What is Decentralized Finance (DeFi)?
By | John Preston
Decentralized Finance (DEFI) is a new form of financial services that uses blockchain technology to create a decentralized, intermediary-free, and transparent system.
Data and transactions are recorded collectively in the networks, thus promoting the decentralization of information, although there are also blockchains for private use, whose control is more centralized.
Cryptocurrencies are a key element in Decentralized Finance, since they allow the use of digital currencies that are secure, globally accessible and decentralized.
Many of the decentralized financial services are based on the use of cryptocurrencies, as collateral or as a means of payment, and are driving the adoption of DEFIs worldwide. In fact, DeFi is one of the fastest growing areas in the blockchain space and the decentralized web.
How does Defi finance work?
Let’s take the oldest and most demanded financial service in the world as an example: loans. In the relationship between lender and client there are three key elements to set the terms of the operation: the amount of credit, interest, and the guarantee in case of non-payment.
In the case of Decentralized Finance (DEFI), any user could go to these cryptocurrency ‘pool’ services to obtain liquidity. The terms of the cryptocurrency loan would be set in a ‘smart contract’, which would establish the amount, interest, and a settlement threshold.
For example, some platforms offer a net credit value of around 75% of the guarantee, with a liquidation threshold of 80%-83%. This means that, if the value of the crypto assets that you put up as collateral are listed below this limit, the smart contract would automatically settle the operation.
Few users have found in this type of service an alternative financing vehicle to the traditional one. In most cases, this type of decentralized finance loan has served as a leverage formula for investors.
Decentralization is one of the most important features of DeFi. Being a decentralized system, DeFi does not depend on intermediaries to function. Instead, use smart contracts on the blockchain to automate and secure transactions for financial assets and services.
This makes it possible to be more efficient and less prone to the risks of fraud and manipulation, since the transaction records are immutable and public.
What are smart contracts?
A smart contract is a stand-alone computer program on the blockchain that runs without the need for intermediaries. Smart contracts are programmed to execute specific actions when certain conditions previously defined in your code are met.
Smart contracts are used in Decentralized Finance (DEFI) to automate and guarantee the transaction of financial assets and services safely and without intermediaries.
These contracts can be programmed to carry out a wide variety of financial tasks, such as loans, investments, and asset transactions.
In addition, DEFIs are more accessible than traditional financial services, since they can be used by anyone with an internet connection.
By not requiring the involvement of intermediaries, DEFIs are also cheaper than traditional financial services, making them more attractive to users.
Another of the key characteristics of DeFi is the transparency it has as it is a decentralized system on the blockchain, since it allows you to verify and monitor your transactions in real time.
DEFIs offer a wide variety of financial services, from loans to investments. For example, users can obtain cryptocurrency loans without having to go through intermediaries, and they can also invest in financial assets such as bonds, stocks, and commodities.
Advantages and Disadvantages of Decentralized Finance
Unlike traditional finance, accessing DeFi traders is still a somewhat cumbersome process. First of all, you need a wallet (digital wallet) in which to deposit the cryptocurrencies. Second, decentralized finance protocols are new and sometimes difficult to understand. Finally, since there is no intermediary or agent that verifies the transactions, any order executed in the system becomes effective. Also errors, which cannot be undone once it is registered in the blockchain.
However, DeFi finance allows anyone with a wallet and internet connection to access these kinds of services. Including large parts of the population that do not have access to traditional banks. The operations are visible in the chain of blocks, improving the transparency of the system, although the identity of the users remains anonymous.
The future of finance Defi
In the coming years, DeFi decentralized finance can benefit from the work many developers are doing to innovate new ways to interact with financial infrastructure and services.
The possibility of reducing time lapses and costs in large operations, such as reinsurance, currency exchange, or capital inflows and outflows in exchange-traded funds (ETFs), are some of the pilot projects carried out around decentralized finance.
With the development of new economic and technological environments, companies are facing a paradigm shift due to digital assets, blockchain applications in the economy, tokens and NFTs.