Decentralized finance (DeFi) is an emerging model for organizing and enabling cryptocurrency-based transactions, exchanges and financial services.
DeFi (or “decentralized finance”) is an umbrella term for financial services on public blockchains, primarily Ethereum. With DeFi, you can do most of the things that banks support — earn interest, borrow, lend, buy insurance, trade derivatives, trade assets, and more — but it’s faster and doesn’t require paperwork or a third party.
In the DeFi approach, individual traders have control over the private cryptographic encryption keys, which enable custody of cryptocurrency assets. Financial transactions within the DeFi model are enabled with smart contracts that are often supported on Ethereum-based blockchains. The DeFi model also includes the notion of decentralized exchanges (DEXs) that operate with the purpose of helping to connect and enable individuals looking to execute cryptocurrency transactions.
How does DeFi work?
Users typically engage with DeFi via software called dapps (“decentralized apps”), most of which currently run on the Ethereum blockchain. Unlike a conventional bank, there is no application to fill out or account to open.
DeFi blockchain makes sure that the process is secured by using “keys.” In this technology, when you will use a set of encrypted keys, you will get a unique identification that no one can get access to. Usually, this key pair includes a public and private key.
In reality, this process of using key pairs to encrypt information is called “asymmetric cryptography,” and it’s widely popular in the blockchain space.
Basically, here, other peers can see or use your public key to find you on the system. On the other hand, using your private key, you can authorize your transactions or any type of action. So, you will need a private key to perform certain actions on the DeFi blockchain network.
Although, some decentralized finance applications work differently where you may perform actions with KYC protocols.
As there are cryptocurrencies involved, so your public key will more likely work as your digital wallet. So, using your private key, you can buy, sell, or even send cryptocurrencies. This is why you really need to keep it safe.
So, for sending a transaction, you’ll have to authorize it with your private key. Once you do it, the system will create a block representing the transaction and notify the system for others to verify. After that, when others verify that it’s a valid request, then it will execute your transaction request and add the block to the ledger.
Furthermore, all the block gets a unique id and time frame that prevents any kind of malicious activity.
In DeFi, you will get pseudo-anonymous addresses. So, basically, no one can see your name, but they can see your address, which will contain random numbers and letters.
- Open: You don’t need to apply for anything or “open” an account. You just get access by creating a wallet.
- Pseudonymous: You don’t need to provide your name, email address, or any personal information.
- Flexible: You can move your assets anywhere at any time, without asking for permission, waiting for long transfers to finish, and paying expensive fees.
- Fast: Interest Rates and rewards often update rapidly (as quickly as every 15 seconds), and can be significantly higher than traditional Wall Street.
- Transparent: Everyone involved can see the full set of transactions.
- Fees: DeFi provides users with the promise of lower fees than transactions executed in the CeFi model.
What are the downsides?
- Fluctuating transaction rates on the Ethereum blockchain mean that active trading can get expensive.
- Depending on which dapps you use and how you use them, your investment could experience high volatility – this is, after all, new tech.
- You have to maintain your own records for tax purposes. Regulations can vary from region to region.
Uses of DeFi
There are a broad range of use cases where DeFi is being implemented today, including the following:
- Payments. DeFi can enable P2P payments without the need for a central authority.
- Lending. The ability to lend and borrow cryptocurrency assets is a common use case for DeFi.
- NFTs. Non-fungible tokens enable users to own tokens that can be traded.
- Stablecoins. An increasingly common use of DeFi is stablecoins. The purpose of a stablecoin is to help limit the volatility of cryptocurrency by pegging the value of a coin to another asset, commodity or currency.
- Yield farming. For those using DeFi as an investment vehicle, yield farming enables individuals to gain interest income on cryptocurrency assets.
- DApps. DApps run on DeFi and enable multiple types of use cases, including financial services and gaming.
There are multiple DeFi services and platforms available today, including the following:
- Avalanche: Avalanche is a proof of stake blockchain for supporting DeFi smart contracts. It also has its own token with the AVAX cryptocurrency.
- DYdX: DYdX is a DEX that enables cryptocurrency trading.
- Index Cooperative: Index provides several capabilities, including the DeFi Pulse Index, which tracks the performance of DeFi assets and cryptocurrencies.
- MakerDAO: MakerDAO is a decentralized autonomous organization for governing cryptocurrency operations and created the Dai stablecoin, which is linked to the U.S. dollar.
- TrueFi: TrueFi provides a lending credit protocol, as well as the TRU token.
While DeFi has gained significant traction and popularity, it's important to note that it still poses risks. Smart contract vulnerabilities, security breaches, regulatory challenges, and market volatility are some of the risks associated with participating in the DeFi ecosystem. Users must exercise caution, perform due diligence, and understand the risks before engaging in any DeFi activities.