the core premises behind DeFi, where two parties agree to exchange goods or services for cryptocurrency without the involvement of a third party.
Using DeFi enables:
- Accessibility: Anyone with an internet connection can access DeFi platforms, and transactions are not limited by geography.
- Low fees and high-interest rates: DeFi allows any two parties to directly negotiate interest rates and lend cryptocurrency or funds through the DeFi network.
- Security and transparency: Smart contracts and records of completed transactions published on the blockchain are available for anyone to view, without revealing your identity. Blockchains are immutable, meaning they cannot be altered.
- Autonomy: DeFi platforms do not rely on centralized financial institutions. The decentralized nature of DeFi protocols reduces the need and cost of managing financial services.
Drawbacks of DeFi
Decentralized finance is constantly evolving. It is unregulated, and its ecosystem is prone to faulty programming, hacks, and scams. For example, one of the primary ways hackers and thieves steal cryptocurrency is through vulnerabilities in DeFi applications.
The law has not kept up with technological advances. Most current laws are based on the idea of independent financial jurisdictions, each with its own set of laws and rules. The borderless transaction capability of DeFi poses fundamental questions for such regulation. For instance:
- Who is responsible for investigating financial crimes that occur across borders, protocols, and DeFi applications?
- Who will enforce these regulations?
- How will they enforce these regulations?
What Role Does Decentralized Finance Serve?
The goal of DeFi is to challenge the use of centralized financial institutions and third-party involvement in all financial transactions.
Is Bitcoin Part of Decentralized Finance?
Bitcoin is a cryptocurrency. While DeFi aims to use cryptocurrencies in its ecosystem, Bitcoin is more a part of DeFi rather than being DeFi itself.
What is the Total Value Locked in DeFi?
The total value locked (TVL) is the sum of all cryptocurrencies staked, lent, deposited in pools, or used for other financial behaviors across the entire DeFi. It can also represent the sum of a specific cryptocurrency used for financial activities, such as Ethereum or Bitcoin.
Bottom Line
Decentralized Finance (DeFi) is an emerging financial technology challenging the current centralized banking system. DeFi seeks to eliminate the fees charged by banks and other financial service companies while facilitating peer-to-peer transactions.
Like the blockchain and cryptocurrencies it supports, DeFi is still in its infancy. It must overcome significant hurdles to replace the existing financial system, which has problems of its own that are difficult to solve. Ultimately, financial service companies and banks won’t go down without a fight—if there’s a way for them to profit from the transition to a blockchain-based financial system, they’ll find it and ensure they’re a part of it.
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