A Beginner's Guide to Decentralized Finance
DeFi democratizes finance. It is a movement to create an open and decentralized financial system that gives anyone, regardless of their geographic location or socioeconomic status, access to a wide range of financial products, services, and tools. Continue reading to learn more about how DeFi works.
What Is Decentralized Finance (DeFi)?
DeFi (Decentralized finance) is an umbrella term for financial applications built on top of blockchain networks. The main aim of DeFi is to provide a more open, transparent, and inclusive alternative to the traditional financial system.
DeFi applications range from decentralized exchanges and lending platforms to trading aggregators and stablecoins.
How Do DeFi Applications Work?
The logic for DeFi applications is typically built using smart contracts — self-executing pieces of code that run on a blockchain. Since blockchains are distributed computer networks that are cryptographically secured and publicly viewable, rules encoded in smart contracts are immutable and transparent. This allows developers to create financial protocols that are independent of any centralized authority and that can safely automate complex financial interactions.
DeFi vs. Centralized Finance
In centralized finance (CeFi), the rules governing customer interaction with their funds are set by centralized intermediaries such as banks. Thus, CeFi users do not usually have full autonomy over their money, and their financial security is reliant on the trustworthiness of the centralized institution they are using.
In DeFi, on the other hand, the logic for financial services is coded into smart contracts, which execute agreements between parties in a fully trustless and transparent manner.
Why Will DeFi Revolutionize the Financial Industry?
Here are a few reasons why DeFi is likely to revolutionize the financial industry:
Accessibility: DeFi is accessible to anyone with an internet connection, so no one is barred from using decentralized financial services based on their location or financial status.
Lower Costs: DeFi protocols are often much cheaper than traditional financial services due to the fact that they are automated and don’t require manual labor.
Autonomy: Since decentralized financial protocols are not owned or managed by any single entity, they are much more resistant to manipulation or censorship compared to centralized platforms.
Transparency: All DeFi protocols are open source, meaning that anyone can audit their code and see how they work.
Security: All transactions in Defi are secured by cryptography which makes them extremely hard to tamper with.
Since DeFi is building an ecosystem of financial services that aims to be able to perform similar functions as traditional finance, it is in need of a stable asset to be used as a medium of exchange and a store of value. Stablecoins do just that. They are a type of cryptocurrency designed to maintain a stable value relative to a particular fiat currency, such as the US dollar. DAI is a good example of a decentralized stablecoin. Learn more about how stablecoins work in this article at TabTrader Academy.
Decentralized exchanges (DEXs)
Decentralized exchanges operate similarly to centralized and traditional exchanges in that they allow users to buy and sell value. However, since decentralized exchanges are run by smart contracts instead of centralized organizations, they provide users with greater control over their funds and increased privacy. They do not require their customers to submit personal information and do not take custody of user funds. Some well-known decentralized exchanges include Uniswap, PancakeSwap, and dYdX.
Decentralized lending protocols are applications that allow users to borrow and lend cryptocurrencies through decentralized networks. Compared to centralized lending protocols, they can offer higher yields for lenders and better terms for borrowers, not to mention higher security and privacy.
Aave, Compound, and Maker are among the most popular decentralized lending protocols in the industry. Check out our article on crypto lending to find out more about both decentralized and centralized crypto lending platforms.
Aggregators and wallets
Aggregators and wallets are essential components of the DeFi ecosystem. Aggregators provide users with a single point of access to multiple decentralized finance protocols, while wallets offer a secure and convenient way to store and manage cryptocurrency. MetaMask and Trust Wallet are some of the most popular wallets in the DeFi space. Popular DeFi aggregators include 1inch and Zapper.
Blockchain oracles are protocols that provide DeFi applications with real-world data such as stock prices, weather data, etc. This data is then utilized to trigger certain events within the DeFi applications, thereby allowing them to interact with the outside world. Centralized oracles use a single data source, while decentralized oracles are powered by a network of nodes that are incentivized to provide accurate data. Chainlink is one of the most popular decentralized oracle networks. For more information on blockchain oracles, check out our dedicated article.
Is It Safe to Invest in DeFi?
Investing in DeFi can be a great way to access new financial opportunities in the cryptocurrency space. However, it's important to remember that DeFi is still a relatively new technology and therefore can come with risks.
- Smart contract risk: smart contracts can contain bugs or be vulnerable to hacking.
- Lack of regulation: there are currently no legal frameworks governing DeFi protocols, so there is often no legal recourse if something goes wrong.
- Volatility risk: as with the majority of cryptocurrencies, cryptocurrencies used in DeFi can be highly volatile.
Please be sure to do thorough research and weigh the risk involved before investing in any cryptocurrency project, including but not limited to DeFi projects.
Where Is DeFi Headed?
Despite the fact that DeFi is a relatively young technology, many industry experts agree that its potential is enormous. In the nearest future, as more and more users become aware of the advantages DeFi has to offer, more and more decentralized applications will likely start popping up. This should lead to increased liquidity, better accessibility, and improved user experience in the space. Moreover, as DeFi continues to grow, we can likely see broader institutional adoption, increased regulatory clarity as well as better security measures.
DeFi is revolutionizing the established financial system by giving users a safer and more convenient way to manage their money. With its innovative technology and quickly expanding user base, DeFi will likely soon become an integral part of the global financial system.