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What Is DeFi: A Beginners Guide to Decentralized Finance

By Arthur Crowson09/30/2022

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Cryptocurrencies like bitcoin and ethereum have made it easy for anyone to control and send money to any part of the globe without a government-controlled intermediary. Financial transactions are seamless and instant, that’s the beauty of cryptocurrency.

DeFi, also known as Decentralized Finance, is a system on a blockchain network that makes it possible for buyers and sellers to transact cryptos without any financial institution acting as an intermediary. It’s a group of software programs on the blockchain that gives you the freedom to access financial products anywhere and anytime.  That is what DeFi is all about.

DeFi is a global and open financial system built for everyone. Thanks to the internet age, DeFi is becoming more accepted as a way to gain visibility over your money, control, and maintain it, provided you have a stable internet connection.

Why Was DeFi Developed?

Decentralized finance was born as a result of certain restrictions and lack of access from centralized financial infrastructure. DeFi regulation are minimal, unlike decades-old finance systems. Although financial institutions like banks make use of technology to facilitate transactions, limitations are still present. For instance, it can be complicated to make transactions faster, navigate through the financial market and compete. Above all, your money can be blocked or frozen.

This is why companies and people are embracing Decentralized Finance. With DeFi, payment delays and slow transactions are eliminated. Since you are sending digital currency instead of government-backed money, transactions costs are also minimal, and you have complete, uninterrupted access to your money. Some companies now pay their employees with digital currency, thanks to DeFi systems.

It also reduces the interdependency rate. For instance, before now, large institutions with branches around the world depended on their headquarters for everything. This model gave the branches less power so they couldn’t act on certain financial decisions within its jurisdiction. That meant less efficiency, higher costs, more delays and more burdens.

Thanks to Decentralized Finance, financial services in terms of crypto can be provided anywhere to anyone, disintegrating the centralized model. The crypto market is open 24/7 to everyone, and centralized institutions can’t deny you access.

DeFi applications are now built on blockchains to offer the public more control over financial products through wallets and crypto exchanges. As earlier explained, all you need to access these products is a stable internet connection.

Bitcoin was the first digital currency to use the DeFi application. Since it’s decentralized, you own and control the value. You can send it anywhere, provided both parties agree to the rules on the blockchain. Other cryptos like Ethereum many even more interesting DeFi applications possible such as loans thanks to the invention of smart contracts.

Decentralized Finance Components

DeFi provides services to users via crypto and smart contracts without any intermediaries. Cryptos take the form of stablecoins and exchanges. DeFi applications function through a framework, which smart contracts provide. For instance, the framework establishes precise terms for an individual to get a loan. If the borrower doesn’t meet the criteria, the loan won’t be granted to that individual.

These smart contracts substitute financial institutions, which act as guarantors in all transactions. Smart contracts hold your funds and help you send them to whomever you want to. They are programmed, so you can’t really alter them when they are life.

DeFi systems are built on layers or software stacks. Each layer performs a distinguished function in the building of the components that make up the DeFi system. Four layers make up the system – Settlement Layer, Protocol Layer, Application Layer, and Aggregation Layer.

The settlement layer is the base layer on which the DeFi transactions are built. This layer is also called Layer 0. It includes the blockchain and its native cryptocurrency. This currency may or may not be traded on public markets. For example, Ethereum is a settlement layer or the blockchain, and it has its native token, Ether.

The protocol layer consists of rules written to oversee activities happening in the DeFi system. The application layer is where consumer applications, such as crypto exchanges and lending services, reside. We use applications to access and manage these protocols.

The aggregation layer comprises aggregators that connect applications from all the layers to offer a service. They enable trading, exchange and facilitate the transfer of money. They keep track of your investments, trades, transactions, balances, etc. An example is a crypto wallet.

Comparing DeFi and Traditional Finance

DeFi has solved many problems that Traditional Finance has created. For example, people couldn’t access financial services or set up their bank account without government-issued IDs, make payments instantly, and trade in the market 24/7. In addition, transactions had a hidden charge, which went to the pocket of the financial institutions. 

With DeFi, companies don’t hold your money because you have full control over it. You can send it to whoever you want to via wallets and not trust some companies to manage the transaction. Additionally, you can transfer in minutes and trade in the open market 24/7. You aren’t limited to specific business hours or apply to use any financial service as they are common with traditional finance.

DeFi has made it easy to access stable currencies to counter the effect of the volatility of cryptocurrency. Their values remain stable over a long period, making it more convenient to save than government-backed currencies.

An individual can also borrow money from decentralized lenders, either from a pool of lenders or through peer-to-peer without much paperwork, identification, or private information, unlike traditional finance. All you need is to put up collateral that the lender will receive instantly if the loan isn’t repaid.

Conclusion: Living on the Frontier

DeFi is still in its infancy, as many countries are yet to adopt this financial model. As of March 2021, DeFi contracts were worth approximately $41 billion. It’s expected to be worth more in subsequent years. However, like most things that are software-controlled, the system is still prone to hacks. This can cause the system to crash and make investors lose their funds.

Due to its borderless and open regulations, financial crimes will also be on the rise. This will pose some problems to government financial regulations if more protocols aren’t established to curb the risk.

However, DeFi as already provided enormous benefits to the small number of people that use it.  This will continue to expand to larger and larger populations in the future.

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Arthur Crowson

Editor

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