The opposite of centralized finance, DeFi is a catchy umbrella term encompassing P2P financial services. These P2P financial services run on public blockchain networks, and no central authority governs them. Few words are more abstract than this one.
DeFi represents a radically new vision of banking based on trustlessness, transparency, and immutability. DeFi includes a few thousand applications related to financial services like lending, trading, exchanging assets, etc., and the Ethereum network powers those services.
According to the legend, the term appeared in August 2018 in a Telegram chat by people in business and ETH programmers. Undoubtedly, “DeFi” sounds just like “defy” intentionally, as it reflects the essence of the concept.
However, DeFi existed long before it finally got its name. Bitcoin is an example of a classic DeFi project since it has no central authority as it runs on its blockchain and doesn’t require intermediaries.
DeFi vs. CeFi (Centralized Finance)
For this comparison, commercial banks will be used as an example. In the traditional world, you may use financial institutions to store money, borrow capital, earn interest, send transactions, etc. Commercial banks carry a lengthy, proven history of performance. Commercial banks can provide insurance and have security measures in place to ward off and protect against theft.
On the other hand, such establishments hold and control your assets. You are limited by banking hours for particular actions, and transactions can be cumbersome, requiring settlement times on the back end. Additionally, commercial banks require specific customer details and identifying documents for participation.
DeFi is a segment comprising financial products and services accessible to anyone with an internet connection and operates without the involvement of banks or any other third-party firms. The decentralized financial market doesn’t sleep; transactions occur 24/7 in near real-time, while no intermediary can stop them. You can store your crypto on computers, hardware wallets, and elsewhere and gain access anytime.
Bitcoin and other cryptocurrencies
Bitcoin and most other cryptocurrencies hold these characteristics due to the underlying technology that backs these assets. Thanks to DeFi’s dependence on blockchain technology, transactions are completed faster, cheaper, and — in some cases — more securely than human intervention. Decentralized finance seeks to use crypto technologies to solve a plethora of issues that exist in the traditional financial markets:
People or companies in centralized finance handle the asset class and processes. However, decentralized finance manages assets through a collection of smart protocols, which all boils down to faith in the platform’s people or organization. CeFi platforms, like Coinbase.com, are custodial, which means it stores crypto for you. You can, however, utilize a Coinbase wallet like a regular cash wallet, giving you complete control over your crypto assets.
DeFi allows participants to access borrowing and lending markets, take long and short positions on cryptocurrencies, earn returns through yield farming, and more. Decentralized finance has the potential to be a game-changer for the 2 billion unbanked people in the world, in particular, who don’t have access to traditional financial services for one reason or another.
DeFi solutions are built on various blockchains. The ecosystems comprise participants interacting in a peer-to-peer (P2P) fashion, facilitated via distributed ledger technology and smart contracts, which keep the systems in check. Such results are not bound by geographic borders and do not require identifying documentation for participation.
The framework for this financial system functions according to programmed rules. Instead of using an intermediary such as a bank to borrow capital, you would send amounts of a specific cryptocurrency to a secure digital location — a smart contract — as collateral for your loan, receiving a different asset in return. Your collateral assets would then sit locked up until you return the loan amount.
Though you may or may not interact in a straightforward P2P manner when using DeFi solutions, the spirit of the process is P2P in that third parties are replaced with technology not ruled by a central authority.
Why is decentralized finance(DeFi) critical?
Through a P2P network, DeFi eliminates intermediaries and permits decentralized banking, which wasn’t possible before due to the need to get transactions approved through third parties. The global financial crisis of 2008–09 showed that intermediaries could not be trusted as customers are frequently unaware of the underlying regulations governing financial products and services.
DeFi aims to create an open, trustless, and permissionless financial market. Much of the technology in the DeFi space seeks to improve the current economic system, improving the user experience (for both businesses and their clients).
Decentralized exchanges (DEXs)
DEXs allow users to trade digital assets in a noncustodial way without the need for an intermediary or third-party service provider. Although they comprise only one element of the DeFi sector, DEXs have been a part of the overall crypto industry for years. They offer participants the ability to buy and sell digital currency without creating an account on an exchange.
DEXs let you hold assets away from a centralized platform while allowing for trading at will from your wallets via blockchain transactions. Automated market makers, a type of DEX, became prevalent in 2020 and use smart contracts and liquidity pools to facilitate the purchase and sale of crypto assets.
DEXs are typically built on top of distinct blockchains, making their compatibility specific to the technology on which they are developed. DEXs constructed on Ethereum’s blockchain, for example, facilitate the trading of assets built on Ethereum, such as ERC-20 tokens.
Using DEXs requires having compatible wallets. In general, self-custody crypto wallets let you control your assets, and some are compatible with DEXs. However, this type of asset storage puts more responsibility on you for the security of your funds.
Additionally, certain DEXs may have fewer features and higher associated financial fees than centralized exchanges.
DEXs have come a long way in terms of liquidity and accumulating a regular user base, which continues to grow. As DEXs become more scalable — that is, faster and more efficient — their trading volumes are expected to increase even more.
How do you make money with DeFi?
Depositing your cryptocurrency onto a platform or protocol that will pay you an annual percentage yield is the most straightforward approach to earning a passive income through DeFi.
Staking is locking tokens into a smart contract in exchange for more of the same token. Yield farming is another way of rewarding yourself with more of the same or new token.
Your initial step will be to use a fiat on-ramp to purchase some cryptocurrency (i.e., using cash to buy cryptocurrencies). However, before purchasing crypto, remember that most DeFi is based on the Ethereum blockchain, so BTC is rarely accepted.
Is it safe to invest in DeFi?
The smaller a token’s market capitalization is, the riskier it is as an investment. Therefore, look at the liquidity of tokens before committing your funds. Ensure you know how long a DeFi protocol has been in operation and how much money it has in total deposits before you invest.
You can look at its website to see if the company has taken reasonable steps to reduce its risks. You can also look for news about the protocol being hacked on the internet and their precautions to prevent it from happening again.
To make it clear, there is no DeFi protocol without risk. Still, the above considerations can help you to evaluate the investment risk before you put your money into any protocol.
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