DeFi (Decentralised Finance) is a new financial system built on secure distributed ledgers. The system removes the control that banks and institutions have over money, financial products, and financial services.
With DeFi, people can do many things that banks do, such as borrow and lend money or assets, earn interest, buy insurance, and trade assets. But, these happen in a way that is faster and does not involve paperwork or a third party.
DeFi, like crypto in general, is global, peer-to-peer, and pseudonymous. It is not routed through a centralized system like banks are. Instead, it allows several entities to keep a copy of the transaction history that happened on it.
Unlike DeFi, centralized systems (banks) and gatekeepers (bankers) can restrict transaction speed and sophistication. They also limit the control that users have over their money.
DeFi is unique because it extends the use of the blockchain beyond the simple transfer of value to more complex financial use cases. It allows developers to build more open, free, and fair financial markets available to anybody with an internet connection.
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How DeFi differs from traditional financial systems
It is vital to understand how DeFi differs from centralized finance to comprehend how it works. Banks and corporations whose goal is to make money hold your money in centralized finance systems.
Many third parties in this system enable money flow, and each one charges a fee. For example, you pay for a good with your credit card. The payment passes from the seller to the bank and then to the debit card network.
The network clears the transaction and asks your bank for payment. Your bank accepts the transaction charge and sends it to the seller via the acquiring bank. Each organization in this chain gets paid for its services.
Other financial transactions also cost money in a similar way to this. Loan applications might take days before it is permitted. You may sometimes not be able to use a bank’s services when travelling, etc.
How it works
DeFi removes the need for third parties by allowing individuals, entrepreneurs, and businesses to conduct financial transactions on the blockchain network. This happens on peer-to-peer networks that use advanced security protocols, software, and hardware.
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DeFi uses the same blockchain technology as cryptocurrencies. A blockchain is a distributed and secure database, also known as a ledger. Decentralised applications (dAPPs) run the blockchain and process transactions.
Transactions are recorded on blocks and then verified by other users. When they agree on a transaction, the block is closed and encrypted. Thereafter, they create a new block with information about the previous block.
This links the blocks in a chain (hence, the name blockchain). There is no way to change a blockchain because a change in a block affects the others. This approach, along with other security procedures, makes the blockchain reliable and safe.
You can lend, borrow and trade from anywhere in the world using DeFi software that records and certifies your transactions in distributed financial databases. These collect data from all the users and verify it through a consensus process.
DeFi applications give people greater control over their money through personal wallets and trade services. Although it takes away control from third parties, DeFi does not hide the identity of users completely.
Organizations that have access to the DeFi system can trace users. These organizations may be governments, law enforcement agencies, or organizations with authority. However, their only purpose is to defend the financial interests of users.
Advantages of DeFi
- Open: anyone with an internet connection can use it without needing approval from any company or authority.
- More private: users do not need to open an account or provide personal information like names or email addresses.
- Flexible: users can move their assets anywhere anytime without asking for permission, waiting for long transfers to complete or paying high charges.
- Transparent: everyone on the system can see records of all the transactions.
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Disadvantages of DeFi
- Transaction rates on the Ethereum blockchain often fluctuate. This means that active trading can become very expensive.
- Some dAPPs make may your investment value less stable than usual. This is because DeFi technology is still growing.
- Tax regulations may differ from region to region, so users may need to keep their records for tax purposes.
DeFi aims to remove third parties in financial transactions. But, the technology is still in its early stages of development, meaning that the ecosystem is still unstable. Present challenges include infrastructural errors, hacks, and frauds.
Others are energy requirements, carbon footprint, and system maintenance. Therefore, DeFi developers must solve many problems and make better advances before mass adoption can happen.
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