Decentralized Finance (DeFi) is one of the most popular newly emerging financial technologies which use distributed ledgers just like cryptocurrencies.
Decentralized Finance is challenging the traditional centralized financial system by providing consumers with P2P (peer-to-peer) digital financial and capital services through exchanges. DeFi is also known for not charging any transaction fees like banks.
Through this technology, people can easily deposit and secure their funds within minutes. All you need to access DeFi platforms is an internet connection and a device that can access these platforms.
Centralized Vs Decentralized Finance
We can’t fully understand the concept of decentralized finance unless we go through an example of centralized finance. So, let’s discuss both of these types briefly.
Centralized finance is controlled by third parties like banks which act as facilitators of money movement between different parties. Centralized financial institutions charge fees for their services.
Credit card payments are initiated by a merchant and make their way to the destination bank. Details of the transfer are then transferred to the relevant network. The network is responsible for requesting the concerned bank to clear the payment.
Since merchants have to pay for using credit card services, every party involved in the transaction receives its payment.
In centralized finance, every transaction is overseen by centralized institutions.
Decentralized finance uses digital technology to allow seamless transactions between different parties, and thus eliminates intermediaries. DeFi platforms use advanced software, hardware, me secure P2P networks to ensure secure transactions.
Any user with a stable internet connection can lend and borrow money by using automated software which can analyze and verify financial actions in a secure distributed database.
These databases collect data through various means and use a unique consensus mechanism to verify the collected data.
The key advantage of decentralized finance is that it eliminates the need for a centralized finance model, and allows everyone to easily access financial services no matter where they live. Personal wallets allow safe deposit and use of money without the need to pay high fees.
How Does Decentralized Finance (DeFi) Work?
DeFi uses the same blockchain technology as cryptocurrencies. Blockchain is made a ledger or database. DeFi platforms use dApps (decentralized applications) to give users secure access to their ecosystem.
Every transaction is added to the blockchain in the form of a block. Blocks are verified by other users who are randomly selected by the algorithm. After successful verification, blocks are encrypted and closed before being added to the blockchain.
Every closed block contains some information about the last block on the blockchain, and the cycle continues.
Since all the blocks form a chain with the help of shared information, this is why the whole system is termed a blockchain. If someone tries to alter the information in one block, they’ll automatically affect the surrounding blocks.
This is why the blockchain technology is unalterable. This nature of a blockchain is combined with several other security features to make the decentralized technology much safer and cost-effective as compared to its centralized alternative.
Advantages of DeFi
The key usage of DeFi lies in P2P financial transactions it offers. P2P, or peer-to-peer transactions are so because two parties agree to exchange cryptocurrency or tokens (NFTs) as a transfer of value for goods or services without the presence or involvement of a third party.
DeFi can utilize its automated P2P infrastructure to match a lender’s loan requirements with a compatible borrower, and easily issue the loan. dApps are used to handle payments from DeFi platforms. The same is the case with blockchain technology as well.
Some benefits of using DeFi include:
- A person with a smartphone and internet connection can use DeFi platforms.
- Interest rates for loans can be easily discussed between the concerned parties without the need for a third party.
- The blockchain technology behind DeFi is transparent, and transaction records can be accessed by everyone.