Imagine having a system that does not require any permission from the authorities to perform a certain function. A century ago, such a system would only exist in our dreams, yet it has become a reality. Before our financial systems were revolutionized, we were simply relying on traditional finance to help us get our job done. This would mainly include government intervention, which was one of the reasons why the subprime mortgage crisis took place. It was only a decade ago when a new system was created that would forever revolutionize the way we have been doing business or handling our finances. Today, this system is known as Decentralized Finance (DeFi), and to help you understand this a bit better, here, we will discuss the term Decentralized Finance, how it works, and various characteristics of DeFi.
What Is Decentralized Finance (DeFi)?
Decentralized Finance, also known as DeFi, is an ecosystem of financial applications that is being built using blockchain technology. Under the DeFi application, the financial services offered are decentralized, which means that they are not under the control of a single entity. Take this as an example, if you want to take a loan for some purpose, you have to approach the bank first. The bank will then review your application and decide whether you qualify for the loan. If you qualify, then they set an interest rate and grant you the loan against a collateral. In any case, if you fail to make a payment, the bank will seize the asset that was held as a collateral. Banks will always remain as an intermediary when it comes to financial services. What DeFi does is it breaks down the entire centralized process of the financial system and establishes a peer-to-peer network between two parties without any intermediary.
Currently, DeFi is built on Ethereum, which is an open-source blockchain network that functions using smart contracts. A smart contract is a code running on the Ethereum platform that is responsible for executing the code when the transactions are sent or received and also for holding all the tokens in the public ledger established on the network. Since all the functions are fully automated and the transactions are recorded, there is no need for a “middle man.” This enables you to control your own financial transactions, savings, and even investments that ensures that everything is truly self-owned. With the help of DeFi, each of us has the potential to become our own bank. It’s a new yet blossoming space that is going to revolutionize the way the world works. However, you must be wondering about how DeFi works in the real world. The next section will highlight the entire process of DeFi to help you understand how it actually works in reality.
How Does Decentralized Finance Work?
Rather than the traditional financial services that use people within the banking facility, DeFi leverages the use of technology. As I have already stated in the previous section, everything is fully automated in Decentralized Finance through the smart contract code. Before jumping onto the DeFi process, it is important to understand the two important factors that must be considered for DeFi to function smoothly:
Decentralized Infrastructure
DeFi will not work without a decentralized infrastructure, which acts as a fundamental base for the entire process. It was mentioned earlier that DeFi can be built on the Ethereum platform, which is well-known for writing such programs. The reason why you need the Ethereum platform is because it has the smart contract code that will enable you to control the financial services.
For example, you can use the smart contract feature to set up some rules that highlight how the financial services will be provided. Once you have created the rules, you can deploy them on the Ethereum platform. A word of caution; the smart contract that has been deployed on the Ethereum network cannot be changed since the rules have already been established on the network.
Users usually use Ethereum to develop decentralized apps or DApps for their own financial services. Using the smart contract feature, the users can autonomously establish their own rules to manage their financial services. Through this decentralized infrastructure that is available on the Ethereum platform, more now than ever it has become easier to use Decentralized Finance.
DeFi Currency
A financial system without a currency system is another hollow bone. No one in this world can do any business without any currency that has some monetary value attached to it. For DeFi to come to life, you will also need a currency that will power up the financial services. In the case of DeFi, there is a need for stable currency, one whose value will not fluctuate much.
Cryptocurrencies are decentralized but highly volatile in nature. For example, the Ethereum platform has its very own token that goes by the name Ethereum or ETH token. The only issue with the ETH token is that it is volatile in nature as the prices witness major swings. On the other hand, Bitcoin may be the best option, yet the crypto token cannot be easily deployed on the Ethereum platform.
Considering that two of our best possibilities have already been ruled out, there is only one option left, and that is stable coins. The reason why many people have been recommending stablecoins is because its value is pegged against the US Dollar, which means there is a minimum space for the price to undergo any wild fluctuations.
For illustration, we can consider DAI, the world’s very first decentralized stablecoin whose value is pegged against the US Dollar. In simple terms, 1 DAI is equivalent to $1. The other reason why DAI is a stable currency is because the monetary value of DAI is backed by a collateral of cryptocurrency rather than a direct pegging with the US Dollar. In other words, DAI would be the perfect option that can be used as DeFi currency on decentralized infrastructure.
Once the two important factors that affect the DeFi protocol have been developed and fulfilled, we can head onto the next step that is understanding the process or how the DeFi actually works.
DeFi Process: How Does It Work?
From the way the term DeFi was defined in the very first section, you have a short idea about what it means, i.e. peer-to-peer network without any hindrance of the authorities. But how does DeFi work in our world? It has happened many times; a concept sounds successful and worthy in the textbook but in reality, it is dull and does not make any sense. However, DeFi has been in use for quite some time on the Ethereum platform and it has been popular among the users. Here are some of the key points that will help you understand the process of decentralized finance:
- Eliminates intermediaries-The process of DeFi completely knocks out the intermediaries from the financial system. Many people view intermediaries (usually regulatory authorities that watch your every move) as a form of security. In the case of a centralized financial system, banks or financial institutions that have been powered by the authority of the Central Bank act as intermediaries. The financial institution ensures that all your transactions are safe and secure, as a result, your money flows through them before it reaches the second party. The result is that at the end of the day, these intermediaries have more power over you because they hold your money, and without them, the financial system will cripple. Decentralized Finance completely eliminates these intermediaries or third parties from the financial system.
- Uses Smart Contract feature-After eliminating the intermediaries in the system, you will need someone who will record your transaction and keep an account of your funds. The DeFi system uses the smart contract feature on the Ethereum platform that acts as an account. This account will then hold all your funds and use them for transaction as per the given set of instructions that you have enclosed in the smart contract. By leveraging the smart contract and the cryptocurrencies, DeFi makes every transaction smooth and possible without any involvement of a third party or a middle man.
- Gives back control-The problem with the centralized system is that the control lies in only one hand and that is the regulator. This enables them to exploit their authority and sometimes overlook the flaws in the system. DeFi has decentralized this control by establishing a peer-to-peer network that involves transactions between two parties. It means that you are in control of your funds and transactions without any authoritative hassle. DeFi has made decentralized financial systems a reality, which would have only been a dream a few decades ago.
- Accessible to everyone-There are people around the globe, situated in certain geographies, who cannot avail any banking services, which serves as a limitation for them to open a bank account. In a traditional financial world, anyone without a bank account is restricted from doing any transaction as a bank account verifies your identity and serves as a proof for all the transactions. In the world of DeFi, however, one does not necessarily face the same level of restrictions. Currently, even those people who do not have any access to banking or financial institutions will be able to enter into the new financial system through the decentralized finance system. Finally, they will be allowed to gain access to global methods of value exchange.
After going through these points, it will be easy for you to understand how the DeFi system works on a basic level.
Characteristics of Decentralized Finance System
Since we have already discussed the meaning and the process of DeFi, you have a brief idea about the decentralized financial system. But as a beginner, you are still unaware about many things related to the decentralized financial system. In order to help you understand the term better, we will be listing down some of the main characteristics of DeFi to help you that will give you a quick insight before we move onto the greater details.
Non-custodial in Nature
Custody also refers to the control that you will maintain over the ownership of your assets. In traditional finance, the custodial ownership will remain with the intermediaries since they have a tight control over the financial transactions that involve your assets. The DeFi system follows a non-custodial approach whereby the owners maintain a control over the ownership of their assets without any third party involvement. For example, if you deposit your money into the bank account, your bank also possesses complete control over your funds, which they often use for lending purposes. With DeFi, you are still allowed to store your money in the form of crypto tokens in the safe wallets while maintaining control over those funds.
Open Source Technology
DeFi allows the users to build a financial system on a decentralized public network, which is powered by the blockchain technology that can be used by everyone. It is like an upgraded version of the internet whereby information can be sent to anyone around the globe in a matter of seconds. However, in the case of DeFi, you will be transferring the ownership of assets in the same way. If anything, it makes it more convenient for the users to transfer their funds through a digital network with ease compared to the traditional paperwork involving intermediaries. The best thing about open source technology is that anyone can access these platforms and reap the rewards of seamless and uncontrolled transfers of value (money).
Provides Transparency
DeFi is well-known for providing transparency to its users that is seldom neglected in a centralized system. Making the blockchain technology available to the public also ensures that all the transactions are verified by miners who solve complex mathematical codes and reap rewards in the form of crypto tokens. The transparency feature allows the users to avail information on every activity that is conducted on the blockchain network. This makes DeFi a legitimate and a transparent financial system as against the centralized network.
Composability
When you hear someone saying that the “system is composable,” it simply means that it is designed using various parts that can operate together to provide the best service to its users. In a technological sense, the parts can operate together by communicating with each other through different codes. DeFi is a composable system that is essentially like a lego, whereby different applications are constantly interacting with each other without any permission. These applications keep communicating with each other and they leverage every code and utility in the system to provide the best user interface to its audience.
Fully Decentralized Network
The operations under the DeFi system are fully automated by the blockchain technology, which means that there is no need for a third person intervention. Traditional finance not only consists of third parties (financial institutions and regulators) but can also be a hassle with tons of paperwork and restrictions. DeFi is a paperless, technological, decentralized system that gives back the power to its community rather than controlling their every action and placing restrictions on their every move.
Secured Network
Most people are highly concerned about security when it comes to digital assets. It is easy for the attackers to infiltrate the system and steal the tokens. There have been instances where many people have lost their crypto token because the attackers hijack their wallet, leaving them penniless. However, you can build a DeFi system that is immune to the online threats from cyber attacks and hackers. The smart contract mechanism ensures that the system verifies your transaction while maintaining the data integrity so that information can be smoothly passed on across the system. Transmitting the data through a secured network that is established by the blockchain technology, DeFi could establish a safe financial network that can verify all the transactions.
Looking at all the key features of DeFi it is safe to say that it could be one-of-a-kind technology that could forever revolutionize our financial system. In certain cases, DeFi has also been referred to as “open finance.”
Why Is DeFi the Future?
DeFi didn’t exactly have a very easy start. Earlier, people were still wary of an unregulated financial system that could potentially change their lives. The centralized financial system has crippled us to an extent where we might question the safety of any system that seems to challenge it. However, DeFi was slowly adopted and, more now than ever, it has been the need of the hour.
Since its launch, there have been many decentralized apps, and some of them include decentralized exchanges such as Uniswap. What makes these exchanges different from our stock exchanges is that they will not hold back the funds to restrict you from executing the trades. DeFi also makes it possible for you to take on loans without going through all of the paperwork. For example, Compound is like a P2P lending platform where you can borrow money against a collateral or even earn interest against it. DeFi has been scaling and growing continuously. According to an article written by Natalie Zhang for CNBC in September 2021, it is that DeFi assets in the crypto market have increased from $4 billion in 2018 to $93 billion as of June 2021.
Looking at all the key characteristics that I have listed in this article, it can be anyone’s guess that DeFi is much more robust and a reliable mechanism compared to the previous financial system. Imagine having complete control over your actions so that you can do what you want and change your life. DeFi is doing the same thing, except, in this case, you will have a better hold over your finances and data. Blockchain technology is supreme and most definitely the future of the financial system.
Based on what we have seen in this article, now you have a better idea on what DeFi means and the various features of the DeFi ecosystem.
