What is Decentralized Finance?
Decentralized Finance (DeFi) is a platform for financial products that can be accessed on a decentralized public blockchain network.
DeFi allows market participants—buyers, sellers, borrowers, and lenders—to interact directly with each other or with a software intermediary, eliminating the need for a company or institution, such as a bank, to facilitate transactions.
In this article, we will look at what Decentralized Finance is, how it works, and why it is such an important innovation in today’s crypto world.
Decentralization means that it is a system that is not controlled by one central authority, but by a group of people or computers.
Finance is a broad term that includes any activity related to money, whether it be transferring, lending, or investing. So DeFi is any activity in which money runs on a platform supported by multiple servers rather than just one.
DeFi protocols are becoming more and more popular because they help eliminate the flaws and corruption that have been exposed over the years of using CeFi (centralized finance).
There are a number of different types of finance that are currently centralized, but there are opportunities for these systems to move towards decentralization.
What types of DeFi projects are there?
Decentralized finance is trying to recreate an entirely new financial ecosystem in an open and permissionless way. Here are the main parts of the ecosystem that DeFi is trying to recreate:
- Money transfer
- Margin trading
- Lending and loans
How can you make DeFi?
The best example of a decentralized system in use today is Bitcoin. Bitcoin is the first decentralized currency.
BTC was created in 2009 by an individual or group of people under the pseudonym Satoshi Nakamoto. While creating Bitcoin, Nakamoto also created blockchain technology.
A blockchain is a digital ledger that records transactions and distributes them among multiple connected computers (or nodes) to verify the authenticity of the transactions.
Any bitcoin transactions are in this digital ledger and will remain there forever. This makes the system nearly impossible to modify or hack because so many different computers around the world are running it.
How to create a DeFi system?
The Bitcoin blockchain is just one example of a decentralized infrastructure, but it is very difficult to build other applications on top of it.
But the Ethereum blockchain is an open self-made platform on which any developer can create decentralized applications (dApps).
Many DeFi projects are built using the Ethereum blockchain – to create automated code or smart contracts to set up decentralized financial systems.
What is smart contract technology?
Smart contracts are a specific set of instructions built on a blockchain like Ethereum and executed by code when certain conditions are met. These DeFi protocols and standalone programs are consistent and consistent, where errors are kept to a minimum.
For example, if the smart contract says “pay dividends only after reaching a profit of $5,000”, then this action will occur every time.
Once this code is written, it will run on its own and cannot be changed unless the smart contract specifies that it can be changed. Usually, smart contacts are created and launched without additional changes – they are more trustworthy.
If the smart contract is changed, it will be shown on the Ethereum blockchain across multiple servers, meaning it is impossible to hide the change if it does.
Consider examples of DeFi platforms
One of the first DeFi projects that was created and is still running today is called the Maker DAO. This essentially started the DeFi lending and borrowing movement, a huge part of the financial ecosystem.
Another DeFi project dedicated to lending and borrowing is Compound, which is an offline interest rate protocol built for developers. This project was created to open the universe of open financial applications.
Another example is the Aave project, which is an open-source liquidity protocol that is not related to the custody of assets but is only used to receive interest on deposits and borrowed funds.
Cryptocurrency and DeFi tokens
Some of the most popular DeFi cryptocurrencies are Uniswap, ChainLink, and Terra. DeFi cryptocurrencies or DeFi tokens are designed to recreate traditional financial services such as earning interest or a loan.
The only difference is that instead of using a bank or institution, DeFi crypto allows you to perform these actions on your computer using code or a smart contract.
Another form of receiving interest from crypto assets is called Staking. This type of earnings allows users to lend their cryptocurrency to the Proof of Stake network for verification of transactions, and in exchange for this contribution, users receive a reward for staking.
Pros and cons of DeFi exchanges
Kyber, Uniswap and 0x are the most popular DeFi exchanges right now (also known as DEX). Top exchanges like Binance and Coinbase are centralized.
Yes, centralized exchanges are very popular right now as they are easy to use and users can buy cryptocurrencies with fiat currency. But in the future, more and more people will pay attention to decentralized exchanges.
Let’s look at the pros and cons of decentralized exchanges:
– Users own private keys
– Greater privacy and anonymity
– Large selection of low-cap altcoins.
– Low liquidity (so far)
– Order speed may depend on network congestion
– Exposure to risky investments.
Security of Decentralized Finance
DeFi uses smart contracts to operate, which provides a high level of security. However, there are also some risks associated with DeFi. The biggest risk comes from the DeFi projects themselves. While many of them are indeed legitimate and truly decentralized, here are a few that are scams.
In 2021 alone, more than $10 billion was lost due to the actions of scammers with DeFi projects. That’s why it’s very important to do a thorough research to see if projects are reputable before using them.
As far as smart contracts are concerned, many users do not take the time to study contracts as they are often very long with a lot of technical terms. As a result, some errors and protocol changes may occur that affect existing contracts.
Every new technology has flaws and room for improvement. This also applies to decentralized finance, which is currently still in its infancy. But we hope that over time, DeFi projects and smart contracts will only improve and improve, leaving less and less room for errors.
Conclusions about Decentralized Finance
It is likely that the popularity and use of DeFi will continue to grow. It is likely that more and more companies and private investors will use DeFi technology in the coming years as it has shown to be faster, safer and smarter than traditional financial tools and infrastructure.