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Defi, pronounced as Dee-Fye, is the short form for Decentralised Finance. This is a broad term that refers to financial services and products that are available to anyone with an internet connection. You can earn interest, borrow money, lend money, buy insurance, trade derivatives, and trade assets with Defi. The only difference between Defi and financial institutions is that there is no centralized authority, no paperwork, and no third party.
Before receiving or sending money using the traditional financial systems, you needed intermediaries, commonly called "middlemen." These middlemen are the commercial banks, the stock exchanges, and payment gateways.
These intermediaries needed to certify that your transaction was valid before any money could flow to you or from you. In Defi, these intermediates are replaced by codes and software. Instead of transacting directly with a bank to make a payment, people can transact directly with each other using blockchain-based smart contracts. These smart contracts verify the transactions and make sure that they are valid.
History of the Financial Sector
In the 1920s, the use of accounting machines and punch cards was one of the first attempts to transform the financial sector. This was followed by mainframe computers in the 1950s. After the 1950s, the use of automated teller machines (ATMs) and credit cards came in the 1970s. Another element in the 1970s that was a massive improvement was the stock market. Manual order entries were replaced by machines.
In the 1990s, due to the rise of the Internet, the computerization of finance began. Bank accounts, wire transfers, and stock trading came along. Institutions like PayPal, Robinhood, TransferWise, and Stripe took a tech-first approach to finance like other tech companies like Facebook, Amazon, and the rest. This was a completely different approach from the financial sector that we know. Despite all these gradual improvements, the industry is far from perfect.
The Loopholes of the Financial Sector
Settlements of bonds, stocks, and other financial securities take a lot of time to process and require a lot of capital. Key financial decisions are made behind closed doors. Massive financial scandals and public-funds embezzlement continue to be commonplace. Because international banking and remittance services are so expensive, developing countries have unequal access to financial services.
There is a high barrier of entry for new players in the fintech space without access to large amounts of capital. These factors, and more, plague the financial industry. This is where Defi comes into play. It uses cryptography, decentralization, and blockchain to build a more efficient system. The system is efficient in the sense that financial transactions are done almost instantaneously despite the players' being in different geographical locations.
Why Defi?
Defi enables a frictionless international money transfer with minimal human intervention. Anyone with an internet connection can use the system. There is no need for bank verification, proof of citizenship, income statements, or anything else. Because the Defi protocol is not governed by a central authority, it is resistant to censorship.
In contrast to the financial system, the Defi system is open because anyone can build on existing Defi applications (also known as dapps). New applications can take advantage of the existing protocol to create solutions that benefit the entire ecosystem. Accounting records, trading volume, outstanding loans, and total debt are all visible on the blockchain, which makes it extremely transparent. This was what gave rise to Bitcoin and Ethereum, the most popular cryptocurrencies.
Benefits of Defi
Every financial system revolves around international payments, lending, borrowing, trading, and derivatives. Greater security, lower costs, and the ability to earn a higher income through crypto holdings are all advantages of Defi.
All of Defi's major advantages are based on decentralized apps. According to Oleksandr Lutskevych, CEO and founder of CEX.IO, decentralized applications, or dApps, allow people to transfer capital anywhere in the world, enabling peer-to-peer borrowing and lending, crypto exchange services, NFTs, crypto wallets, and storage solutions.
Exchanges, games, finance, gambling, development, storage, high-risk, wallet, governance, property, identity, media, social, security, energy, insurance, and health are among the 17 categories of dApps. Augur, a prediction market platform, and Crypto Kittie, an Ethereum-based game, are two examples.
Other examples are: Blockstack-a platform for developing decentralized applications; Freelance-a platform on smart contracts; Steem-a blogging and social media platform; and Uniswap-a decentralized cryptocurrency exchange. While Bitcoin is the more popular cryptocurrency, Ethereum is much more adaptable to a wider range of uses, which means Ethereum-based software is used in a large number of dapps and protocols.
The applications of decentralized apps include:
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Financial transactions. Anything from payments, to trading securities and insurance, to lending and borrowing, can happen using Defi.
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Decentralised Exchanges, or DEXs. The most popular exchanges used by crypto investors are Coinbase and Gemini. DEXs facilitate peer-to-peer financial transactions and let users retain control over their money.
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Crypto Wallets. Defi is developing digital wallets that can work independently of cryptocurrency exchanges and give investors access to everything from cryptocurrency to blockchain-based games.
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Stable coins. Stable coins, unlike cryptocurrencies, attempt to stabilize their values by tying them to non-cryptocurrencies, such as the US dollar. Some are USDT.
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Non-fungible tokens (NFTs). NFTs create digital assets out of assets that can't be traded. Slam dunk videos or the first tweet on Twitter are two examples.
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Flash loans. These are cryptocurrency loans that allow you to borrow and repay money all at once. Borrowers can profit from an Ethereum blockchain-based contract that borrows funds, executes a transaction, and immediately repays the loan. If the transaction fails, the funds are automatically returned to the lender. If you make a profit, you can keep it after deducting any interest or fees. Consider flash loans to be a type of decentralized arbitrage.
Defi protocols currently have a total locked value of nearly $43 billion. Defi adoption is fueled by blockchain's ubiquity: once a dApp is encoded on the blockchain, it becomes globally available. dApps exist outside of these rules, increasing their potential reward while also increasing their risks. While most centralized financial instruments and technologies roll out slowly over time, they are governed by the rules and regulations of regional economies.
Benefits and Drawbacks
Although Defi is an amazing innovation in the financial sector, there are still a lot of downsides to this technology. Examples are fluctuating transaction rates on the Ethereum blockchain. This means that active trading can get expensive over time. This is the issue of high gas fees on Ethereum.
One main issue of Defi is the presence of high volatility. Also, you have to maintain your records for tax purposes and regulations can vary from region to region. The truth is up to us to continue educating people about the potential of Defi. But we also need to keep working hard to build the tools that will allow people to see it for themselves.
Author Bio
Emmanuel Nwaka is a Tech writer covering the latest trends in the blockchain industry. My goal is to make blockchain easy for anyone to understand. I write about the ways blockchain technology can revolutionize businesses and improve operations for enterprises. For more info, connect via linktr.ee/emmanuelnwaka
Disclaimer
The views and opinions expressed in this article are solely those of the authors and do not reflect the views of Bitcoin Insider. Every investment and trading move involves risk - this is especially true for cryptocurrencies given their volatility. We strongly advise our readers to conduct their own research when making a decision.