With many businesses such as Microsoft or Tesla accepting Bitcoin as a payment method, this digital currency is becoming more and more popular. Over time, people have paid more attention to the crypto world. However, have you ever wondered what is behind the surge of cryptocurrencies? If you’ve, you’re at the right place.
Decentralized Finance (or DeFi in short) is a rapidly growing trend in finance, making changes to how people exchange value and do trade. In this article, we will discover what is DeFi and how this form of finance can have a great impact on the whole financial system?
The Blockchain Technology
Before answering this question, we want to explain to you the underlying technology in DeFi, which is blockchain. blockchain is a record-keeping technology that makes the data stored difficult or impossible to change or hack.
Unlike other types of databases, blockchain stores data in blocks that are then linked together, creating a chain of blocks. Therefore, when a transaction is conducted, it’s duplicated and distributed globally, across millions of computers on the blockchain.
It means that if you want to hack the system, you have to hack your target block and all the preceding blocks as well. In other words, you have to hack the entire history of commerce simultaneously on the blockchain, which is a tough thing to do.
Thanks to blockchain technology, people can trust each other and transact peer to peer. And that is the core element of DeFi.
So What is Decentralized Finance?
Decentralized Finance (DeFi) is all about recreating traditional finance by transforming them into trustless and transparent protocols via smart contracts and tokens. The aim of this system is to carry out traditional activities such as lending, borrowing, investing in platforms that are decentralized open-source and do not rely on big institutions.
Common functionalities of DeFi
Borrowing and lending
DeFi lending platforms are revolutionizing the ecosystem of lending. DeFi allows participants to programmatically take out a loan, even without a bank account. In traditional banking, when you ask for a loan, it’s necessary to put up collateral. Similarly, in DeFi, borrowers can stake their digital assets as collateral, which are locked within a smart contract until the loan is repaid.
Instead of turning to intermediaries, DeFi applications use smart contracts, enabling users to engage in open peer-to-peer lending and borrowing platforms. The interest rates are calculated algorithmically based on supply and demand by a protocol called Compound.
Examples of DeFi lending platforms include Compound, Aave, Maker.
Decentralized exchanges (DEXs)
The next functionality of DeFi is decentralized exchanges. With DEXs, trade can occur between users, allowing one another to buy, sell, borrow, and lend tokens in a faithless environment through an automated process without any intermediaries.
To understand more about decentralized exchanges, it’s important to know how centralized exchanges work. In the process of centralized exchanges, you have traders and the server of the exchange. First traders need to fund their accounts, so they will send a crypto to the address of the Bitcoin, ETH, or other cryptocurrencies. That means after this transfer the crypto doesn’t belong to them. They belong to a middleman or third party.
In contrast, assets traded under decentralized exchanges are never held in an escrow or by third-party people. These types of exchanges function as peer-to-peer exchanges. Therefore, DEXs can reduce the risk of theft from hacking of exchanges.
The most popular decentralized exchanges include MDEX, Uniswap, Binance DEX, and SushiSwap.
Decentralized Prediction Markets and Insurance
Decentralized prediction markets are all about betting on something happening or not happening in the future. Market prices will show what the crowd thinks the likelihood of the event is. Nowadays, these platforms are often used to insure against a flaw in a smart contract. In the future, these platforms will be used to insure against accidents and natural disasters.
Augur, Gnosis, and Stox are examples of DeFi prediction market platforms.
Yield Farming is the procedure of trying to maximize a rate of return on capital by using DeFi apps, wallets, and protocols when you have idle assets available (for example DAI). More simply, it means locking up cryptocurrencies and achieving rewards.
It’s currently the biggest growth driver of the DeFi space and it often involves providing liquidity. Yield comes in many forms such as interest, marketing-making fees, and incentives or rewards allocated by the protocol.
Compound and Aave are two main markets for DeFi yield farming.
Although DeFi is a potential financial system, its security risks still remain critical. Coding errors, and hacks, are common. Blockchain transactions are impossible to change, which means that an incorrect transaction in a DeFi platform or even the implementation of an error-containing smart contract code cannot always be easily fixed.
Additionally, an increased demand for DeFi applications among people make it a target for hackers. In 2020, hackers stole more than $27 million from DeFi projects.
The potential of DeFi to change the world is undeniable. We are moving into a new financial system that is more liberalized and decentralized than ever, whether we like it or not.
However, how to direct its growth with controls to mitigate the risks is still a vexed question. On the horizon, we can hope to see additional resources for surveillance, insurance, and other compliance measures. Demand for these services is also rising as developers understand that they cannot handle security alone.
Summary of DeFi
The world’s traditional financial systems are changing since DeFi is building a smarter, more open financial system. Although any modern technology comes with its limitations, it is encouraging to see the inventive and revolutionary ways in which blockchain is used to transform society and build a more egalitarian finance structure.
After reading this article, you may probably already know that DeFi is an extremely potential and vibrant space that would have more chances to develop in the future. Despite that, we still have to remember that it is still a very new industry, so it’s full of risks.