DeFi: what is decentralized finance?
DeFi, or decentralized finance, is a “permissionless” way to transact between two parties. These transactions use public blockchains that allow open access to validation and mining. They are also used to buy, sell and trade digital assets, like Bitcoin.
DeFi projects use dApps (decentralized applications) that anyone can develop and customize.
How DeFi Works
Like Bitcoin, DeFi’s software runs on a blockchain that makes every transaction immutable, tamper-proof, pseudonymous, and public. All network nodes accessible by dApp maintain an accessible record of transactions between crypto addresses.
DeFi primarily runs on the Ethereum blockchain, but there are projects that run on other networks, such as Binance. Additional networks that include Cardano, Solana, and Polkadot are also emerging as DeFi adoption increases.
DeFi eliminates the need for a middleman or agent through smart contracts, while removing technological and regulatory barriers to entry.
Smart contracts are automated protocols that are fulfilled when certain conditions are met. Anyone with a network connection can make or conclude a financial transaction with another user through a smart contract.
This removes third-party and centralized controls, making financial transactions borderless and without regulatory mediation.
Multi-chain protocols are expected to dominate DeFi growth as users develop and execute smart contracts on different blockchains. dApps with cross-chain compatibility are also likely to become favored instruments for financial transactions.
DeFi is inclusive and borderless as any user can enter into an agreement and develop a smart contract through dApps. The tedious “know your customer” process, used by banks and brokers to ensure the authenticity of transactions, is completely avoided. This allows anyone to make a financial deal.
There are no mediating agents or intermediaries, which significantly reduces financial transaction costs. Transactions are also processed faster, bypassing the lengthy verification process often required by banks and brokers.
The flexibility and options available in DeFi are also advantageous, allowing users to choose between multiple dApps or develop their own, depending on the nature of the transaction and preferred features.
Loan guarantee and income generation
DeFi supports several methods of using assets as collateral for loans. Users can transact through a stablecoin like Tether, or the native token of a DeFi blockchain like Ether. Even real-world and physical assets are accessible through securitized tokens as collateral for loans.
Bad debts are a major banking risk that can take weeks to identify and mitigate. However, a DeFi network can instantly identify bad debts, thanks to the distributed digital ledger used by dApps.
DApps can also interact with each other, helping users find ways to generate income from their digital assets on a DeFi network. For example, it is possible to convert Ether into stablecoin cryptocurrency Dai and place it in a DeFi protocol. This allows the asset to earn interest.
Alternatively, users can place the stablecoin in a liquidity pool, earning transaction fees.
Since fiat processes do not exist in DeFi, financial tools that were not available without a bank account are now at your fingertips. This is another way DeFi is making finance inclusive.
Additionally, Ethereum or a similar blockchain preserves transaction history, which makes it faster and cheaper to verify the authenticity of the financial instrument.
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