A Brief Guide To DeFi
Blockchain was created to ensure a transparent and inclusive digital infrastructure. Unfortunately, our current financial system is lagging when it comes to transparency and inclusivity, and it needs to see a change. The technology behind decentralized finance can bring about the change, bringing in new capabilities, a quicker settlement time, and trustless global accessibility.
Our financial system and infrastructure are heavily centralized, with central authorities controlling and regulating the money supply and supply and demand.
Users also end up giving control of their financial assets to centralized authorities. The system is also prone to manipulation by central authorities who can regulate the system whenever they need to or introduce arbitrary changes to it. The online banking infrastructure isn’t exactly secure either, thanks to the use of outdated networks vulnerable to cybercriminals.
DeFi hopes to change the existing financial system, giving control back to the system’s users and ensuring transparency and inclusivity.
What Exactly Is DeFi?
DeFi refers to Decentralized finance, a completely decentralized financial system that uses blockchain technology and blockchains like Ethereum as the underlying technology. DeFi consists of different assets ranging from DeFi protocols, digital assets, decentralized applications (dApps), and smart contracts.
DeFi aims to create a permissionless, open-source, and decentralized financial ecosystem that operates without any influence from any third-party or central authority and is available to everyone while also allowing users to maintain complete control of their assets.
The DeFi ecosystem now comprises an array of financial instruments and protocols. With $71 billion of value locked in DeFi and Ethereum smart contracts, DeFi has become the most significant player in the blockchain industry.
DeFi is inclusive, allowing easy access to financial services. This is especially beneficial to unbanked individuals or those individuals that have limited access to the current financial system.
What Are The Advantages Of decentralized financial DeFi?
DeFi utilizes and leverages blockchain technology to unlock liquidity and growth opportunities, and It also brings transparency and security to the financial system. Some of the critical advantages of decentralized financial (DeFi) are
DeFi does not rely on traditional financial institutions
The current financial system relies heavily on conventional financial institutions such as banks to act as intermediaries during transactions. On the other hand, decentralized finance does not require any third party to act as an intermediary. The code and users who resolve all disputes are always in control of their assets.
DeFi cannot be tampered with
DeFi uses blockchain technology, making it immutable. Once the data is stored on the blockchain, it cannot be altered or deleted.
Smart contracts are highly programmable, allowing users to customize them easily. Smart contracts can be programmed to execute automatically, and the flexibility enables users to create new assets and financial instruments.
DeFi runs on the Ethereum blockchain, utilizing its protocols. This makes DeFi interoperable since the architecture is similar. Developers can also build new features on existing DeFi applications.
DeFi uses blockchain technology to function; one of the defining characteristics of blockchain technology is transparency. Every transaction on the blockchain is verified by users giving an unprecedented level of transparency, ensuring that all transactions are visible to any user who chooses to verify them.
DeFi is accessible to anyone with an internet connection and a cryptocurrency wallet. This is because DeFi is permissionless, and anyone can access it.
Use Cases Of Decentralized Finance
DeFi is building a parallel financial ecosystem that is transparent, resilient, and more accessible to the masses. DeFi has several use cases, some of which are
1. Asset Management
DeFi gives control of the assets back to the user, with users utilizing cryptocurrency wallets to interact with dApps. The wallets that users use allow them to buy, sell, and transfer crypto while enabling them to control their assets. User data like passwords and seed phrases are stored locally, meaning only the user can access them.
2. Lending Protocols
Decentralized borrowing and lending protocols are hugely popular in DeFi and have significant advantages over the traditional financial system.
Users can collateralize their digital assets and avail of instant settlement services. DeFi also does not require any background checks or credit history. The use of blockchain technology ensures verification through cryptographic means, reducing the level of risk involved and making borrowing/lending cheaper and accessible to all.
3. Banking Services
Banking services are an important and prominent use case for DeFi. The advent of Stablecoins, a digital asset that is pegged to a real-world asset that has the ability to be transferred quickly, has contributed to additional focus on adopting them for everyday transactions, pushing their use as digital cash. DeFi also uses smart contracts to issue loans and mortgages, cutting out any intermediaries involved.
4. Decentralized Marketplaces
One of the most crucial use cases of DeFi is Decentralized Exchanges.
Decentralized exchanges allow users to trade with each other without needing a third party to hold their funds. The trades are carried out directly between users through smart contracts.
Decentralized exchanges have far fewer trading fees as compared to centralized exchanges. Decentralized exchanges also provide projects with liquidity without charging any listing fee.
DeFi has also found use cases in the gaming industry thanks to Ethereum based games and their in-built economies. Users can utilize in-game cryptocurrencies that are represented on the blockchain beyond just using them as in-game assets.
6. Prediction markets
Prediction markets utilize DeFi to predict events. Platforms like Augur offer predictions of events ranging from politics to sports.
Since Ethereum is moving towards Ethereum 2.0, users will be able to stake ETH and earn rewards. They can stake their ETH as validators or staking providers and start earning rewards for validating transactions on Ethereum.
What Is The Role Of Smart Contracts In DeFi?
DeFi is heavily reliant on smart contracts, with most applications utilizing smart contracts.
Smart contracts specify the terms of a partnership or a relationship between two entities, allowing the contracts to be easily enforced. In addition, since they are written in code, the contracts can be executed automatically, cutting out the requirement to oversee the contracts manually.
Smart contracts make DeFi risk-free for all parties involved. However, there are some risks associated with smart contracts. This is because code is vulnerable to bugs which introduce some amount of risk in using smart contracts.
What Are The Challenges Faced By Decentralized Finance DeFi?
Even though DeFi is changing the financial landscape for the better, it has its fair share of issues. Some of the pressing problems faced by DeFi are
DeFi cuts out intermediaries from transactions and transfers responsibility to the users.
While this may have a positive impact as it cuts out the middleman, it also brings in a negative aspect as user error could become a significant factor. If a user makes an error during transactions, it is almost impossible to reverse it.
Developers should create products that consider high user error, but until that happens, this will be a significant issue for DeFi.
Since the technology behind DeFi is new, users have to strive to use DeFi applications and figure out how it works. DeFi needs to offer incentives and benefits to attract more users and convince existing users to stay.
DeFi is built using blockchain technology that is slower than traditional financial systems, highly centralized. Even though users can utilize private blockchains and alleviate the problem of slow speeds to a certain extent, developers need to optimize their applications to address the performance issues of DeFi.
An ecosystem that is cluttered
The DeFi ecosystem consists of several apps that carry out a single task, making it highly confusing for users to find the application that best suits their requirements.
Problematic smart contracts
Sometimes, smart contracts have incorrect or buggy code because developers do not properly check and test the codes. This results in buggy smart contracts that are also vulnerable to attacks.
DeFi has a scalability problem because current blockchains are not adequately scalable. This hinders DeFi from reaching mainstream audiences. The lack of scalability also means that DeFi networks and platforms perform poorly when many users are on the network.
volatility is an issue that plagues all crypto assets. Crypto assets by nature are volatile, making DeFi an extremely volatile ecosystem.
The Difference Between Decentralized Finance and Centralized Finance
With DeFi emerging as an alternative for traditional financial systems, the debate around DeFi vs. CeFi is hotting up. Therefore, it is essential to understand the critical differences between the two.
How Is Centralized Finance Better?
Centralized exchanges and financial institutions keep user information and user funds in centralized systems. This makes the funds and data vulnerable as centralized finance has a single point of failure, making it susceptible to security breaches. However, Centralized finance does bring a degree of flexibility when it comes to functions such as margin trading, lending, and borrowing.
Another aspect of Centralized finance is the flexibility that working with fiat currencies offers. The centralized agency is responsible for managing fiat, giving control to customers to ensure fiat conversions. Centralized finance also offers cross-chain services and support for trading cryptocurrencies. As a result, users do not have to depend on different blockchain technologies to convert their assets.
How Is Decentralized Finance Better than Centralized Finance?
DeFi does not require users to furnish personal information to access its financial services. DeFi is accessible to all who wish to utilize it.
DeFi does not rely on users’ personal information; instead, it provides users with identification numbers to leverage their services. Decentralized finance also keeps the user in complete control of their funds and data, ensuring the total safety of user assets.
- Permissionless system: DeFi is permissionless in nature, meaning users do not have to go through mandatory KYC processes to start using DeFi services. Users can connect their wallets and directly start trading.
- DeFi is Innovative: The DeFi space is constantly innovating and improving thanks to new financial services that transform the existing financial market. Innovation in Centralized Finance has hindered, thanks to its centralized nature significantly.
DeFi is working on introducing a financial system that is open and inclusive and one that prevents censorship. Although decentralization is beneficial in most cases, there are also several examples where it does more harm than good. Therefore, finding proper use cases and building upon them is vital to create financial products that will help take DeFi mainstream.
DeFi hopes to control and responsibility of their assets and information back to the users, creating a community that is open and creating a financial system that will one day replace the traditional financial system.
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