Understanding Decentralized Finance (DeFi)
How can finance without central authority work?
Decentralized Finance aka DeFi (pronounced like “defy” & formerly known as Open Finance) has to do with the financial or banking aspect of cryptocurrency, web3, or the blockchain. It involves finance without a central authority/control.
But like how?
By providing a space for a more open & free market where anyone with internet can access financial services similar to what banks have to offer. Services like currency exchange, loans, payments, lending, etc. except that this time you’d be operating or transacting on a more global level without needing to go into a bank, stay in a queue or fill any forms.
“The goal of DeFi is to challenge the use of centralized financial institutions and third parties that are involved in all financial transactions.” — Investopedia
And that’s where the differences between DeFi & traditional banking (aka CeFi for Centralized finance) lie.
In CeFi, money is handled/controlled by the bank. They can decide to approve or disapprove transactions, decide on whether or not you’re deserving of a loan, they act as a middleman between you & your money.
While in DeFi, everything happens & is recorded on the blockchain. The middleman is replaced by something called a smart contract & transactions like lending are made possible via peer-to-peer (p2p).
Protocols that make DeFi work
Peer-to-peer
Think of peer-to-peer transactions this way; you just finished a class test & your teacher asks everyone to exchange test notes so you can grade one another. You do the marking, while the teacher is there to verify that everyone is grading correctly.
P2P in DeFi means that transactions happen between the users themselves. No middleman (or “teacher”) is involved. You can take a loan as long as the person on the other end is willing to agree to give it to you. The bank has no business coming in between.
The role of the class teacher/middleman here is replaced by what’s called a smart contract.
Smart contract
A smart contract is like a form that represents the set rules for DeFi service to take place.
It exists to verify, enforce transactions & make sure that the conditions by both parties are met. It’s on the blockchain for everyone to see (minus your identity of course) & make sure that nothing suspicious is going on.
For example, say you want to purchase a digital product from someone in Russia (actually, with DeFi, you don’t know the other person’s location but they might as well be in Russia ‘cos “Defi = global business”).
The smart contract in this case would be programmed to release payment to the seller in Russia only when you’ve confirmed that the product you got is intact.
Decentralized exchange (DEX)
A DEX is the playground, the environment where these DeFi activities happen. It’s a “decentralized” platform that facilitates the trading of crypto, & other crypto-related stuff directly between users (asin p2p) while employing the use of smart contracts to execute orders.
Examples of such playgrounds are; Uniswap, SushiSwap, PancakeSwap, etc. (funny names :))
Decentralized apps (DApps)
This can also be described as a playground but it takes the shape of an app, either on a mobile phone or a computer.
The “DApp” runs on a decentralized network, typically a blockchain, rather than on a traditional centralized server.
Medium would be decentralized if it operated on a blockchain, but it doesn’t, so it can’t be considered a DApp.
An example of a Medium-esque platform that operates on a blockchain is IQwiki or Mirror. Those are DApps & they can be either informative like IQwiki is or game/entertainment-focused, like Decentraland.
Why not DeFi?
Having touched on some of the Whys & benefits of finance on the blockchain, let’s see some of the Why Nots:
- Complexity: there’s no denying the confusion & complexity of this whole money & blockchain thing. And it’s a valid challenge because even though DeFi allows anyone with internet to access banking services, there needs to be a concrete understanding of how it works in order to venture into it & not everyone is able to grasp that.
- Volatility: cryptocurrency fluctuates. It could be up this minute & down the next. It’s unlike regular money whose value is only affected by inflation. Therefore, trading on DeFi might not always have you smiling at the bank.
- Security: it can be hacked or breached. But then, so can any financial institution no matter how tight the security. DeFi or CeFi.
Wrapping up
DeFi is still relatively new in the space & it’s constantly evolving. Some people have already started utilizing it to its full potential, some have lost money, some have gained plenty, some are still skeptical and some are still watching the space closely.
Only time will tell how useful or vice versa it can turn out to be.
