Bitcoin’s launch in 2009 led to a robust crypto and blockchain industry, with the decentralized finance (DeFi) sector emerging as an alternative to traditional financial services. DeFi consists of smart contracts that power decentralized applications and protocols, often built on Ethereum. DeFi offers services like saving, investing, trading, and market-making, aiming to challenge traditional financial services providers. DeFi often uses open-source code, allowing anyone to build on pre-existing applications permissionlessly. Decentralization means no central body controls something, reducing power and risk. DeFi trading and decentralized banking are examples of this decentralization.
What is Decentralized Finance(DeFi)?
Decentralized finance, or DeFi, is a new way to set up and run trades, exchanges, and financial services that use cryptocurrencies.
The main idea behind DeFi is that no group can tell or direct how things work. It’s not the same as the usual ways of handling money in fiat currency or centralized finance (CeFi) in the coin markets. In centralized models, a central authority can control and affect interactions. A lot of the time, the main body is also in charge of keeping assets safe.
The Federal Reserve and the Securities and Exchange Commission (SEC) in the U.S. make the rules for centralized financial institutions like banks and brokerages. People depend on these institutions to access cash and financial services directly. DeFi questions this centralized financial system by giving people the power to make digital transactions with each other.
Benefits of Decentralized Finance
Defi gives users a lot of benefits that can help them feel safer and more confident in deals and apps that use cryptocurrency, such as the ones below:
Anonymity
Smart contracts can be open on the blockchain, but users don’t have to be named. Know Your Client rules don’t apply to DeFi. These rules are usually part of centralized and controlled models.
Having custody
In DeFi, users own assets and keep the secret cryptographic key for cryptocurrency tokens safe.
Decentralized
DeFi doesn’t have the same risks as CeFi because it’s uncontrolled. With CeFi, the whole system can crash if an exchange fails and users lose their money and accounts.
Permission
A decentralized model doesn’t need a central authority to proceed with a deal or make it possible. Instead, the model doesn’t need permission because what is possible is set by the programmed logic of smart contracts.
Apps for devices
DeFi offers apps that let users get the most out of financial and other social media and games apps.
Transparency
With the intelligent contract approach, users can see the terms and logic of a deal without having to dig through any hidden code.
Fees
Users can expect lower fees with DeFi transactions than CeFi transactions because there is no central authority.
How Does Decentralized Finance Work?
By building a financial system on a blockchain-based network and eliminating intermediaries, trades can be more direct, service fees can be cut down, and it will be almost impossible to change how assets are transferred or exchanged.
Blockchains are digital ledgers that all computers that are part of the network (called “nodes”) share and keep up to date. Only specific nodes in a network check all the transactions that are added to a blockchain. All blocks are encrypted, and the information inside them is locked down and can’t be changed once the block is closed.
Any attempt to change what’s in a block will send a message to all computers on the network, which can be thousands of them. This is what makes a blockchain safe and almost impossible to break into.
If you compare this to the current financial system, blockchain supporters say that even the most efficient, price-competitive banking systems can’t provide these benefits simultaneously.
DeFi can do one better. Anyone and any business can trade assets like intelligent contracts and non-fungible tokens that can’t be exchanged for cash using traditional financial methods because they use the blockchain.
Challenges in Decentralized Finance
DeFi is a new trend that comes with a lot of risks. Decentralized finance is a new idea that hasn’t been tested for long-term or general use. The national government is also looking more closely at the systems it sets up to regulate them. These are some of the other risks of DeFi:
Less Security
DeFi has done very well since there aren’t many rules and laws. There may not be much users can do if a deal goes wrong. As an example of centralized finance, the Federal Savings Insurance Corp. (FDIC) pays back savings account holders up to $250,000 per bank if the bank fails.
Also, banks are forced by law to keep a certain amount of their capital as reserves. This keeps things stable and lets you get cash from your account whenever necessary. In DeFi, there are no similar defenses.
High Rate Of Hack
A blockchain may be very hard to change, but other parts of DeFi are likely to be hacked, which could cause money to be stolen or lost. All possible uses for decentralized banking depend on software systems that can be hacked.
Collateral
Collateral is something of value that is used to get a loan. For example, when you get a mortgage, the house you want to buy is used as security for the loan.
When DeFi lends money, they almost always need security worth at least the loan amount, if not more. These requirements make it difficult for some people to get certain DeFi loans.
Need For A Private Key
When using DeFi and cryptocurrency, you must ensure that the wallets you store your cryptocurrency assets are safe. Private keys are long, unique numbers that only the wallet owner knows. They keep your wallet safe. No matter how hard you try, you can’t regain your money once you lose your secret key.
Is Bitcoin a Decentralized Finance?
The best way to explain the difference between Bitcoin and DeFi is to compare them to email and the internet.
Email was the only thing people could do on the internet when it first came out. This high-speed technology let people talk to each other, and they thought this was what the internet was all about.
But over the next few years, as internet technology grew and changed, everyone saw that it wasn’t just emails and opened up a new world of options.
In the same way, it was great when the blockchain world was all about Bitcoin. A lot of people loved it. It allowed them to send money from person to person without being tracked. But we learned what this technology could do in less than ten years.
There was more than one thing about blockchain that made payments faster and cheaper. Anything you could think of could be done with that method, even using money. People were freed from banks and other financial institutions.
Difference Between Centralized Finance and Decentralized Finance
Two primary banking services deal with cryptocurrencies now: CeFi and DeFi. When you look at CeFi vs. DeFi side by side, you should remember that the two methods are similar and different.
Both models have an exchange that can help make deals more accessible, and traders can buy, sell, and loan cryptocurrency assets. Both the CeFi and DeFi models depend on technologies that are built on blockchain.
The two methods have very different effects on management and organization. It is up to a central body to oversee transactions in the CeFi model. The main body is also in charge of the assets.
The DeFi system, on the other hand, uses smart contracts and a P2P decentralized method to make financial services possible. Instead of centralized exchanges being in charge of keeping assets safe, users are the ones who keep their digital assets safe.
How Blockchain Runs on Decentralized Finance (DeFi)
The leading technologies that make decentralized finance possible are blockchain and cryptocurrency.
When you make a transaction in a regular checking account, it’s written down in a private ledger called your banking transaction history. This ledger is owned and handled by a big bank.
The blockchain is a decentralized, widely shared public ledger that stores financial events in computer code.
Everyone who uses a DeFi app has the exact copy of the public log, which stores every transaction in encrypted code. This is what we mean when we say that blockchain is distributed. That keeps the system safe by giving users privacy, making sure payments are made, and keeping a record of who owns an asset that is (almost) hard for fraudsters to change.
Blockchain is said to be autonomous if no one is in the middle running the system. Transactions are recorded and checked by people who use the identical blockchain. This is done by answering complex math problems and adding new blocks of transactions to the chain.
People who support DeFi say that the decentralized blockchain makes financial deals safer and more precise than centralized finance’s private, opaque systems.
What is Decentralized Finance Insurance About?
Many insurance policies built on blockchain cover things that happen in the real world, like farming, disasters, and more. Many blockchain-based insurance policies use a parametric insurance model. This model pays claims to the person involved as long as certain conditions are met.
These parametric insurance plans often use hardware and software oracles to determine when payments should be made. Innovative contract technology lets costs go out instantly instead of waiting for a central authority to send the money.
There are many reasons why decentralized insurance policies are better than centralized policies. For instance, if you had centralized storm insurance and a hurricane damaged your home, you would have to go through a lengthy claims process before you could get the money to fix it.
On the other hand, an autonomous policy could use smart contracts to pay the total amount immediately after the damage happened.
DeFi Insurance also refers to insurance that covers things related to blockchain. This coverage is excellent for people with many crypto assets on an exchange. If you lose money because of an exchange hack, your DeFi insurance contract can cover it. There is also DeFi insurance that can protect stablecoin buyers in case the price drops.
Conclusion
The current controlled banking system is being challenged by a new financial technology called decentralized finance (DeFi). Banks and other financial companies charge fees to use their services. DeFi removes those fees and encourages people to use peer-to-peer (P2P) transfers.
