What is DeFi, How does it work, and the Future
Defi stands for decentralized finance. It is an emerging financial technology based on secure distributed ledgers similar to those used by cryptocurrencies. However, unlike banks, there are no other parties involved. Hence it is called decentralized.
To understand decentralized finance more, we have to understand centralized finance first.
In Centralized Finance, the banks, corporations, etc., hold your money more like a custodial authority. Their objective is to make more money using your money.
Let’s say you are purchasing a mobile phone using your card details; the credit card details are sent to the merchant’s bank for verification. Then the banks send the exact information to the credit card network for clearance. The credit card network then checks your balance, eligibility, etc., and processes the request. The credit card network also clears the charges for all the other services involved in the transaction, fees, etc. Once everything is confirmed, the network sends a confirmation to your bank regarding the successful transaction. All the entities involved in the process receive their fair share of money for their service during the entire process. And lastly, you pay the bill to keep using your credit card. This was a simple example. Apply the same process for loan applications as well. Sometimes, it becomes very hectic with all these middlemen involved.
Now, this is where Decentralized finance comes into the picture.
What is Decentralized Finance?
Decentralized finance eliminates all these intermediaries by allowing people, merchants, and businesses to conduct financial transactions through emerging technologies (for example, Blockchain!).
This is done through peer-to-peer networks that use security protocols, advanced hardware, and software to achieve this.
Decentralized finance uses advanced technology to eliminate centralized finance models by enabling people to use financial services anywhere and everywhere regardless of who they are and who they represent without getting any private information about that person.
Anyone can lend, trade, and borrow using software that records and verifies financial actions in distributed financial databases over the internet. And the distributed database is accessible across various locations and verified by a trusted consensus mechanism.
How DeFi work?
Decentralized finance uses Blockchain technology to run transactions on applications called DApps or Decentralized Applications and handle the transaction on one of the widely available Blockchain networks. In a blockchain, all the records are recorded in immutable blocks and verified by a peer-to-peer network of users called miners.
When the transaction is complete, the block is closed and encrypted, and a new block is created with the information of the previous block on it. Hence, the technology is called Blockchain.
Information in the previous block can not be changed, making the blockchain network immutable and secure from data tampering.
What currency is used in DeFi?
Unlike traditional centralized finances, DeFi does not use Fiat as the currency for financial transactions over the DeFi protocols. Instead, they use cryptocurrencies, decentralized entities that live on some blockchain network. When writing this, there are more than 4000 different cryptocurrencies available in the market, and new ones are added to the list every day.
The technology is new, but it develops daily, making it more scalable and future-proof. Mainly, the concept revolves around a stable coin, a cryptocurrency backed by an entity or pegged to fiat currency like the dollar.
The future of DeFi is hard to predict because all these protocols and blockchains are still in the development phase. For example, Bitcoin and Ethereum both have their own issues. Bitcoin has high transaction time, and Ethereum has scaling issues and high gas fees. The Ethereum developers are working day and night to find a way to fix these issues. Scams are also a significant concern when you are looking at DeFi. There is no central authority involved; there is no way to get your money back once you are scammed.
Another primary concern is the regulations. DeFi facilitates borderless transactions, which sometimes creates concerns due to national security. Some of the cryptocurrencies have a terrible reputation because of their scams, terrorist financing, etc.
Other concerns are system stability, energy requirements, carbon footprint, system upgrades, system maintenance, and hardware failures. All these issues need to be addressed before the DeFi becomes mainstream.
Thank you for reading this! All this information is from my own research, the internet, different articles, videos, and books. Don’t take it as financial advice, and I am not a financial advisor. If you want to add something or find anything wrong with the article, please connect with me on Twitter at @AskSnehasish.
Originally published at https://snehasish.dev on January 29, 2022.