By | Bailey Merton
DeFi (Decentralized Finance) is a global and open financial system. It is an alternative to the traditional tightly controlled and opaque systems that are operated and controlled by rigid institutions and processes. It offers an option to local currency and exposure to the global markets, primarily owned and maintained by the users.
What Is DeFi?
DeFi is a general term for financial services and products that are accessible to anyone with internet access. DeFi services utilize smart contracts and the blockchain, especially Ethereum. The markets are open and no centralized authority can deny access or block payments. The services at risk of human errors are automated and safe due to coding that you can easily scrutinize and inspect.
How Decentralized Finance Work
Rather than banks facilitating services and transactions between parties, decentralized finance uses open-source protocols alongside public blockchains to form a decentralized finance framework. The two components that allow the finance system to work include infrastructure and currency. In centralized systems, banks act as infrastructure and fiat money is the currency. Ethereum is the platform to write decentralized programs. DAI is a stable coin that pins its value to the US dollar and is supported by cryptocurrency collateral. Due to stability, it’s an ideal currency for decentralized finance.
Decentralization, as the basic tenet of blockchain, helps reduce dependency on corporations. Moreover, it relieves dependence on institutions for server space, oversight, and data storage. Blockchain networks achieve these aspects by ensuring transaction histories can easily circulate between members.
Through the use of consensus algorithms and cryptography like proof-of-work, the technology achieves immutability. It guarantees the impossibility of manipulating records on blockchain networks and creates higher security impossible to attain with traditional systems.
Decentralization entails a higher level of transparency and distributed ledger information on all activities in the blockchain network. Cryptographic principles on blockchain also ensure documentation of information after verification and authentication. Transparency in DeFi applications can support identification and avoiding financial scams and harmful business practices. For instance, the Loop is built from blockchain to allow you to control your cryptocurrency. You can navigate to these guys to learn more about the workings of DeFi and how you can leverage the same.
Many discussions on decentralized finance primarily focus on the benefits. However, for a neutral account, you need to know that it has some problems associated with the related technologies. Below are the critical setbacks you can encounter.
Defi projects are suitable for financial inclusion to a broader population. However, projects can encounter difficulties in the scalability of the host blockchain as this needs extended periods for confirmation. Also, transactions on the protocols are expensive during congestion, unlike centralized counterparts that accommodate more transactions in the same period.
There is uncertainty and instability on the blockchain hosting the DeFi project as the project inherits the instability.
- Liquidity Concerns
Liquidity is a critical factor in blockchain protocols and DeFi projects since the market is smaller than traditional financial systems meaning some people may not trust the sector.
- Shared Responsibility
Shared responsibility works negatively for users since the projects don’t take responsibility for mistakes. They take away intermediaries as users take responsibility for their assets and funds. Therefore, it needs tools to prevent human error and mistakes.
The Bottom Line
Despite the drawbacks, DeFi (decentralized finance) is promising to transform conventional benchmarks in financial services as it promotes blockchain application in financial services with transparency, decentralization, and higher security.