Decentralized Finance Explained - A Complete Guide

DeFi serves as an alternative to the centralized financial world by offering peer-to-peer relationships that can have a full spectrum of benefits.

Various financial services are available through decentralized finance, from everyday banking, all the way to asset trading, loans and mortgages. So, how does DeFi work? Are there any risks attached to it? Let’s walk you through everything you need to know!

How DeFi Works?

As mentioned above, DeFi works through peer-to-peer financial networks and it takes full advantage of security protocols, connectivity, software, as well as hardware.

We are talking about a system that seeks to eliminate the so-called “middlemen” with all transactions. The reason is quite simple – all these financial institutions charge a fee for using their services.

Those fees are a necessity if the system is to work, but DeFi uses blockchain technology to at least reduce the need for such intermediaries.

Blockchain Technology

Blockchain is a secured and distributed database that stores transactions in blocks. It also verifies them via automated processes, and once it does – that block is closed. Then, another is created with information about the previous and the new transactions.

You can think of these blocks as being chained together through all the blocks information, hence the name – blockchain. Due to that, no one can change information about previous blocks without affecting the newer ones, so that provides the secure nature of blockchain.

The Role of Applications

Moving on, a key component of blockchain are DeFi applications. They exist to communicate with a blockchain, allowing users to buy products, gifts, trade, or any other service without using a third party. You can install these apps on any device you wish, and using DeFi without them would be much harder – you will have to know how to use the command line or terminal in the operating system of your device.

DeFi applications are quite simple to understand – you will have a wide range of financial services to choose from. If you need a loan, you can search for that service and after you agree on the terms with the person or company that will lend you crypto, you will get the digital assets.

Bitcoin – Where it All Started

It is not a coincidence that Bitcoin was established in 2009 – right after the 2007 financial crisis! Even though Bitcoin is not a DeFi application, the entire decentralized system was made possible through the ideas that came from Bitcoin’s emergence.

Everyone must be interested to see how governments around the world use the money they collect through taxes – whether a portion of that money goes into someone’s pocket or it is really used to improve infrastructure, education, science, military, and so forth.

So, after the financial crisis, people started doubting the governments and their ability to rationally allocate the funds they obtained from the citizens.

That is why Bitcoin’s mysterious creator sought a technology that would change how we deal with currency – there would be no need for a central authority, as Bitcoin would work on its own protocol.

DeFi Goals and Advantages

We live in a centralized financial network, meaning that all your personal information is out in the open. So, when you apply for a loan, a bank will consider your previous loans, your income, potential bankruptcy filings, etc.

Therefore, the bank won’t hesitate to use every piece of information to prevent you from using certain financial services. And there is nothing you can do about that as the bank is the main financial authority.

For that reason, you can imagine just why decentralized finance can be so appealing to people. In it, there is no central authority that will dissect your privacy.

There is absolutely no need for middlemen and extensive paperwork to process any potential loan you need.

That way, users will save a lot of time and resources, and due to the blockchain technology, we can even make the argument of DeFi protocols being safer than banks. Of course, DeFi is still new, so there is room for development, but the early signs are quite promising.

As stated beforehand, P2P transactions are the cornerstone of DeFi – two parties agree to exchange digital assets for goods or services without the need for third parties. Therefore, we can sum up the advantages that come with using DeFi:

• Accessibility – you only need a stable internet connection to access a DeFi platform, so convenience is one of its main attributes;
• No countryrestrictions – you can make transactions from anywhere, as there are no geographic restrictions with DeFi;
• Low fees and high-interest rates – two parties negotiate interest rates directly and lend digital assets. As there are no intermediaries, there are very low fees attached to these transactions;
• Transparency & Security – records of transactions and blockchain smart contracts are available for everyone to review. They will not reveal an identity, so the security is still intact;
• Autonomy – finally, we arrive at the main pillar of DeFi – the lack of centralized financial institutions. That is why you won’t get to experience the costs of administering various financial services.

Get Started in No Time

You might be surprised, but starting your adventure in the DeFi world is rather straightforward. This is the complete opposite of what you can expect in a bank, where you need to speak to a banker, who will then activate a debit card, then collect personal information, and so forth.

To start your journey in DeFi, you need to buy cryptocurrencies – usually Ethereum. Note that some applications will serve you better if you use stablecoins, as cryptocurrencies can be volatile. You need a stable asset in a decentralized world, and that is one of the ways experts say will allow the DeFi space to grow.

As DeFi is efficient and fast, it won’t be surprising to see it unearthing its potential to enable people to have access to financial services that wouldn’t necessarily be available to them.

Some estimates say that more than 1.7 billion people in the world don’t use bank services, which is simply a staggering number. So, just imagine the potential DeFi holds – it can help all these people to have access to necessary financial services – all at once!

What About the Disadvantages?

Well, not everything about the DeFi space is rosy after all! DeFi is still evolving, and it is an unregulated space, of course. However, that reason makes it vulnerable to faulty programming, hacks, scams, and whatnot. Arguably the most common hacker attacks occur when people steal cryptocurrencies through DeFi apps’ weaknesses.

It is clear that financial regulations around the world haven’t caught up with all the advancements made in technology. Most laws we see nowadays are based on one premise – the existence of separate financial jurisdictions, each of which will have its own scope of activities, laws and rules to abide by.

As a result, DeFi promises a lot, sure, but it still has some essential questions and problems it needs to solve, such as:

• Who will be responsible for investigating a financial crime through DeFi apps?
• Who will be the one institution to enforce the regulations?
• How would those regulations be enforced by institutions?

An additional problem that has occurred recently is that certain DeFi projects are closely connected to financial institutions.

Binance is a platform that serves as a great example – it combines decentralized and centralized finance – a move that enraged plenty of DeFi purists who believe that the old ways should just be quashed aside.

All in all, it is very difficult to determine what the future holds for DeFi. The advantages are obvious, but there is no going away from the fact that there are still some important questions that are left unanswered.

We reckon that until we get satisfactory answers to those questions, we cannot expect a fully decentralized financial system.