Imagine a world where you could make a series of financial transactions without limit. A world where buying and selling financial assets beat the obstacle of geographical location, slow speed, and unreliable intermediaries. If you haven’t noticed by now, you are living in one! With the help of DeFi, you can see your dream of new-age finance come true. However, there’s more to DeFi that a lot of people know about. Hop on this article to learn what DeFi is all about.
What is Decentralized Finance (DeFi)?
Decentralized finance is a blockchain technology that enables users to buy and sell financial assets without intermediaries. It eliminates the need for middlemen in making transactions thereby providing a more direct and seamless experience. DeFi supports many financial activities performed by conventional financial institutions. But in this case, its operations are more public and direct.
How does DeFi work?
DeFi is broken down into two words- Decentralized Finance. An important bit of this term is “decentralized”. This word differentiates the operations of DeFi from the operations of centralized finance. Decentralized entails that a system lacks sole authority. In decentralized systems, no one person can claim ownership of a network. Instead, everybody contributes to the activities and maintenance of the network. When transactions occur, the process is just between two parties: the sender and the receiver. This is opposed to centralized finance where a third party has to come to handle operations. Decentralized networks have brought a new outlook on security because all eyes are on the network. The likelihood of data manipulation is very little because the network is public with so many watchers.
Transactions in decentralized finance are performed with the help of smart contracts. Smart contracts are programs that are executed only when certain conditions are met. Let’s assume that the financial asset needed to be sold is an NFT. A smart contract will help to make that transaction possible only if it acknowledges that a certain condition is met. The smart contract must acknowledge that the other party has paid the required amount of money to the seller. This will then send a signal to the smart contract that the transfer of ownership can begin. The smart contract will then transfer the ownership of the NFT to the buyer.
Types of Decentralized Applicatons
- Decentralized Exchanges: These are platforms that allow the buying, selling, and swapping of digital assets. On decentralized exchanges, users can easily exchange one digital asset for another or for fiat currency. Users do not need any third parties to manage the transaction processes with this means. With decentralized exchanges, you can trade, save, and invest digital assets.
- Wallets: These are needed to store your public and private keys. Wallets make it easy to send and receive cryptocurrency. Once you open your wallet account, you will be given a recovery phrase that will enable you to recover your wallet if need be. If you need to receive a particular coin, you will also be provided with a public address to which the coins would be sent. Examples of wallets include MetaMask wallet, Trust wallet, MyEther Wallet, and so on.
- Stablecoins: These are coins that a pegged to a fiat currency. An example of a stablecoin is Tether which is pegged to the Dollar. The value of a stablecoin mirrors the value of the fiat currency it is attached to. In essence, the value of Tether does not go far beyond $1. Stablecoins make certain things like liquidity pools easier. It could also serve as a good store of value. You can save money using stablecoins since they are not as volatile as other coins.
How does DeFi make money?
DeFi is not only used for making transactions but also for earning money. DeFi has various means of earning passive income through investment on its platforms. Here are some ways you can earn money through DeFi:
- Staking: This is the process of storing your coins over time while they yield interest. Staking is a win-win for both parties involved which are the blockchain and the users (aka validators). Staking is usually done with tokens which are a blockchain’s native assets. For instance, you can stake Ether tokens on the Ethereum blockchain because Ether is the native token for the Ethereum blockchain. The tokens staked are used to maintain the blockchain. The network picks at random which validator’s token to use for the blockchain. The validator, in turn, gets rewarded in the form of interests. An important note is that a larger amount staked attracts larger rewards.
- Liquidity Mining: This helps decentralized exchanges provide funds to run their operations. Decentralized exchanges that utilize yield farming include UniSwap, SushiSwap, PancakeSwap, and so on. Their main activity includes letting users swap tokens. However, such decentralized exchanges are efficiently run through liquidity pools where crypto assets are locked by various investors. These investors get a cut out of the trading fees paid by users on the network.
- Borrowing and Lending: You can earn through DeFi by borrowing and lending tokens or coins. You can borrow a certain amount of coins or tokens from a platform and put that money back into the same or another platform. The money put in will attract a reward of a certain percentage of the initial amount put in. Let’s assume that depositing a coin worth $50,000 will attract a 1% which is equivalent to $500. You can deposit that amount into a DeFi protocol that can grant you a collateralized loan. You can also lock your tokens on lending platforms. Your tokens will then be lent to users that need them. They will in turn pay interest in addition to the amount you borrowed them.
What are decentralized finance apps (dApps)?
Decentralized finance applications are digital software that is run by a blockchain and utilizes a peer-to-peer network that comprises a network of different computers. In the discourse of decentralized finance, dApps are usually an important addition because it falls under the wide umbrella of decentralized finance. The main difference between centralized apps and dApps is that centralized apps involve only a single computer, while dApps involve using different computers. Centralized apps can be controlled or manipulated by another party since it has a centralized authority. But since dApps do not have a centralized authority, nobody can change or manipulate already existing data on a decentralized application.
- Quick speed: Blockchain technology offers quicker speed of processing transactions in decentralized finance. The lack of a third party also eliminates a long chain of processing transactions, making it faster and more direct.
- Immutability: Immutability in decentralized finance entails that data cannot be changed. This is because the technology supporting DeFi, which is the blockchain, is open source and cannot easily be manipulated. Hence, security is tight and you can be assured of the safety of your assets.
- Transparency: Unlike centralized finance where users are not aware of many things happening on the network, DeFi provides users with optimum transparency. Take the Etherscan for instance. The Etherscan is a block explorer that contains a list of transactions that happened on the Ethereum network. After a transaction has been validated, it reflects on the Etherscan. So it is not as easy to scam with DeFi because evidence of transactions is public for every user on the network to see.
- Easy lending and borrowing: DeFi tackles the problems of borrowing and lending money with hassles using centralized finance. On DeFi, you do not need to make so much paperwork or spend a long amount of time processing loans. DeFi offers amazing means to borrow your money and receive interest.
- Auditing: DeFi requires auditing on the smart contract since that is where the service is built. Since a smart contract can be compromised with errors in the code, a third party is required to audit it. Smart contract auditing involves checking for any possible errors and vulnerabilities and correcting them in the contract.
- Attacks: Although DeFi boasts of top security due to its decentralized feature, it can also be prone to some attacks. These attacks may be a result of errors with codes and attacks from miners.
- Lack of accountability: DeFi takes no accountability for any errors or problems with the network. Since there are no central authorities, the users bear the burden of all the problems without having anyone to hold responsible.
- High transaction fees: Some decentralized exchanges require high transaction fees due to network congestion. This is seen especially in blockchain networks like Ethereum where high transaction fees are seen in transacting tokens and minting NFTs.
Since the rise of decentralized finance, the world has recognized its potential and uniqueness in comparison to conventional finance. We can see that DeFi offers a new approach to financial transactions while prioritizing users’ convenience. While it is in its early stages, DeFi still has a long way to go. The earlier you hop on the wave, the better it is for you in the long run. Brace up as you enter into the new world of DeFi.
Ebiere Watchman is a prolific writer specialized in web 3.0 and finance. Ebiere’s experience includes research projects, sales copywriting, and storytelling. She prides herself in crafting impeccable content to drive mass adoption in cryptocurrency.