What is Decentralized Finance (DeFi), and How Does it Work?

HomeBlockchain

What is Decentralized Finance (DeFi), and How Does it Work?

Last updated on March 21st, 2023 at 09:46 am

A common term we have all heard countless times in the crypto world is DeFi, Decentralized Finance. As one of the primary drivers of cryptocurrency resurgence, especially during the cold 2020, DeFi continues to embrace decentralization and its focus on all things crypto. 

However, the term ‘Decentralized Finance‘ may be unfamiliar if you’re an outsider starting to learn about the crypto world. But if you’re planning to stay and be a part of this emerging and advancing crypto world, don’t miss out on exploring Decentralized Finance (DeFi), especially since it is a decentralized alternative to financial service providers like storage, loan, etc. 

With Decentralized Finance taking away the lack of privacy we face in the modern world by excluding third-party involvement, you can access fully secure and anonymous financial services through this technology in the web3 space. 

Advertisement

thegreensafe banner

But is that all to DeFi, and how does DeFi work? Or there’s more to this financial technology that you can explore and benefit from? Let’s explore this below in detail.

DeFi: A Brief Introduction and How Does DeFi Work?

DeFi, also known as decentralized finance, is a fast-expanding element of the crypto market. It is a network-based financial system with no centralized control. DeFi is distinct from the centralized financial system because it uses blockchain-based smart contracts, allowing users to conduct financial transactions without relying on centralized institutions.

Precisely, it is a new sort of financial system that limits the control of any centralized financial organization on its user’s funds and services.  Instead, it is based on decentralized networks that enable intricate financial transactions to be carried out without intermediaries. As a result, this technology allows for increased access to finance, direct interest rate negotiation, trustless transactions, and additional financial services. 

With its decentralized financial solution, this technology allows people to borrow, trade, lend, and invest in digital assets without relying on traditional banks and financial firms. This implies that customers can get loans, derivatives, insurance, and other financial products simply through DeFi.

The Working

As mentioned earlier, Decentralized Finance (DeFi) enables decentralized financial transactions by utilizing blockchain-based smart contracts. These smart contracts are self-executing digital contracts maintained on the blockchain, allowing transactions between two parties without third-party interference. 

Today, various DeFi apps and services like peer-to-peer payments, borrowing and lending platforms, and savings accounts allow users to access capital and financial assistance directly. So you can borrow money and/or get interest on your money to grow in the crypto space by accessing a DeFi protocol.

Advertisement

thegreensafe large horizontal banner

The Rise of Decentralized Finance: How Did It Become a Prominent Part of the Crypto World?

DeFi’s origins are sometimes traced back to MakerDAO, a 2015 platform that allowed users to utilize cryptocurrencies as collateral for loans. With time, DeFi protocols, like regular cryptocurrencies, claimed to eliminate unneeded middlemen. Until recently, the market has been propelled by this libertarian viewpoint and the desire of investors to gain money.

But what is the reality? So before DeFi, Bitcoin was established in 2009 as an alternative to traditional finance and financial institutions like banks. Yet, while bitcoin was designed to act as money, it continued to have numerous restrictions. With time, Bitcoin’s operation depends on a network of new central authorities who keep the wheels rolling. Some common examples of these authorities include miners, node operators, exchanges, and wallets. 

While beneficial, these authorities tend to behave like those they came to eliminate. Therefore, they control several crucial factors, including clients who may use their services, stated assets, etc. This shows how truly democratized financial assistance should be accessed and governed entirely by the people. Although bitcoin hinted at how this idea can be possible and become a potential success, it couldn’t keep up with this financial demand in the crypto world. 

Eventually, with DeFi operating as an open, trustless, and decentralized financial network is integral, it became possible to manage protocols with smart contracts that prevent tampering and limit the need for a central authority. This transparency has attracted many investors, with tokens presently locked in DeFi protocols topping US$165 billion, until September 2021.

Uses of a Decentralized Finance

As the crypto world evolves and improves, we can clearly see that peer-to-peer (P2P) financial transactions are one of the underlying tenets of DeFi. This transaction method is based on two people agreeing to exchange cryptocurrencies for products or services without the involvement of a third party.

P2P can satisfy an individual’s loan demands in DeFi, and an algorithm will connect peers who agree on the lender’s terms, and a loan will be granted. Additionally, P2P payments are made via a decentralized application, or dApp, and follow the same blockchain method.

Having said that, with the growth, adoption, and efficient usage of DeFi increasing, you can now access DeFi portals to access:

  • Anonymity: 

DeFi platforms are not reliant on centralized financial institutions and are not vulnerable to crisis or insolvency. Therefore, most of this danger is mitigated by the decentralized nature of Decentralized Finance (DeFi) protocols.

  • Reduced Interest Rates and Overall Fee: 

DeFi networks allow any two parties to directly connect, negotiate interest rates, and lend money without third-party interference. 

  • Accessibility: 

Anybody with an internet connection may use a DeFi platform, and transactions can occur anywhere.

  • Financial Transparency and Security: 

Smart contracts used by DeFi technology based on the blockchain network and the records of completed transactions allow easy accessibility for the users without disclosing their names and details. Hence, it’s evident that blockchains can not be altered, keeping your transactions transparent and secure at all times.

Centralized Finance vs. Decentralized Finance: The Difference

So what comes to your mind when you differentiate centralized finance vs. decentralized finance? When people talk about centralized finance, they generally mean traditional financial institutions like banks, not cryptocurrency exchanges

Typically, centralized financial institutions control this financial system, whereas decentralized finance is built on dispersed networks. Additionally, this technique is highly popular and well-known among the general public because everyone, whether an adult or a child, is familiar with debit and credit cards nowadays.

Decentralized finance (DeFi), on the other hand, is a far more innovative notion. Thus, if you ask a random individual about it, you could learn what DeFi is and how it works. (Only if such a discourse arises in the present world.)

Conclusion

Despite the prominent difference in familiarity between centralized finance vs. decentralized finance, we can not overlook the solutions and benefits provided by DeFi in today’s digitally invasive world. 

In fact, DeFi, as a superior financial system, offers solutions to many of the fundamental difficulties that people often have with traditional institutions, such as one’s local bank, and it has a place in both the present and the future. 

Therefore, since blockchain provides the immutability of any data stored on it, the decentralized nature of dApps and DEXs makes DeFi protocols significantly less vulnerable to hacking and online threats and much less expensive than their traditional equivalents.

Special Offer (SPONSORED)

Binance Free $200 (Exclusive): Use this link to register and receive $200 free trading fee credit (terms).

"3Commas Trading Bot" Special Offer: Use this link to Sign up with 3Commas and get 10% off your first monthly subscription.