The 2008 financial crisis gave the world a wake-up call about the pitfalls of our current traditional, centralized financial system. Satoshi Nakamoto responded promptly by publishing the Bitcoin whitepaper detailing a new financial system.
Over a decade later, those predictions are closer to actualization than ever before. DeFi is coming to the fore as crypto mounts a revolution of pressure on the traditional financial system.
If all that sounds like jargon to you, this article will help you decode the salient ideas.
This is DeFi Decoded!
What is DeFi?
DeFi stands for Decentralized Finance. It represents a new order of financial services and systems built on blockchain technologies for the creation of a peer-to-peer financial network as opposed to the traditional centralized financial systems.
This new financial system signals an evolution towards an inclusive financial environment. As such, users can borrow and trade a crypto coin with anyone from anywhere in the world due to the decentralized nature of the blockchain upon which the financial system is built.
The ability of the blockchain to allow several entities access to a record of financial transactions puts the control of the entire system in the hands of more than a single entity. While DeFi leverages this quality for decentralization, it extends to other use cases like lending and borrowing, as opposed to mere value exchange.
DeFi is challenging traditional financial systems by democratizing access to financial services. More importantly, it is granting underbanked individuals access to financial services as long as they can access a reputable crypto platform. DeFi is shaping up to be the future.
Components of DeFi
Traditional financial systems have been around for a long time. As a result, they have developed firm systems that might require more work to overhaul. However, DeFi is making significant moves to replace or at least serve as an alternative to this system, and this has only been possible due to the following components:
1. Stablecoins
Extreme volatility and crypto price fluctuations have been some of the emerging cryptocurrency sector’s major shortcomings. This potential for significant upward and downward movements has significant effects on decentralized financial systems.
However, stablecoins — tokens whose values are pegged to the values of stable assets like Gold and Silver or fiat currencies like the dollar or Euros — help mitigate these risks. They help to facilitate seamless transactions and lending activities without having to worry about price fluctuations.
They are fundamental to the growth of DeFi.
2. Decentralized Exchanges
Although decentralization and peer-to-peer transactions are the core concept behind DeFi systems, users still have to meet at a centralized location. Decentralized exchanges serve this purpose as they position themselves as peer-to-peer marketplaces where crypto traders execute crypto transactions. However, they ensure that these transactions remain peer-to-peer by allowing traders to execute their transactions without having to hand over the management of their funds to intermediaries or third parties.
3. Smart Contracts
So, if transactions occur without intermediaries, how can we trust that both parties will play their part in the bargain?
Smart contracts—self-executing contracts whose agreement terms have been written into code—step into the shoes of intermediaries like brokers and banks. They trigger the terms of the agreement following the execution of previously agreed-upon conditionals to effect transactions.
4. Blockchain
This is quite an obvious one, but everything about DeFi systems and applications is built on the blockchain. This distributed and secure database or ledger records and verifies all DeFi transactions in blocks, allowing the system to operate smoothly.
5. Lending and Borrowing Protocols
Lending and borrowing protocols are one of the major ways DeFi democratizes access to financial services. These protocols leverage blockchain technology and smart contacts to allow individuals to lend and borrow money from each other instead of traditional financial institutions. This is one of the major ways that DeFi extends its use cases beyond mere value exchange.
Role of Cryptocurrencies in DeFi
Obviously, cryptocurrencies are central to this financial revolution. DeFi is a close description of the financial system Satoshi Nakamoto envisioned when he launched Bitcoin.
As such, apart from the fact that many DeFi applications and systems are built on the blockchain of many cryptocurrencies (mostly Ethereum), crypto also serves as the primary medium of exchange on these systems. Furthermore, they are also used as collaterals in lending and borrowing protocols.
Niche cryptocurrencies also play significant roles in the DeFi ecosystem. For instance, stablecoins help to avoid losses due to volatility, while utility tokens are used to perform the same function within a DeFi application or platform. The list continues with governance tokens helping to promote ownership in decentralized autonomous organizations.
In general, cryptocurrencies are involved in every aspect of the DeFi revolution.
Benefits of DeFi
Traditional finance has long held world economics down and is still doing so. However, the emergence of DeFi presents fresh and exciting possibilities. Here are some benefits of decentralized finance.
1. Decentralization
Starting with the obvious ones, DeFi can transfer the control of financial services from the hands of single entities to all participants. Centralized financial institutions have long been associated with high administration costs and system inefficiencies. However, DeFi protocols are capable of eliminating those needs and costs, replacing them with autonomy and efficiency.
2. Transparency
Consequently, financial services and ecosystems will be poised to experience a different level of trust, transparency, and security. The impact is a reduction in the risks of fraud and corruption, which is often possible with traditional or centralized financial systems.
3. Innovation and Efficiency
The concept in itself is genius! However, it gets even better as the infrastructure is set up to allow for new ideas and concepts that increase the efficiency of financial systems. Having eliminated intermediaries by bringing trading parties in direct contact, some transaction wait times and fees have been cut.
4. Accessibility and Inclusion
With the internet, blockchain, and cryptocurrencies, anyone can initiate transactions in DeFi systems. It provides global access to financial services, especially to people in rural areas. The borderless nature of the blockchain is one of the major determinants of this benefit.
Conclusion
The crypto revolution is on. Decentralized finance has plenty of potential to replace existing financial systems. Stablecoins, decentralized exchanges, smart contracts, and the blockchain are helping to create this new financial system, which offers immense benefits.
DeFi might just be the future of finance.
Read more:
Defi Decoded: The Crypto Revolution
