What is DeFi? A Beginner’s guide to Decentralized Finance
DeFi is gaining popularity as the main use case of cryptocurrency. Hardly will you hear any discussion on cryptocurrency or read an article on cryptocurrency without mentioning of DeFi. But, what is it? Is it risky? Will it change the future of finance as we know it? Read along, in this article, we will break it down in simple language.
Before we define DeFi, let us first look at bitcoin and our financial system.
A cryptocurrency is a decentralized form of money that is, it is not controlled by any central bank or government. Bitcoin is the most popular cryptocurrency. This form of money can be transferred from anyone across the world, without the need of a financial institution such as a bank
However, transferring money is just one of the many components of a financial system. Other services, built around money that creates a financial system include stock markets saving plans, and loans.
Our current financial system and its entire services are all centralized. For example, Banks, insurance companies, stock markets, and other financial institutions have someone in charge – whether a government, a company, or a person that offers and controls these services.
This centralized financial system, however, has its risks. Imagine if there is a mess at the level of the central authority, the problem will quickly spread to the rest of the system. Some of the risks associated with a centralized financial system (CeFi) are fraud, mismanagement, and corruption. But what if we could have a fully decentralized financial system in the same way we have decentralized money (Bitcoin)? That is what DeFi is all about.
What is DeFi?
DeFi is a decentralized financial system. It describes financial services that have no centralized authority such as a bank, a company, or a government. DeFi uses cryptocurrencies, which can be programmed for automated activities. Therefore, financial organizations that are not controlled by anyone can be built. Such organizations include exchanges, lending services, and insurance companies.
Components of DeFi
DeFi has three major components:
Infrastructure, stable money, and financial services.
The first requirement for creating a decentralized financial system is an infrastructure for programming and running a decentralized financial service. Ethereum provides a ‘Do-It-Yourself’ platform where anyone can write a decentralized program (decentralized apps or Daaps). Uses can write automated code (smart contracts) to provide decentralized management for any financial service they would like to create. The developer of the system determines the rules but once the rules are deployed to the Ethereum network, they have no control over them, the rules become immutable. Through Daaps, it is possible to build decentralized financial systems.
The second component is stable coins, which are cryptocurrencies pegged on the value of the real-world assets, usually a major currency such as the US dollar. Stablecoins act as money in this system.
The third component of DeFi services. One of the DeFi use cases is Decentralized Exchange (DEX). DEX allows uses to buy, sell, and trade cryptocurrencies, think of the stock exchange market for the fiat currencies. Other services include decentralized insurances.
Advantages and Risks
Major advantages include transparency, free for all services, interoperability, and flexible user experience.
The most significant risk is that DeFi is in its early stages, which means things may go wrong. Additionally, smart contracts have had issues where the program developers fail to define the rules properly. Consequently, smart hackers found clever ways to exploit the existing loopholes to steal money.
DeFi revolution is still at its early adoption stage. However, it is clear that it brings a revolution to the financial industry. If it manages to cross the schisms, then we will have a whole new financial system with transparency at its core. This system will also create financial inclusion and help a large portion of the population currently suffering from financial discrimination, financial literacy, and high fees.