What Is Decentralized Finance (DeFi)?
A new financial system called decentralized finance (DeFi) is based on safely distributed ledgers that are similar to those used by cryptocurrencies.
For centralized financial institutions like banks and brokerages, which customers depend on for direct access to capital and financial services, the Federal Reserve and the Securities and Exchange Commission (SEC) in the United States determine the standards. DeFi disrupts the centralized banking system by enabling people to make peer-to-peer digital transactions. DeFi eliminates the usage fees imposed by banks and other financial organizations. Anyone may use DeFi from any place with an internet connection, retain their money in a secure digital wallet, and transfer money in just a few short minutes.
Centralized Finance vs. Decentralized Finance (DeFi)
Decentralized finance is distinct from conventional, centralised financial institutions and banking.
Finance centralization
Money is held by banks and third parties who facilitate money movement between parties in centralized finance, with each charging fees for using their services. A credit card charge is initiated by the merchant and transferred to an acquiring bank, which forwards the card information to the credit card network.
The network authorizes the charge and asks for payment from the bank. Each organization in the chain is compensated for its services since retailers are required to pay for the use of credit and debit cards.
All financial dealings, including loan applications and bank services, are governed by centralized finance.
Decentralized Finance
By allowing people, corporations, and merchants to perform financial transactions utilizing developing technologies, decentralized finance eliminates middlemen. Peer-to-peer financial networks are used by DeFi to implement security protocols, connectivity, software, and hardware developments.
Whenever there is an internet connection, people can lend, trade, and borrow using software that logs and validates financial transactions in distributed financial databases. Because a distributed database gathers and aggregates data from all users and verifies it using a consensus process, it may be accessed from several locations.
Decentralized finance eliminates the need for a centralized finance model by allowing anyone, regardless of who or where they are, to use financial services anywhere. DeFi programs allow customers more control over their money by providing personalized wallets and trading opportunities.
How Does DeFi Work?
Similar to cryptocurrencies, decentralized finance also uses blockchain technology. A distributed and secure ledger or database is what a blockchain is. Applications known as dApps manage transactions and power the blockchain.
On the blockchain, transactions are stored as blocks that are later validated by other users. A new block is formed containing information about the preceding block and is closed and encrypted if these verifiers concur on a transaction.
The information in each succeeding block “chains” the previous blocks together, giving the term “blockchain” its meaning. There is no method to alter a blockchain since changes to one block’s data will have an impact on all subsequent blocks. This idea helps to make the blockchain secure, along with other security procedures.
Uses of DeFi
Peer-to-peer (P2P) financial transactions are one of the key tenets of DeFi. When two people agree to exchange cryptocurrencies for goods or services without the need for a third party, this is known as a P2P DeFi transaction.
In DeFi, peer-to-peer lending can fulfill an individual’s financial demands. An algorithm will connect peers who concur with the lender’s terms, and a loan will be granted. Payments from P2P are made through a decentralized application, or dApp, and are recorded in the blockchain in the same way. Using DeFi enables you to:
• Accessibility: Anyone with an internet connection can access a DeFi platform, and transactions can take place anywhere in the world.
• Low fees and high-interest rates: DeFi networks allow any two parties to directly negotiate interest rates and lend money.
• Smart contracts and records of completed transactions broadcast on a blockchain are transparent and secure, but they do not reveal your name to anyone who looks at them.
• Autonomy: DeFi platforms are not dependent on any centralized financial institutions and are not vulnerable to adversity or bankruptcy. Because DeFi protocols are decentralized, a large portion of this danger is reduced.
Advantages and Disadvantages of DeFi
Pros
- Decentralized applications enable individuals to send money all over the world.
- The ability of the investor to create income
- High level of protection
Cons
- Participation in DeFi is complex and difficult to understand
- The possibility of deception is very high.
The Future of DeFi
Decentralized finance is always changing. Its environment is filled with errors, hacks, and frauds because it is unregulated.
The idea of distinct financial jurisdictions, each with its own set of laws and regulations, is the foundation of current legislation. DeFi’s capacity for transacting without borders creates significant problems for this kind of regulation.
Who is responsible for looking into financial crimes that occur across boundaries, protocols, and DeFi apps? Who and how would be in charge of enforcing the rules?
System stability, energy use, carbon footprint, system upgrades, system upkeep, and hardware failures are other factors to take into account.
What Does Decentralized Finance Do?
DeFi’s goal is to challenge the use of centralized financial institutions and third parties in all financial transactions.
Is Bitcoin a Decentralized Finance?
Bitcoin is a type of cryptocurrency. Bitcoin is not really DeFi, but rather one of its components because DeFi is built to leverage cryptocurrencies in its ecosystem.
What Is Total Value Locked in DeFi?
Total value locked (TVL) is the total value of all cryptocurrencies staked, loaned, deposited in a pool, or used for other financial purposes across DeFi. It can also represent the total value of specific cryptocurrencies used for financial transactions, such as ether or bitcoin.
The Bottom Line
Decentralized finance (DeFi) is a new financial technology that threatens the existing centralized banking system. DeFi promotes peer-to-peer, or P2P, transactions by eliminating the fees that banks and other financial institutions charge for using their services.
Investing in cryptocurrencies and other Initial Coin Offerings (“ICOs”) is extremely risky and speculative, and this article is not a recommendation by Investopedia or the author to do so. Because every person’s situation is different, a qualified professional should always be consulted before making any financial decisions. Investopedia makes no representations or warranties about the accuracy or timeliness of the information provided on this site.
