Understanding Decentralized Finance (DeFi)
DeFi or Decentralised Finance is the movement to replace traditional, currently centralised finance institutions with peer-to-peer finance enabled by decentralised technologies atop the Ethereum blockchain. It’s often defined by what it does, the liberation of individuals who no longer need to rely on banks, insurance funds and clearing houses to govern their finances.
How Does DeFi Work?
But, in its essence, DeFi involves using decentralised applications, or dApps, to control movement of money. These dApps are built on a blockchain (primarily, Ethereum), and use smart contracts. Smart contracts are self-executing agreements between two parties whereby the conditions of the agreement are encoded and then run directly on the blockchain.
DeFi is a beautiful thing because you, the merchants and businesses can all conduct these financial transactions without the need for a third party in the middle. Let’s say you want a loan. Well, through DeFi, you can find other parties who may be willing to offer a loan with terms set through a smart contract. Once parties agree on terms, then the smart contract automatically executes and works in the background. There is no need for intervention from any third party.
Key Components of DeFi
- Stablecoins: Most DeFi applications require a crypto-currency whose value is relatively constant. To limit the wild swings endemic to regular cryptocurrencies, stablecoins are pegged to less volatile assets such as the US dollar.
- Exchanges: a decentralised exchange (DEX) allows the swapping of cryptocurrencies without involving a mediator. Instead of relying on an order book, trades are made either from shared assets (liquidity pools) or peer-to-peer.
Lending decdma: Lending platforms let users put their cryptocurrencies to work by lending them out to earn interest payments; they can also borrow cryptocurrencies by putting up some as collateral.
- Wrapped Bitcoins (WBTC): This allows Bitcoin holders to interact with the Ethereum-based DeFi system. This token represents Bitcoin on the Ethereum blockchain as an ERC-20 token tailor-made for the Ethereum network. It is designed to increase liquidity on the Ethereum blockchain in decentralised exchanges (DEXs) and DeFi applications.
Benefits of DeFi
There are many benefits to DeFi: eliminating intermediaries saves money for everyone; open access to financial services benefits those who are unbanked or underbanked; transaction histories are unchangeable and publicly viewable through blockchain technology.
Risks and Challenges
With all this enthusiasm, one might think that DeFi is the real deal, but it is not without its problems. First of all, contracts themselves carry some risk (hence ‘smart’ contracts). Since they are self-executing and irreversible, errors in the code can lead to funds being lost. Furthermore, the inherent volatility of crypto assets as collateral is a major risk in and of itself, as the size of the collateral can cause a downward movement towards the liquidation price.
Future of DeFi
The DeFi economy is a work in progress, and it’s still not clear what its full impact will be. As cryptographic technology matures and better, safer and faster platforms come along, adoption of DeFi could grow, potentially opening up a more inclusive international financial system.
In conclusion, Decentralised Finance is a clear potential alternative to traditional finance. It has a great potential as it leverages blockchain space technology that enhances the level of security and transparency of financial records and also ensures flexibility and speediness in the process. As with every new technology, there are risks involved, but its potential benefits are huge and can potentially change the scope of finance in the future.
