DeFi is the abbreviation for Decentralized Finance.
Before we explain it, let's talk about what came first - Centralized Finance.
But, what is Centralized Finance?
Centralized Finance (also known as CeFi) is basically what we think of as traditional finance.
It’s the modern way of making business and personal transactions that we’re all used to. It could include transfers between bank accounts, loans, real estate purchases and sales, stock Investments, government services, the credit system, and any transactions in the public and private sectors. This system is operated by corporations, governments, and middlemen who regulate commerce throughout the world.
Transactions can often become so complex that middlemen are used to process them, acting as intermediaries between the parties doing business together. In return, they get a percentage of the transaction, referred to as a transaction fee. So much money is generated this way that it has created transaction processing giants that turnover billions annually across centralized finance.
So how does DeFi fix problems?
DeFi, is the answer to the question of how people can keep the government and other middlemen out of their financial affairs.
DeFi allows transactions to be made directly between two parties, for example. There’s no need for oversight, regulation, auditing, or even reporting of the transaction to organizations not directly involved in it.
Basically, DeFi removes the need for middlemen, gatekeepers, and regulators. It keeps transactions private through peer-to-peer exchanges on the blockchain.
The blockchain is a kind of ledger that allows people and companies to directly engage in transactions with one another, without anyone in the middle. While transactions may be listed publicly, they are pseudonymous. This means that names are kept private, and the transaction is recorded using digital addresses instead.
What technology is behind it?
The transactions are made by using something called smart contracts. These are self-executing, digital contracts hosted on a blockchain.
Smart contracts are called self-executing because they are coded to transfer payments or digital possession from one party to another after their terms and conditions have been met. Once activated, smart contracts cannot be altered, but they can be reset if conditions are not met.
In an escrow smart contract, for example, if the conditions for payment were not satisfied before expiration, the payment held in escrow would be returned to the person or organization that posted it.
Why is DeFi called decentralized finance anyway?
Well, it’s called decentralized finance because the blockchain that hosts it is decentralized. Blockchains are created by connecting networks of independent computers, which keep them operational. The computers in a blockchain's network, called nodes, each contain a copy of the blockchain’s ledger.
The blockchain ledger is constantly updated across all of its nodes. As the peer-to-peer blockchain network itself actually processes transactions, instead of a central server or hub - it is said to be decentralized.
Because of this decentralization, no individual, government, or organization can shut it down. Transactions on decentralized blockchains can be processed anywhere, at any time, by any node.
Ultimately, this makes DeFi more accessible and powerful than CeFi - as CeFi can be interfered with by governments and organizations at any time.
How do DeFi transactions take place?
Blockchain transactions do not use fiat currency like dollars - they generally use a type of digital currency called ‘stablecoins’, such as USDT, USDC, or BNC.
They’re called stablecoins because their value is pegged to a real-world, hopefully stable, asset! The idea is that their value is not likely to change, from the time when contracts are negotiated, to when the contract and payment are finally completed. They can be easily exchanged for fiat currency, being pegged to a fiat currency. This reduces the time and cost of redeeming the stable coins for fiat currency.
The same cannot be said for every type of cryptocurrency. The value of a crypto token can significantly rise and fall in seconds - just look at 2022!
What are DeFi's main advantages?
DeFi is awesome because of the possibilities it opens up when compared to CeFi.
Low Transaction Fees
One of its biggest advantages is DeFi’s potentially lower transaction fees. With traditional banking, banks are involved in several stages of processing transactions - which often leads to a higher overall fee.
In contrast, with DeFi transactions being processed on a decentralized network, there’s no need for intermediaries and their costs. The result is the potential for much lower fees for users - and, who doesn’t like to keep as much of their money as possible?
Faster Processing times
DeFi also offers enhanced processing times, making it a lot more efficient. Traditional banking used to take days, or sometimes even a week or more, just to process simple transactions - whereas some DeFi transactions can be completed in just a few minutes!
The speed is made possible through its design, as the decentralized nature of the network allows for much faster processing and so a much more modern approach to banking and finance.
Created Without Borders
Another advantage of DeFi is its borderless nature. In traditional banking, it is very easy to place restrictions on individuals or groups, based solely on their location or nationality if necessary. In the case of DeFi though, anyone can receive and place transactions regardless of who or where they are.
DeFi therefore opens up financial opportunities to individuals stuck in countries facing sanctions, but who still need to process transactions. As a result, DeFi offers a much more inclusive and accessible outlook for everybody.
Asset Control
It could be argued that DeFi can also offer users greater control over their assets. In normal banking, control of assets is basically put in the trust of an intermediary - usually the bank itself or a brokerage, for example.
The problem with that kind of system is that it can be pretty intrusive when it wants to be! Intermediaries can block user access to, control or even confiscate assets as a result of policy, governmental or other legal pressures.
In DeFi scenarios, however, users themselves can be 100% responsible for holding and managing their own assets if they want to be. This gives them a degree of control which hasn’t been seen up until now.
Better Loans
The last benefit we'll talk about is flash loans. Flash loans are loans borrowers can use when they don't have enough cryptocurrency to guarantee a particular crypto loan they want to make.
These flash loans let people borrow cryptocurrency and return it in the same transaction. If the borrower cannot repay the loan before the transaction is finished, the lender cancels the smart contract, and the borrowed funds are immediately returned to the lender instead.
These loans can be used to buy cryptocurrency, crypto investments, or even as emergency financing. They are loans that crypto users couldn’t dream of accessing from traditional lenders; and, present an interesting choice for anyone with access to blockchain transactions and DeFi.
Now you might be thinking: “so what’s the catch?”
DeFi isn't completely without its drawbacks.
The Wild West
First and foremost, DeFi has no consumer protection - compared to CeFi, which is chock-full of it. CeFi has limits in place to help cushion consumers against losses to unscrupulous companies, bad financiers, and even robberies!
DeFi unfortunately has no consumer protection mechanisms in place. At its current, early stage, DeFi is full of scammers, defrauders, cheats and liars. Sadly, without protection in place, victims who lose crypto assets in DeFi transactions almost never get any of it back.
Hungry Hackers
Secondly, there is also the ever-present threat of hackers. Thanks to poor coding, and overlooked loopholes in both software and blockchain design, hackers have successfully made off with a lot of funds over 2022 and they don’t seem to be stopping!
Unfortunately, without protection - victims are unlikely to see their cryptocurrency again, with no avenues for reimbursement, or justice for the hackers. Hackers are steadily growing in number and prospering due to the rapidly increasing numbers of DeFi transactions and increasing value. It looks likely to continue that way until security measures improve.
High Entry Barriers
Finally, initial collateralization can often restrict access to DeFi. The vast majority of DeFi loan terms require borrowers to pledge collateral that is equal to 100% or more of the crypto loan they want. This ends up being a pretty high wall to get over for many, and greatly reduces the number of crypto holders who can use the DeFi loans system.
Conclusion
DeFi removes middlemen and can significantly reduce commercial transaction costs.
It has created new ways to manage transactions globally, make commercial contract fees, and get access to crypto loans.
Although it looks like a very promising, lucrative, and rapidly growing area of finance, it does have its downsides. Anyone who engages in DeFi transactions should be aware of the risks, and have a Plan B prepared just in case the worst situation happens.
