A Beginner’s Guide to Decentralized Finance (DeFi)
Decentralized Finance, short for DeFi, is an open-source, permissionless platform built on blockchain technology. The term DeFi refers to a decentralized, transparent ecosystem that is openly available to anyone on the network.
No central authority operates the DeFi ecosystem. All the users on the network will have access to the data and are given complete control over their assets. The ecosystem also enables interaction through peer-to-peer (P2P) and decentralized applications (dApps).
DeFi is built upon interoperable DeFi applications, open blockchain technology, and easy access to the financial system. It potentially creates an opportunity for modern financial markets with enhanced services and products. Above all, it provides diverse benefits to those who are unable to access the traditional financial system.
Advantages of Decentralized Finance (DeFi)
The traditional finance system depends on the central authorities, banks, and other financial institutions. In contrast, DeFi applications are independent and free from intermediaries. As mentioned earlier, the users can maintain and control their funds anytime from anywhere of the globe. This independent nature of DeFi reduces the costs associated with the utilization of products and services and enables a more frictionless financial system.
Unlike the traditional financial system, the DeFi ecosystem is available for almost all the communities – irrespective of the location, income, etc.
DeFi applications are built one above the other with enhanced security and fewer complications. The data recorded on the blockchain technology is shared across infinite nodes. It makes it difficult to manipulate or delete, or potentially shut down the entire service. The whole of the DeFi ecosystem runs on top of blockchains and eliminates the failures involved in the ecosystem.
Use Cases of DeFi
Borrowing & Lending – DeFi Credit System
The borrowing & lending system on the DeFi ecosystem is a boon than the traditional credit system. DeFi’s well-known open lending applications offer instant transaction settlement, collateralize digital assets, and no credit checks by standardizing the financial system.
All these lending services have the assurance of cryptographic verification methods. Thus the lending applications built on the blockchain network reduce counterparty risk and offer cheap and faster borrowing and lending options to everyone.
Decentralized Marketplaces
Decentralized marketplaces offer a vast room for financial innovations. These applications can be challenging, but they play the most crucial role on the DeFi platform. The decentralized exchanges (DEXes) applications allow users to trade digital assets without any intermediary dependency. They can send, receive, custody with the support of smart contracts and wallets.
Compared to the centralized exchanges, trading on the DeFi platforms requires less maintenance work and low trading fees. Decentralized exchanges eliminate custodians and single-point failures. Since it is backed by blockchain technology, DeFi can also issue and allow a wide range of ownership over conventional financial instruments.
DeFi Smart Contracts
Most often, decentralized finance applications create and execute smart contracts. A smart contract uses a computer code to specify the legal terms of the relationship between the entities entering the contract. Thus, smart contracts are enforced through computer code. The smart contracts execute and automate the business process without any manual supervision.
Smart contracts are faster, easier, and the most reliable for both entities. However, since it is computer code, it may be prone to have bugs, vulnerabilities, and the information is exposed to risk.
Challenges for DeFi
Although DeFi is an open-source platform, it has several challenges that need to be addressed yet.
Blockchain technology is growing in a fast-paced environment. But slower than the centralized counterparts. Hence this also affects the applications that are built on top of the DeFi platform.
At times, when the whole responsibility is moved onto the user, this can bring in a negative impact as well. Designing products and their deployment might involve errors and challenges. Thus, there’s a high risk of these errors on the user.
Since the DeFi platforms are just growing, there are quite a few user experience related issues.
Maybe, DeFi platforms should also offer tangible benefits to users, such that they are diverted from the traditional financial system.
The Conclusion
In open banking, third-party financial institutions get access to financial data through APIs. This enables data sharing between both banks and non-banking institutions.
DeFi offers an entirely new financial system that is decentralized, open, permissionless, and independent. DeFi is also referred to as open finance and is highly decentralized and focused on building a new financial system that avoids censorship and discrimination across the world. It is building open financial products backed by blockchain technology.
In the coming days, DeFi will take over the centralized financial system and provide an open-source platform for individuals and businesses.