What is DeFi? Decentralized Finance Explained

  • 2021-09-17

Imagine a world without banks and bankers, stock brokers or exchanges! Decentralized finance allows you exactly that. It allows you to make pure financial transactions, and cuts out the intermediaries.

Decentralized finance is an innovation led by the mission to make financial transactions transparent and more accurate. It functions on a digital platform called the blockchain network, which acts as an autonomous ledger. Compare this with banks, stock exchanges and other financial institutions–these institutions basically act as centralized ledgers that aggregate and maintain records of financial transactions. This is what gives them their power. In the act of collecting, storing, and organizing sensitive information about people’s financial transactions, they not only control access to the information, but indirectly end up controlling the money itself. Decentralized finance finds a way around precisely this glitch, and the risks involved with letting others control your finances.

It’s not that the ledger is not there in decentralized finance, but just that nobody owns it. And it is built on this utopian premise–of bettering financial transactions, and making them more accurate, by making the ledger, the record of transactions, autonomous. So, now that the intermediaries have been cut out of the picture, the value of your money is not dependent on totally arbitrary risks arising from mismanagement, fraud, corruption and more systemic problems like artificial inflation, that traditional finance is subject to.

DeFi is now commonly hailed as the future of finance!

How Does it Work?

DeFi is not just a platform that allows the exchange of currency between two parties, but is able to support the whole range of financial operations, like loans, savings, insurance and so on, that typical banks, stock exchanges and other financial institutions perform. It operates on the blockchain infrastructure. Blockchain, much like the World Wide Web, is basically a digital network of information. It is made up of millions of tiny pockets of highly specific information that document financial transactions. It acts as the ledger and contains records of every unit of cryptocurrency in circulation. These pockets of information are recorded in incorruptible code that follows strict protocols. And because no specific person or organization owns the blockchain network, it is fully transparent and cannot be easily manipulated.

Not just currency, but any form of assets can be secured on the DeFi network. Assets are logged into the blockchain economy by assigning them tokens, through which they are then secured. And now, anybody with a crypto wallet can trade their respective assets with diverse markets and pools. This also makes trading a more equitable undertaking, by removing several institutional obstacles that gatekeep who gets to trade what.

Another feature that DeFi incidentally introduces is increased liquidity. Since blockchain networks allow for a variety of assets to be tokenized, the tokens can then be converted and interchanged between drastically distinct investment and trade markets.

DeFi Services

Cryptocurrency

DeFi has given rise to several digital or ‘crypto’ currencies, the most popular being Bitcoin and Ether. The main feature of cryptocurrencies is that they are not pegged to any currency or object in the real world, i.e, they are pure digital currencies. However, DeFi also allows for interactions between real world and digital currency, in the form of stable coins. These are pegged to real-world currencies, and the value of a stable coin thus depends on the value of the currency that it is pegged to, rendering them more ‘stable’.

Note that pure cryptocurrency comes with its own guards against inflation–cryptocurrencies like Bitcoin are not pegged to other currencies, like the dollar is. To break down what this means, let us look at how inflation works with the dollar. The more dollars printed, the less the value of each dollar. Bitcoin, on the other hand, is built on a de-inflationary model, and is not subject to systemic loopholes like this. The more bitcoin minted, the less the amount of inflation–and this is because the more the number of bitcoin units in circulation, the more widely spread it is on the transparent blockchain network. The more the number of users, the more transparent the system!

Decentralized Exchanges

You can buy, sell or trade your cryptocurrencies through Decentralized Exchanges (DEX).

As mentioned earlier, DeFi also supports other financial operations, like lending, mortgage, and even the drawing up of contracts. Ethereum is a blockchain network that really extends the idea of DeFi to allow you to draw up ‘smart contracts’. It does this by facilitating the use of decentralized code to make highly personalized and fully transparent contracts between two or more parties. The quality and legitimacy of smart contracts generated on Ethereum is maintained through the use of a universal protocol which every user has to follow. These ‘contracts’ have a wide range of uses, and can vary from business to exchange of stocks, and so on. Again, the advantage with a DeFi smart contract is the absence of a broker. The contract is transparent and involves only the parties that are agreeing to it.

DeFi also has its own money markets, where you can lend and borrow money for various purposes. You can even use your cryptocurrency as loan collateral to buy a house, for instance. Yield farming is yet another function of cryptocurrency that allows you to earn interest on your latent crypto-savings.

With inflation and corruption affecting financial institutions everywhere, if you’re wondering where to put your money, or how to use it better, DeFi is the way to go!

Image credits : Jernej Furman

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