The innovation of distributed ledger technologies is leading to a quantum leap in the possibilities of the functionalities of money. For the first time in history, a global financial system for a worldwide population is being shaped by that same population. With DeFi protocols' governance, anyone can participate and sit at the table where the world of decentralized finance is actively created.
The DeFi space is gradually catching up with the traditional financial system, despite the obstacles of operating on the cutting edge of innovation. As DeFi and fintech merge, we are on the path to an inflection point where nascent financial technology becomes part of a new financial system that is fast, secure, available, and egalitarian. This realization of the dream of a new financial system will bring about greater prosperity for all.
What is DeFi?
Decentralized finance, commonly called DeFi, is a revolutionary take on developing an alternative to the current global financial infrastructure. At its essence, DeFi would provide those historically left out of the banking system and bring millions, if not billions, into the 21st century.
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.
Ultimately this would be made possible thanks to using blockchain technologies (usually Ethereum) and smart contracts, effectively cutting out any need for intermediaries or go-betweens. Much like Web3, DeFi prides itself on being entirely decentralized, which for many in the financial sector is almost like flipping the world upside down and keeping it there.
It's important to point out that there are a lot of mentioned terms, such as Web3, blockchain technology, cryptocurrencies, and DeFi. To simplify all these terms, think of Web3 as the way information is dispersed and shared, cryptocurrencies are the medium of exchange (think of it like money), and DeFi is the decentralized financial infrastructure. At the same time, blockchain technology is the foundation making everything possible and much more.
Centralized versus Decentralized Finance
Here are the main differences for each type of finance, along with some associated advantages and drawbacks.
Centralized Finance
Centralized finance involves the custody of funds by banks and intermediaries who facilitate money transfers between parties, charging fees for their services. Every participant earns remuneration for their services, as merchants pay for debit and credit cards.
For instance, in a credit card transaction, the merchant initiates the charge, which flows through an acquiring bank and a credit card network before the bank settles the payment. Centralized finance also encompasses regulating financial activities, such as loan applications and providing banking services by local institutions.
Decentralized Finance
Decentralized finance revolutionizes financial transactions by leveraging emerging technologies, eliminating the need for intermediaries. DeFi employs security protocols, software, hardware advancements, and peer-to-peer financial networks that allow individuals, merchants, and businesses to lend, trade, and borrow. Financial actions are recorded and verified in distributed financial databases accessible across various locations.
DeFi provides more autonomy and control to users, allowing them to access financial services anywhere, anytime, through personal wallets and trading services designed for individuals. These databases aggregate user data and use a consensus mechanism to ensure accuracy. The centralized finance model is thus replaced with a decentralized one, making financial services available to everyone, regardless of location or background.
More on the Inner Workings of DeFi
Decentralized finance operates on blockchain technology, similar to that of cryptocurrencies. The blockchain is a distributed and secure database or ledger, and dApps handle transactions and run the blockchain. Transactions are recorded in blocks and then verified by other users. When a transaction is verified, the block is closed and encrypted, and another block contains information about the previous block.
The blocks are connected by the information in each successive block, creating the blockchain. This benefit makes the blockchain immutable, as changes to previous blocks would affect all subsequent blocks. Ultimately, this feature provides security to the blockchain and other security protocols.
One of the core principles of DeFi is peer-to-peer (P2P) financial transactions, where two parties exchange cryptocurrency for goods or services without involving a third party. DeFi facilitates P2P loan transactions, where algorithms match peers agreeing on the lender's terms, and a loan is issued. Payments in P2P transactions operate using dApps, following the same blockchain process.
DeFi provides accessibility, low fees, high-interest rates, security, transparency, and autonomy. Anyone with an internet connection can access DeFi platforms, and transactions are not subject to geographic restrictions. DeFi enables two parties to negotiate interest rates and lend money directly via DeFi networks.
Transactions are transparent as smart contracts published on a blockchain, and records of completed transactions are available for anyone to review. DeFi platforms are decentralized and do not rely on centralized financial institutions, mitigating the risk of adversity or bankruptcy.
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