What Is Decentralised Finance (DeFi)?
Importance of Decentralised Finance (DeFi) is an emerging financial technology based on secure distributed ledgers similar to cryptocurrencies. The system removes banks and institutions’ control over money, financial products, and services.
Some of the critical attractions of DeFi for many consumers are:
- It eliminates banks and other financial companies’ fees for using their services.
- Instead of keeping your money in a bank, you hold it in a secure digital wallet.
- Anyone with an internet connection can use it without needing approval.
- You can transfer funds in seconds and minutes.
Understanding Decentralised Finance (DeFi)
Understanding decentralised finance and how it works helps to understand how centralised finance differs from DeFi.
In centralised finance, your money is held by banks, corporations whose overarching goal is to make money. The financial system is full of third parties who facilitate money movement between parties, each charging fees for using their services. For example, say you purchase a gallon of milk using your credit card. The charge goes from the merchant to an acquiring bank, which forwards the card details to the credit card network.
The network clears the charge and requests a payment from your bank. Your bank approves the charge and sends the approval to the network, through the acquiring bank, back to the merchant. Each entity in the chain receives payment for its services, generally because merchants must pay for your ability to use credit and debit cards.
All other financial transactions cost money; loan applications can take days to be approved; you might not even be able to use a bank’s services if you’re travelling.
Decentralised finance eliminates intermediaries by allowing people, merchants, and businesses to conduct financial transactions through emerging technology. This is accomplished through peer-to-peer financial networks that use security protocols, connectivity, software, and hardware advancements.
From anywhere you have an internet connection, you can lend, trade, and borrow using software that records and verifies financial actions in distributed financial databases. A distributed database is accessible across various locations; it collects and aggregates data from all users and uses a consensus mechanism to verify it.
Decentralised finance uses this technology to eliminate centralised finance models by enabling anyone to use financial services anywhere regardless of who or where they are.
DeFi applications give users more control over their money through personal wallets and trading services that cater to individuals.
How Does DeFi Work?
Decentralised finance uses the blockchain technology that cryptocurrencies use. A blockchain is a distributed and secured database or ledger. Applications called dApps are used to handle transactions and run the blockchain.
In the blockchain, transactions are recorded in blocks and then verified by other users. If these verifiers agree on a transaction, the block is closed and encrypted; another block is created that has information about the previous block within it.
The blocks are “chained” together through the information in each proceeding block, giving it the name blockchain. Information in previous blocks cannot be changed without affecting the following blocks, so there is no way to alter a blockchain. This concept, along with other security protocols, provides the secure nature of a blockchain.
DeFi Financial Products
Peer-to-peer (P2P) financial transactions are one of the core premises behind DeFi. A P2P DeFi transaction is where two parties agree to exchange cryptocurrency for goods or services with a third party involved.
Consider how you get a loan in centralised finance to understand this fully. You’d need to go to your bank or another lender and apply for one. If you were approved, you’d pay interest and service fees to use that lender’s services.
In DeFi, you’d use your decentralised finance application (dApp) to enter your loan needs, and an algorithm would match you up with peers that meet your needs. You’d then need to agree to one of the lender’s terms and receive your loan.
The transaction is recorded in the blockchain; you receive your loan after the consensus mechanism verifies it. Then, the lender can begin collecting payments from you at the agreed-upon intervals. When you make a payment via your app, it follows the same process in the blockchain; then, the funds are transferred to the lender.
DeFi is designed to use cryptocurrency for transactions. The technology is still developing, so it is difficult to determine precisely how existing cryptocurrencies will be implemented, if at all. Much of the concept revolves around stablecoin, a cryptocurrency backed by an entity or pegged to fiat currency like the dollar.
The Future of DeFi
The importance of Decentralised Finance is still in the beginning stages of its evolution. For starters, it is unregulated, which means the ecosystem is still riddled with infrastructural mishaps, hacks, and scams.
Current laws were crafted based on the idea of separate financial jurisdictions, each with its own set of laws and rules. DeFi’s borderless transaction ability presents essential questions for this type of regulation. For example, who is responsible for investigating a financial crime across borders, protocols, and DeFi apps? Who would enforce the rules, and how would they enforce them?
Other concerns are system stability, energy requirements, carbon footprint, system upgrades, system maintenance, and hardware failures.
Many questions must be answered and advancements made before the importance of Decentralised Finance increases. Financial institutions are not going to let go of one of their primary means of making money—if DeFi succeeds, it’s more than likely that banks and corporations will find ways to get into the system; if not, to control how you access your money, then at least to make money from the system.
What Does Decentralised Finance Do?
The goal of DeFi is to get rid of the third parties involved in all financial transactions.
Is Bitcoin a Decentralised Finance?
Bitcoin is a cryptocurrency. DeFi is being designed to use cryptocurrency in its ecosystem, so Bitcoin isn’t DeFi as much as it is a part of it.