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You’ve probably heard the term DeFi many times, but you barely understand what it’s all about. Then, you should read this to the end.
DeFi is one of many use cases in the blockchain ecosystem. It is short for Decentralized Finance. For a better understanding, consider a traditional financial institution and the services it provides.
Financial institutions such as banks and brokerage firms help facilitate payment for goods and services, exchange of funds between parties, loan servicing, and investment servicing.
These companies act as third parties or central agencies for customers. They take custody of funds, charge high transaction fees, and are stiff with regulations.
For example, getting a loan from a bank can be a headache because the borrower needs to prove good credit and has to repay at very high interest
DeFi aims to change that narrative by making financial services accessible to everyone, regardless of your demographics, background, or credit history. It provides financial services like traditional financial institutions, but eliminates centralization
What is Decentralized Finance?
DeFi allows everyone to enjoy financial services without using or trusting third parties such as banks or SEC.
More specifically, it is a peer-to-peer, decentralized, permissionless financial system that supports trustless activities related to traditional banking, money, debt, credit, capital markets, stores of value, investing, and more.
How does DeFi work?
DeFi operates through decentralized financial applications built on programmable blockchain ecosystems such as Ethereum and Binance Smart Chain.
All decentralized applications are powered by smart contracts. A smart contract is a set of codes/programs stored on the blockchain that will run automatically once certain conditions are met.
To understand better, consider what a contract is. A contract is a legally binding agreement between two or more parties.
For a contract to be successful, each party must play a specific role. Likewise, once certain activities are completed, smart contracts execute actions for participants on the blockchain without any intermediaries or third parties.
Key features of DeFi
For a better understanding, let's examine the different decentralized finance functions
This is perhaps the crux of cryptocurrencies and blockchain. Decentralized financial services rely on smart code rather than people or third parties.
These codes are open to anyone and cannot be manipulated or changed by malicious individuals unless a consensus or unified agreement is reached through voting through the decentralized community.
DeFi is all-inclusive. That is, anyone can enjoy financial services through dApps and even build their own decentralized app on the blockchain. All it requires is an internet-enabled device and good tech knowledge.
The ability for users to have full control over their funds is one of the most promising and innovative features of decentralized finance.
With a web3 wallet like Metamask, users can enjoy privacy and greater control over their funds, eliminating the risk of centralized institutions going out of business.
DeFi technology and blockchain systems are immutable and cannot be tampered with. Thanks to cryptography, no one can change or reverse the codes stored on the blockchain.
DeFi has thrived on its ability to allow interaction between different networks and functions. Many new dApps are now cross-chain, a phenomenon that can simplify the transfer of different assets and tokens and unify data and assets in the crypto ecosystem.
Benefits of DeFi over TradFi
Decentralized finance brings many advantages to users. The following are highlights of the advantages of decentralized finance over traditional finance:
DeFi is open to everyone. In contrast, you must apply and be verified to operate in the traditional financial system.
Users have custody of their funds. On the other hand, third parties such as banks are involved in all transactions on TradFi.
Decentralized finance transactions are fast and can be approved in just a few minutes. Trades in traditional finance can take weeks and can sometimes be reversed.
Users and smart contracts control funds in decentralized finance. Instead, financial institutions and partners control the funds in traditional finance.
The decentralized finance market is open 24/7/365 and cannot be closed. Traditional finance markets are open during business hours and can be permanently closed.
Anyone can verify the financial activities of the open-source protocol on the blockchain. Conversely, traditional finance is not transparent because you can't ask the bank for anything other than financial statements.
Smart contract audits help protect investors from exploitation. On the other hand, traditional finance is regulated by central banks and other institutions.
Different DeFi use cases
You can enjoy various services provided by traditional financial institutions through decentralized finance. However, the models are different.
DeFi use cases or services include:
Peer-to-peer (p2p) exchange
Self-hosted wallets to hold your funds (digital assets)
Digital asset trading (just like forex trading)
Lending and borrowing
Yield farming (like stocks)
Stable coins and stable coin swaps (stable coins are cryptocurrencies pegged to fiat currencies or commodity assets like gold)
Prediction market and more
How to Make Money from DeFi
There are many ways to earn passive income from decentralized finance. Some of these include:
Lending and borrowing of cryptocurrencies on dApps like Aave and Compound
Investing in IDOs. Initial DEX Offerings (IDOs) are a crowdfunding technique used by project developers to raise funds and provide liquidity for the growth and development of their projects.
IDO investors make money when tokens launch on DEX and appreciate in value. The good news is that investors have unlimited access to their funds.
Staking crypto assets for APY (Annual Yield) in decentralized applications
There is also yield farming, which involves depositing funds into liquidity pools for ROI
DeFi is the future of finance. Through blockchain technology, individuals can conduct financial transactions without the need for a third party.
For example, cryptocurrency holders can transfer their assets with minimal fees through peer-to-peer (p2p) models offered by decentralized exchanges.
Additionally, individuals can borrow digital assets without reviewing creditworthiness, and investors can trade or invest in their assets and earn money.
Will Decentralized finance replace traditional finance? Well, that is up for debate. But the fact remains that decentralized finance makes capital allocation, financial transaction execution time, participation, transparency, and financial security more efficient.
I'm Oluwaseun Senbadejo, a Blockchain Content Marketer, Community Manager & Growth Strategist For DeFi & Web3 Startups
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.