Have you heard the word “DeFi” or “decentralized finance” thrown around among friends or colleagues, but never understood what it is?
Well, here’s a breakdown for you so the next time you hear it, you’ll know exactly what to say about it.
DeFi is short for Decentralized Finance
DeFi is essentially the new and improved rival to centralized finance. It’s a modern and advanced way of looking at the way our financial institutions operate without needing the middleman. The middleman in this case would be banks, brokers and financial companies.
DeFi empowers individuals by allowing peer-to-peer digital transactions of assets.
- Decentralized finance removes centralized financial institutions and third parties when it comes to financial transactions.
- DeFi aims to reduce transaction times and make financial services more accessible to the public.
Centralized vs. Decentralized Finance
Before we dive further into DeFi, let’s first understand the differences between centralized and decentralized finance.
In centralized finance, money is held in the bank and all transactions are overseen by the bank or third parties that manage the movement of funds.
In the crypto world, CeFi is the word for centralized exchanges that help with crypto transfers. These exchanges hold your private keys for you. They also decide how much fees you need for trading and which coins they list for trading. Users must also adhere to the rules and regulations imposed by the exchange.
In CeFi, only a bank or a third party is able to provide a loan and not everyone qualifies to open a bank account. While centralized finance is highly regulated and quite trusted, it does pose some problems for the general public.
The unbanked problem
Centralized finance poses a banking problem.
It is estimated that half of the world’s population do not have access to a bank account or a savings account.
This could be because they don’t have the proper identification needed to open one or they simply do not have the minimum funds needed to keep an account open.
Either way, these people will miss out on having the opportunities a person with a bank account might have such as getting a loan, keeping money in a fixed deposit etc.
With DeFi, nobody needs a bank account. All you need is a crypto wallet.
High fees and low interest rates
In addition, banks and third parties generally charge high fees and low interest. A classic example would be a credit card. Credit card fees are really high however consumers receive next to nothing on interest in their savings account.
It’s the opposite with DeFi.
DeFi offers lower fees and higher interest rates as it enables two parties to negotiate the interest rate and lend money over the network.
Ever sent a transfer internationally? If you have, you would know it takes ages for the transfer to be deposited. Banks also don’t operate on the weekends which puts restraint on transfer times. In addition, wire transfers charge a hefty fee which is not easy on the wallet.
With DeFi, crypto runs 24/7. The market never sleeps. You’re able to make transfers internationally without hefty fees as long as you have access to DeFi network and an internet connection.
Security and transparency
While banks are highly regulated, there are cases of cyberattacks on a bank or a financial institution. While the US may be less prone to attacks like this, there are governments of third world countries that may not be able to bail out of this situation.
With DeFi, the security depends on the technology you use. The user is responsible for ensuring security. DeFi utilizes smart contracts and AMMs (Automated Market Makers). Everything is built on smart contracts that are ‘open sourced’.
Funds go into the smart contract and run autonomously which makes DeFi uncensorable, transparent and safe. The user is in charge of their own funds in their private wallet.
How Does DeFi work?
A blockchain is essentially a block that consists of a distributed database of transaction records that is linked by cryptography. It’s a public record and completely decentralized so no banks or FEDs are involved.
The blocks are “chained” together giving the name blockchain.
Applications called dApps or decentralized apps are used to run the blockchain and perform transactions.
Information in previous blocks cannot be changed without affecting the following blocks, so there is no way to alter a blockchain. This concept, along with other security protocols, provides the secure nature of a blockchain.
Why Use DeFi?
DeFi is a P2P platform where two entities can agree to transact cryptocurrencies without a middleman involved.
With DeFi, the average person is able to lend, borrow, long/short, earn interest and more according to their own terms.
Companies can send wages to remote workers regardless of geographical location through DeFi and avoid high transaction costs.
Countries that are experiencing crippling inflation are able to salvage their savings by converting it to cryptos and utilizing DeFi.
Some benefits of DeFi include:
Send money across the globe
Regardless of your location or time zones, you can access DeFi services as long as you have an internet connection.
Set your own terms
DeFi allows two parties to negotiate the interests and fees that they agree to.
Access to stable currencies
DeFi had solved the issue of volatility with cryptocurrencies within stablecoins. Stablecoins get pegged to an asset class usually like the dollar. This preserves the value of the crypto even if a market crash occurs.
Borrow without strict regulations
Borrowing money can be done in two ways using DeFi. It could be peer-to-peer or pool-based lending where the funds are borrowed from a liquidity pool. Loans are more accessible and interest rates are better.
Be a banker
You can lend your cryptos and earn interest that is significantly higher than a bank. Set your own interest rates!
How To Invest In DeFi?
There are many ways you can join in the DeFi movements. The easiest way is to buy Ether or another coin that works in the DeFi network.
Next, you could deposit cryptocurrencies into a DeFi network where you will be able to earn interest on staking or lending. The rates will differ depending on the token invested and term of investment.
Demand for deposits is usually high. Thus, for high demand tokens, you could stake the cryptos you own under a protocol called “yield farming”. This way, you are actively contributing by providing liquidity to the pool and at the same time raking up interests.
If you’re looking to decide on the future of the DeFi protocol, you may buy the governance token of the exchange such as UNI for Uniswap.
What DeFi Platforms Can I Use?
Some decentralized exchanges that you can use include :