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  • Writer's pictureMichael Paulyn

The Ultimate Guide on DeFi: An Integral Component for the Future of Web3

Updated: Feb 21, 2023

The world of finance has long been a highly conservative and change-resistant entity, but there are some signs that it might be changing. DeFi, decentralized finance, gives many financial heavy hitters a "run for their money." As more users gravitate toward this new technology, bankers worldwide scramble to prevent this change from unfolding.


This blog examines decentralized finance, compares it to the classic model of centralized finance, and discusses how DeFi is an integral component within Web3.


What is Decentralized Finance (DeFi)?

Decentralized finance, also known as DeFi for short, is a relatively new technology that's only begun to make its presence known. As a blanket term for financial services which operate from public blockchains, the most common being Ethereum, DeFi is making waves within the financial sector.

The true power of DeFi comes from its innate ability to support a vast array of financial activities. This emerging technology is capable of handling everything from:

  • the accumulation of interest on investments,

  • borrowing or lending funds,

  • purchasing insurance,

  • assisting with trade derivatives,

  • monitoring trade assets and much more.

Like cryptocurrencies, DeFi operates globally as a peer-to-peer (P2P) system. This revolutionary P2P system empowers people to conduct business independently with other people without the need to use any centralized banking system full of excessive fees and endless paperwork, thanks to a record system that uses blockchain technology and distributed ledgers.


Ultimately, the true beauty of DeFi comes from the fact that anyone with a stable internet connection can quickly transfer funds; it's just that easy.


How DeFi Works

DeFi is only possible with help from the blockchain network's distributed ledger, just like cryptocurrencies. To handle transactions and ensure the blockchain network functions correctly, decentralized applications (dApps) are necessary, free from a single point of control.

Every financial transaction is recorded on the blockchain, forming "blocks" verified by consensus. These blocks are then "chained" together using the transaction information that details the historical accounts for every exchange.


This consensus method means that most nodes (the computers within the blockchain network) must agree to validate the transaction for successful verification. The owners of these computers receive an incentive every time they verify a transaction, usually in crypto.

All information within the blockchain is permanent, meaning no one can tamper, change, or alter any transaction information. This capability gives blockchain a layer of trust and transparency, providing users with security whenever they complete a transfer.


Comparing Decentralized Finance vs. Centralized Finance

Before diving into DeFi and how it fits into the evolution of Web3, it's essential to talk about the differences between decentralized finance and the classic centralized model. Below is a brief comparison of each system and its associated characteristics.


Centralized Finance

First, it's critical to state that centralized finance operates in partnership with banks and other third-party financial institutions. These entities safeguard and work aid in transferring money between various parties; these firms charge fees for their financial services to remain profitable.

For example, a credit card company will charge a business owner a certain percentage of a sale every time a customer uses their card to complete a purchase. This arrangement works in unison with the banks, as every time a customer uses their credit card, the network clears the charge and notifies the bank that a payment is due.


In this financial model, many companies get a cut of every transaction from the banks, credit card companies, card payment processing firms, and many more. Each company profits by getting a slice from every purchase, transfer, and transaction.


Decentralized Finance

When it comes to decentralized finance, there's no need for any middlemen or intermediaries to try to get a cut from the completion of each transaction. DeFi turns the previous model on its head by streamlining the entire process; people can independently conduct business directly with this innovative technology.


The elements that make DeFi possible and trustworthy are that this technology uses security protocols, connectivity, software, and hardware advancements. Each of these components assists users with transparency and trust when handling any amount of funds, giving anyone peace of mind for every transaction.

A strong internet connection is vital to making this all seamlessly happen. With a stable connection, individuals can freely lend, trade, and borrow with help from specific software that records and verifies each interaction, which then goes on the distributed ledger.


The Ultimate Guide to DeFi: An Integral Component for the Future of Web3

To better understand Web3 and its incredible potential, it's crucial to discuss DeFi as an integral component for the future adoption of the next generation of the Web. This section will dissect how DeFi fits into Web3 and the nature of this dynamic relationship.


A. 4 Key Benefits of DeFi

This section looks at the key benefits of DeFi and examines the real-world impact on people's lives and future; to learn more, read on.


Openness

DeFi allows everyone to seamlessly access a DeFi platform to complete transactions without needing a third party; all anyone needs is a secure internet connection.


Fewer Fees and Lower High-Interest Rates

DeFi allows two people to negotiate interest rates directly or lend using a DeFi platform.


Security and Transparency

With help from smart contracts published on the blockchain, anyone can view the completion of any transactions without the fear of revealing their identity. This security and transparency are because all blockchains are permanent, as all information is unchangeable.


Autonomy

DeFi networks empower users with the autonomy to rely less on centralized financial entities. With help from DeFi protocols, this assists in helping to mitigate any potential risks heavily.

A. 4 Real-World Use Cases of DeFi

While reading the previous sections, it can be easy to think that this sounds more like a dream than a reality. The truth is that there are many different real-world use cases of DeFi already in use and making waves within a relatively traditional and conservative industry. Keep reading to find out more.


I. Decentralized Exchanges (DEX)

A decentralized exchange (DEX) functions as a peer-to-peer marketplace, allowing anyone to buy or sell cryptocurrency to anyone else. While a DEX doesn't have a central authority to protect users, it uses smart contracts as an alternative. In this scenario, users will self-fulfill a transaction by following specific requirements to complete the transaction.


II. Lending, Borrowing, and Staking

Regarding the peer-to-peer model, DeFi allows individuals to lend, borrow, and stake various crypto assets. These functions provide liquidity to the protocol using diverse collectivized liquidity pools (LPs).


III. Synthetic Assets

Synthetic assets are similar to derivatives, financial contracts that determine value from some asset, index, or interest rate. In the real world, synthetic assets, also known as "synths," allow for producing blockchain-based tokenized assets that imitate physical assets such as stocks, bonds, commodities, indexes, fiat currencies, and interest rates.


IV. Non-Fungible Tokens (NFTs)

Non-fungible tokens (NFTs) are unchangeable blockchain-based assets and carry cryptographic verification; these digital assets can be trading cards, tickets, or artwork.

A. Shared Attributes of DeFi and Web3

While Web3 and DeFi are separate segments within the blockchain space, these areas share the same characteristics. Below is a list of many of the shared attributes of DeFi and Web3. To learn more, keep reading.


Permissionless

Both DeFi and Web3 use a permissionless design that's focused on allowing equal access for everyone, without any central authority figure, which allows anyone to have the option to participate.


Decentralized

With a focus on ensuring everything is decentralized, DeFi and Web3 help ensure intermediaries do not need to complete any task.

Interoperable

As a critical characteristic of DeFi and Web3, interoperability allows various blockchain networks and DeFi platforms to share information and tokenized assets easily.


Non-Custodial

Non-custodial refers to an individual's funds not being kept in a bank or financial institution. The benefit for users is that removing or adding funds is more accessible anytime; there's no waiting period.


Programmable

Regarding "programmability," the focus is on a developer's ability to create a network infrastructure capable of completing endless iterations for a specific application.


Data is Unchangeable and Cryptographically Verifiable

Information on blockchain networks is permanent and unchangeable, with every piece of data thoroughly verified using cryptography, providing users peace of mind and a sense of security. For DeFi and Web3, this allows users to work directly with others, knowing that the system is trustworthy.


Token-Based Economic and Governance Systems

Last but not least, DeFi and Web3 use token-based economic and governance systems, both of whose functions are decentralized. These systems use what's known as a Proof-of-Stake (PoS) infrastructure, which allows the system to grow over time.

Final Thoughts on the Future of DeFi and Web3

Regarding the future of DeFi and Web3, the future's already arrived. The internet has become a tool that so many rely on daily for our needs, a trend showing no signs of slowing down. As blockchain application becomes the norm, emerging technologies like DeFi and Web3 will become integral to life.


What does seem inevitable is that thanks to blockchain technology, DeFi is already beginning to disrupt and change an overly antiquated global banking system. DeFi is as much an emerging technology as a tool for social change; it will be interesting to see how everything unfolds and how life will look in five or ten years.


Stay in the Know with EH-3

Jump in and dive into Web3; each month covers two new concepts within this exciting new space. For more information, go to the EH-3 website now!




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