In this article, we will explore what is decentralised finance or DeFi? how it works, and how it can be used in our everyday lives.
If the 20th century was about decentralising production, then the 21st century will be about decentralising finance – let’s call it ‘DeFi’.
It’s an emerging digital financial infrastructure that eliminates the need for central banks or governments to approve financial transactions.
The idea is that no single entity has control over, or can alter, that ledger of transactions – anyone can access it from anywhere at any time and see an accurate record of all the transactions.
What is DeFi?
Decentralised finance (DeFi) has emerged in recent years as an alternative to traditional finance models, where individual users are given control over their own money.
We’ll demystify some common questions about one of blockchain’s most-hyped applications and offer a look at how decentralised finance could change (or not) how we do business.
The idea is that no single entity has control over, or can alter, that ledger of transactions; as a result, trust must be regained through open source code and peer-to-peer connections between users rather than large institutions.
Once you understand DeFi, you’ll see how technologies like payment channels might actually be the key to why decentralised banking will never exist yet will continue to thrive.
How does Decentralised Finance Work?
It’s important to note that decentralised finance doesn’t actually eliminate a central bank’s ability to regulate, restrict, and monitor transactions but rather moves its regulatory powers into software code.
This means that there will always be one governing body with ultimate power over decentralised finance platforms; they just won’t be centralized in one particular location.
It also means that changes within these institutions can occur more quickly than governments can adopt.
In other words, it allows anyone on Earth (with internet access) to access a peer-to-peer global ledger of asset ownership and use automated smart contracts to send those assets directly from one account holder to another, at almost no cost.
If decentralised finance takes off like people think it will (which we sincerely hope it does), all hell could break loose!
Examples of Decentralised Finance Platforms
Maker, Compound, dYdX, Basis Protocol, Dharma Protocol, and many more. In order to answer my question regarding whether or not DeFi can work well enough to eliminate central banking/finance entirely, I think it is first important to define what exactly decentralised finance is.
There are two very simple definitions for decentralised finance that best explain its meaning:
1. Decentralised finance refers to a financial system without a third party, such as a government-backed bank.
2. Decentralised finance refers to transactions facilitated by technology like blockchain and smart contracts instead of by centralized authorities such as banks or regulators.
These definitions lay down an interesting foundation for decentralised finance but don’t give an accurate representation of how far along we are in building our completely decentralised economy.
Let’s look at these different pieces one by one before delving into why decentralised finance is already so prevalent today and why it has massive potential to reshape our global economic structure.
What is a Smart Contract?
In short, smart contracts are self-executing digital contracts. That is, once certain conditions have been met (all signatories sign it, for example), a contract enters an autonomous execution mode.
There is no need for a central agency to approve financial transactions, This means that no single entity has control over, or can alter, that ledger of transactions.
Blockchain technology would allow payments and other interactions to be verified automatically through their associated networks so that two parties will know they can trust each other, even if they don’t know each other.
Related Article: How does the Blockchain Work? – Smart Contract, Ethereum
The emerging DeFi ecosystem:
While blockchain is still far from being widely adopted in many industries especially finance there are dozens of companies around the world working on systems and products that could be used in real life within just a few years.
How DeFi is Different from Traditional Banks?
There’s no need for a central bank or government to approve transactions. All that’s needed is a public, decentralised ledger like Bitcoin’s blockchain.
This makes it very difficult for financial fraud and other illicit activities to occur because all participants in DeFi are privy to any fraudulent activity and can report it on their own behalf.
Additionally, most DeFi projects operate on open-source protocols which enable anyone in the world to develop applications using these same protocols.
How will DeFi affect Banking?:
DeFi could completely disrupt traditional banks by enabling seamless transactions directly between two parties at minimal cost without relying on trusted third parties such as banks.
In fact, an increasing number of cryptocurrency exchanges have begun supporting fiat-to-fiat currency conversion through pairing with existing fiat gateways from banks.
Related Article: Cryptocurrency: Is it the Future of Money?
What are the Decentralised Finance apps?
My favorite DeFi app right now is Prism – it’s a trustless digital asset wallet similar to Coinbase except there’s no middleman.
You simply create your account and you’re ready to send funds anywhere in minutes. It also supports BTC, ETH, LTC, EOS and more so you don’t need to use multiple wallets for each coin.
Related Article: Top 16 Decentralized Wallet App | DeFi Wallet
Should I Invest in Decentralised Finance?
While decentralised finance (DeFi) represents a fundamental shift in how we think about and transact financial instruments, there’s still a long way to go before it takes its place as an accepted form of investment or lending.
Here are some ways you can start to familiarize yourself with decentralised finance today.
Short-term investments may be accessible through apps like Compound and MakerDao; both allow users to lend out digital assets they own and earn interest on that loan it’s something akin to peer-to-peer lending.
If you have longer-term investments you want exposure to, then bitcoin mutual funds or ETFs may be a good choice see Magnr for one example.
Last but not least, you could also buy a basket of cryptocurrencies directly from decentralised exchanges (though these typically trade at higher spreads than centralized exchanges).
Keep in mind all of these options involve some risk due diligence is key when dealing with any type of financial instrument.
Related Article: Is it better to buy Ethereum or Bitcoin?
How is DeFi Different From Bitcoin?
Decentralised finance can be better understood by breaking it into two subcategories: crypto-currencies and Stablecoins.
As noted in Investopedia, a cryptocurrency is an electronic currency that uses cryptography to secure transactions and control the creation of new units. Bitcoin, for example, is a crypto-currency.
Stablecoins are designed to limit volatility which makes them easier to use than other cryptocurrencies like Bitcoin.
These types of currencies typically peg their value to real-world assets such as gold or fiat currencies (i.e., government-issued money). A popular stable coin is Tether (USDT), which aims to maintain one U.S. dollar per coin.
In order to properly understand how decentralised finance differs from bitcoin and more traditional financial systems, you must first look at what sets these systems apart from each other.
With bitcoin, because there isn’t any government regulation or oversight surrounding its use, users have no recourse if they lose their bitcoins (beyond turning to private services like BitGo) due to theft or fraud though this concern has largely dissipated since Mt Gox collapsed in 2014.
What you Can do with DeFi?
Decentralised finance, or DeFi, is an emerging digital financial infrastructure that theoretically eliminates the need for a central bank or government agency to approve financial transactions.
Decentralised finance on-boards users with little or no experience in cryptocurrency markets can be used for a wide variety of applications.
With more than $2 billion in decentralised lending and borrowing taking place between people each month, you should definitely pay attention to what’s happening in DeFi.
You don’t have to worry about security as it uses smart contracts backed by blockchain technology, so there are lower fees too!
If your business needs some funding or other digital currency services, then look into one of these platforms today, you might even make your business better.
What is the Risk Associated with DEFI?
Funding a project with a loan can be an attractive proposition for both parties: businesses get access to resources and individuals receive additional income in exchange for giving up their capital.
However, there are risks associated with loans that investors should be aware of before funding a company.
As borrowers become more skilled at managing debt and as lending practices evolve, these risks will change as well.
That said, here’s how lenders might take extra precautions when entering into smart contracts with borrowers based on lessons learned from traditional finance.
Credit risk Anyone taking out a loan needs to know what they will have to pay back, but traditional financial instruments such as bonds have several different options that adjust payback rates based on whether prices rise or fall relative to an index.
For example, if unemployment increases relative to employment levels previously established by bondholders, then interest rates increase; otherwise, they decrease.
If you fail to readjust your payments correctly, though, you could end up paying higher-than-necessary interest.
When using DEFI and smart contracts, however, there are no single entity monitoring price fluctuations across time, Instead, it’s completely decentralised.
Proof of work and Proof of stake in DeFi
Proof-of-Work(PoW) is a commonly used algorithm for achieving consensus on a blockchain. In PoW, nodes (‘miners’) compete to solve mathematical puzzles in order to validate transactions and be rewarded with tokens.
Proof-of-Stake(PoS) differs from PoW in that validators (‘forgers’) stake their own capital and earn tokens for validating transactions, rather than using computing power.
EOS uses an alternative method known as dPoS: delegated Proof-of-Stake.
Here, token holders select ‘witnesses’ who act as nodes for network operations such as creating blocks.
Witnesses are then paid a portion of block rewards by users through transaction fees. When they fail to carry out their duties appropriately, they can be voted out by node operators in favor of more competent peers.
Consensys Crypto Token How it Works?
Another novel form of consensus mechanism is Ripple’s Federated Byzantine Agreement (FBA).
A great breakdown of these and other methods can be found at wikiHow Blockchain Consensus Mechanisms Explained, Check them out for an overview of the most common algorithms!
FAQ on Decentralised Finance (DeFi)
Why should I care about Decentralised Finance DeFi?
Where can I learn more about it?
Whitepaper of any Crypto or token and Defi Websites (Ethereum.org)
What are some cool projects and tools in Decentralised Finance (DeFi)?
Fantom, PancakeSwap, Colony Lab, Aave, etc.
FAQ on Smart Contracts:
What are smart contracts/tokens/assets?
ETH, bitcoin, etc.
Do smart contracts help me build applications on top of blockchains?
FAQ on Token Marketplaces:
What is an AppCoins?
It is a DeFi Crypto Wallet
Where can I buy AppCoins today?
Any Crypto Wallet or trading Apps
Do tokens represent equity shares for companies using them as utility tokens at token marketplaces?
Are we seeing bubbles in Cryptocurrencies, ICOs, and associated Token Marketplaces?
Should I sell some or all of my digital assets once they become listed on exchanges or when their prices go up appreciably?
Yes, or It Depends on the Application of assets
FAQ on Security Tokens and Capped Tokens
Are Security Tokens similar to cryptocurrencies such as bitcoin and ether (Ethereum)?
No, Both are partially different but the technology is the same
Does regulation play a role in determining whether something is a security token versus not?
Central Banks Are No Longer Needed, Thanks to Decentralised Finance DeFi Financial technology (FinTech) is a broad term for all forms of technology that involve financial services.
Though many people still associate FinTech with digital currencies such as Bitcoin and Ethereum, or other technologies supporting cryptocurrencies and blockchain systems, these days it’s also commonly used in reference to developments in payment solutions, lending, crowdfunding platforms, and much more.
Most recently, news has been buzzing about decentralised finance (DeFi), an emerging concept that promises to revolutionize how we think about value exchanges of any kind – not just ones involving money.
If you haven’t heard anything about DeFi yet, you can get up to speed by learning what exactly it is and how it works by checking out today’s featured study.
Nitin is a professional data Engineer, Who has a Post Graduation in Data Science and Analytics and working in the healthcare sector. Experts in Data analysis, Machine learning, AI, blockchain, Data related tools, and technologies. He is the Co-founder and editor of analyticslearn.com