What is decentralized finance (DeFi)?
Last spring, Forbes magazine called the DeFi sector "a new dynamic that has revitalized the cryptocurrency industry”. The popularity of decentralized finance is indeed still gaining momentum. Let's understand what it is and how it works.
What is decentralized finance (DeFi)?
Decentralized finance (DeFi) is financial instruments in the form of blockchain-based services and applications. The main goal of decentralized finance is to become an alternative to the banking sector and replace the traditional technologies of the current financial system with open-source protocols.
How does DeFi work?
DeFi relies on the use of blockchain, a form of immutable distributed ledger that cryptographically protects the records used for transactions.
Instead of a central authority to execute a transaction, DeFi uses smart contracts, which are blockchain-based applications that take advantage of the distributed ledger and cryptographic encryption capabilities. Smart contracts are available for other users to view as code, making the terms of the transaction transparent and accessible to all participants in the network.
DeFi focuses on empowering each user - storage in the form of private cryptographic encryption keys is done by an individual due to the decentralized approach of the network.
CeFi vs. DeFi
There are two predominant models used to perform financial services related to cryptocurrency - CeFi and DeFi. It is worth noting that both models allow traders to buy, sell and lend and exchange cryptocurrency assets and have both similarities and differences in management.
CeFi's model relies on a central authority to manage transactions and custody of assets. DeFi, on the other hand, has a decentralized P2P approach to providing financial services - individual users hold their own cryptocurrency assets.
Advantages of DeFi
Decentralized. DeFi is decentralized and is not subject to the risks inherent in CeFi, such as exchange failure, loss of user funds and their accounts.
Permissionless. No central authority is needed to approve transactions - the software logic of smart contracts determines what is possible on its own.
Transparency. The smart contract model can allow users to understand the terms and logic of a transaction in a transparent model with no hidden code.
Anonymity. With DeFi Know Your Client requirements that are common to centralized and regulated models do not apply.
Custody. In DeFi, users own a private key for cryptocurrency tokens with which they control assets.
DApps. DeFi supports dApps in which users can benefit from financial services apps, games, and social media.
Fees. Fees in DeFi are lower than transactions performed in the CeFi model.
Confusion. The confusion lies in the fact that DeFi operates in a P2P model, using smart contracts and complex algorithms that are not always understood by newcomers.
Customer Service. Serving customers with DeFi can be challenging due to the lack of a central authority or help desk.
Volatility. There is nothing to limit transactions or market momentum, so there can potentially be more volatility in DeFi approaches.
Security. DeFi platforms are increasingly targeted by attackers - more than $1 billion was stolen in a three-month period in 2022.
Payments. DeFi can allow P2P payments without the need for a central authority.
Lending. DeFi provides loans for cryptocurrency assets.
NFTs. Users own tokens that can be traded.
Stable coins. Their goal is to help limit the volatility of cryptocurrency by tying the value of the coin to another asset, commodity or currency.
Yield farming. Yield farming allows those who use DeFi as an investment vehicle to earn interest income.
DApps. DApps run on DeFi and allow many use cases, including financial services and games.
Many DeFi services and platforms are available today:
Avalanche is a blockchain proof of stake to support DeFi smart contracts.
DYdX is a DEX that allows cryptocurrency trading.
MakerDAO is a decentralized autonomous organization for managing cryptocurrency transactions, which has created a stable Dai coin that is pegged to the U.S. dollar.
TrueFi - provides a lending protocol as well as a TRU token.