Understanding decentralized finance (DeFi)

Decentralized finance, abbreviated to DeFi, is an emerging financial technology. It is based on secure distributed ledgers similar to those used by cryptocurrencies. The system removes the control that banks and institutions have over money, financial products and financial services.

Today, nearly every aspect of banking, lending and trading is handled by centralized systems. The governing bodies and guardians exploit them. Consumers have to deal with a multitude of financial intermediaries to have access to everything. These range from auto loans and mortgages to stocks and bonds.

For example, in the United States, the US Securities and Exchange Commission (SEC) is the federal body responsible for setting the rules for the world of centralized financial institutions and brokerage firms. On the other hand, Congress has a mandate to change the rules over time. Consequently, consumers have few channels for direct access to capital and financial services. They lack the ability to bypass intermediaries such as banks, exchanges and lenders, who earn a percentage of every financial and banking transaction as a profit. Decentralized Finance (DeFi) challenges this centralized financial system. But what do we really mean by decentralized finance?

DeFi, a system that weakens intermediaries

Decentralized finance it eliminates intermediaries. They allow the realization financial transactions through emerging technology. This is accomplished through peer-to-peer financial networks using advanced security protocols, connectivity, software and hardware.

Wherever you have an internet connection, you can lend, exchange and borrow using the software which records and verifies financial actions in distributed financial databases. A distributed database is accessible from different places. Collects and aggregates data from all users and uses a consent mechanism to verify them.

Decentralized finance uses this technology for eliminate centralized finance models. This solution allows anyone to use financial services anywhere. DeFi apps give users more control over their money through personal portfolios and trading services aimed at individuals.

Therefore, consumers are attracted to decentralized finance, particularly because it it eliminates the fees charged by banks and other financial companies to use their services. They can also keep your money in a secure digital wallet instead of keeping it in the bank. Anyone with an Internet connection can use it without approval. Not to mention that it is possible transfer funds in seconds.

Decentralized Finance (DeFi) vs Centralized Finance (CeFi)

Commercial banks will be used as an example for this comparison. In the traditional world, you can use financial institutions for store your money, borrow capital, earn interest and trade. These establishments own and control your assets to some extent. You are limited by bank hours for specific actions. Plus, transactions can be tedious and challenging settlement delays in the background. Commercial banks also require specific customer information and identification documents.

Decentralized finance

DeFi, on the other hand, is a segment that includes financial products and services accessible to anyone with an Internet connection. It works without the intervention of banks or other third-party companies. The decentralized financial market does not sleep. Therefore, transactions occur 24 hours a day, 7 days a week, almost in real time. No intermediary has the power to stop them. You can store your cryptocurrencies on computers, in hardware wallets and elsewhere e access it at any time.

Bitcoin and most other cryptocurrencies possess these characteristics due to the underlying technology that supports these assets. Thanks to DeFi’s reliance on blockchain technology, transactions are completed faster, at a lower cost and, in some cases, more safely than with human intervention. Decentralized Finance seeks to use cryptographic technologies for solve a plethora of problems that exist in traditional financial markets.

How does decentralized finance work?

Decentralized finance is based on the blockchain technology used by cryptocurrencies. A blockchain is a distributed and secure database or registry. Applications called DApp they are used to manage transactions and run the blockchain.

In the blockchain, transactions are saved in chunks and then verified by other users. If these verifiers agree on a transaction, the lock is closed and encrypted ; another block is created and contains information about the previous block.

Defi is based on the Blockchain

The blocks are “chained” through the information of each procedure block, hence the name blockchain. Information from previous blocks cannot be changed without affecting subsequent blocks. So there is no way to change a blockchain. This concept, along with other security protocols, provides the secure nature of a blockchain.

Some DeFi use cases

Here are some of the key use cases for decentralized finance.

Lending platforms

Loans and loans have become one of the most popular activities in DeFi. Loan protocols allow users borrow funds while using their cryptocurrency as collateral.

Payments and stablecoins

So that the Challenge qualifies as a financial system, including transactions and contracts, there must be a unit of account or a stable asset. Participants should be able to expect the fund to not decline in value of the asset they are using. This is where stablecoins come into play.

The stablecoins bring stability to daily activities in the DeFi market, such as loans and loans. They are usually pegged to a fiat currency, such as US dollars or euros.

Margin and leverage

The margin and leverage components take the decentralized financial market to the next level. They allow users borrow cryptocurrencies on margin using other cryptocurrencies as collateral.

How to get started with DeFi?

Here are some steps you can take to get started with DeFi.

Configure your wallet

Configure your wallet

First of all, you will need a cryptocurrency wallet installed on your browserone that ideally supports Ethereum and can also connect to various DeFi protocols. Metamask is the most used wallet. But there is a wide selection of wallets available that will allow you to connect and interact with DeFi.

Buy relevant parts

You will now need to purchase the relevant coin for the DeFi protocol you intend to use. When it comes to DeFi, Ethereum leads because of the value it provides thanks to its smart contracts. Means that most DeFi protocols live on Ethereum. So, you will probably have to purchase ETH to use them.

You can acquire Ethereum on a cryptocurrency exchange such as Binance or Coinbase. You can also buy cryptocurrencies using Fiat in a peer exchange.

Explore DeFi

Some of the DeFi products include:

  • Loan of cryptocurrencies: This involves earning governance tokens that are awarded for lending your cryptocurrencies
  • Put your funds on a decentralized exchange like UNISWAP: With DeFi exchanges, you can earn commissions by becoming a market.
  • Invest in DeFi projects.

Is it safe to invest in DeFi?

In general, the smaller the market capitalization of a token, the more risky it is as an investment. Therefore, consider the liquidity of the tokens before committing your funds. Make sure you know how long has a DeFi protocol been in place and how much money he has in total deposits before investing.

look at the liquidity of the tokens before committing your funds

You can check its website to see whether the company has taken reasonable steps to reduce its risks. You can also look up information about the hacked protocol on the Internet and related precautions to prevent it from happening again. To be clear, there is no risk-free DeFi protocol. But these metrics can help you assess investment risk before putting your money into a protocol.

What are the risks of DeFi?

Despite all its promises, the decentralized financial space remains a nascent market who still has difficulty growing. DeFi has yet to achieve large-scale adoption, and to do so, blockchains need to become more scalable. The blockchain infrastructure remains in its original form.

On some platforms, transactions happen at a snail’s pace. And this will continue to be the case until scalability improves. And this is the idea behind the development of Ethereum 2.0, also known as Eth2. Fiat’s access ramps to DeFi platforms can also be extremely slow, threatening to do so hinder user adoption.

DeFi and its risks

Given its youth and innovation, the legal details on DeFi they probably haven’t fully materialized yet. Governments around the world can aim to integrate DeFi their current regulatory guidelinesor they can develop new laws relating to the sector. Conversely, DeFi and its users may already be subject to specific regulation.

The future of DeFi

Decentralized finance is still at the beginning of its evolution. To start, it is not regulated. This means that the ecosystem is always full of infrastructure problems, hacks and scams.

Decentralized finance

Current laws were developed on the basis of the idea of ​​separate financial jurisdictions, each with their own set of laws and rules. DeFi’s borderless transaction capability presents critical issues for this type of regulation.

For example, who is responsible for the investigation a financial crime happen across borders, protocols and DeFi applications? Who would apply the regulations and how would they apply them?

Other concerns are system stability, power requirements, carbon footprint, system upgrades, system maintenance, and hardware failures. Many questions need to be answered and progress made before DeFi becomes safe to use. If DeFi is successful, banks and businesses are more than likely to find it ways to enter the system.

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