Defi

DeFi (or “decentralized finance”) is an umbrella term for financial services on public blockchains, primarily Ethereum. With DeFi, you can do most of the things banks support — earn interest, borrow money, buy insurance, trade derivatives, trade assets, and more — but faster and without the need for paperwork or third parties. Like cryptocurrencies in general, DeFi is global, peer-to-peer (meaning directly between two people, rather than routed through a centralized system), pseudonymous, and open to everyone. At its core, finance is the interaction between savers and consumers. Savers are people who don't need their money any time soon. They can hold cash, lend it at interest, or invest it. Consumers can borrow money or raise funds to start a business. DeFi attempts to make these interactions frictionless and permissionless compared to traditional finance.

History of Defi

After 2017, several ecosystems – such as Compound Finance and MakerDAO – became popular, popularizing additional financial features for cryptocurrencies and DeFi. In 2020, the DeFi niche started to take off as more platforms emerged, in line with strategies like yield farming as people leveraged DeFi solutions.

DeFi boomed in 2020, bringing an influx of projects into the crypto space and popularizing a new financial movement. Since Bitcoin inherently has many DeFi characteristics, there is no definite start date for the DeFi industry other than Bitcoin’s launch in 2009.

How Does Defi Work?

DeFi relies on the use of blockchain, which is often based on Ethereum in many DeFi operations. Blockchain is an immutable form of distributed ledger that cryptographically secures entries used for transactions. Blockchain is also the basis for cryptocurrencies, which are tokens of value created in the blockchain.

With the Ethereum-based blockchain, smart contracts can help DeFi models function. Smart contracts are applications that run on the blockchain using the inherent distributed ledger and cryptographic capabilities. Smart contracts specify the terms and conditions for performing a given action.

Instead of a central authority initiating transactions, smart contracts are programmatically enabled to perform the financial transactions specified in the contract. Smart contracts can hold cryptocurrency assets that can be sent from one entity to another.

With DeFi smart contracts, the terms and conditions of transactions are also transparent and available as code, meaning others can view them for auditing and analysis. Since the system operates in a P2P model, there is no need for a central authority to enable smart contracts with DeFi. Therefore, if two nodes can agree to execute a transaction, it can be completed without the need for a third-party central authority.

There is an emphasis on empowering individual users in the DeFi model and its use of smart contracts. Cryptocurrency asset custody relies on control of private and public encryption keys. With a decentralized approach, custody in the form of private encryption keys is held by individuals.

Advantages of Defi

DeFi offers many benefits to users that can help increase confidence, security and trust in cryptocurrency-based transactions and applications, including:

• Decentralization. Because it is decentralized, DeFi is not subject to the inherent risks of CeFi, where the failure of an exchange can result in the complete collapse and loss of user funds and accounts.

• No permission required. As a decentralized model, there is no central authority required to approve or enable transactions. In contrast, the model is permissionless because the smart contract’s programming logic defines the possibilities.

• Open and transparent. Smart contract models allow users to understand the terms and logic of transactions in a transparent model with no hidden code.

• anonymous. While smart contracts can be transparent on the blockchain, there is no need or requirement to identify users. For DeFi, know-your-customer requirements are common in centralized and regulated models, but are not particularly applicable.

• Controllable. In DeFi, users control assets and the cryptographic private keys for cryptocurrency tokens are kept by the user.

• Wide range of applications. DeFi supports dApps from which users can benefit from financial services applications and other use cases such as gaming and social media.

• Low fees. In the absence of a central authority, DeFi offers users the promise of lower transaction fees than those executed in the CeFi model.

Risks of Defi

While DeFi has its benefits, it also has some potential challenges, including:

• The operation is complicated. The complexity of DeFi is probably the biggest challenge facing the model. DeFi uses a P2P model, with smart contracts and complex algorithms that may be difficult for laypeople to fully understand. This complexity can also lead to confusion about how a service or application works.

• customer service. Customer service in DeFi can often be a challenge without a central agency or service to call for help.

• Big fluctuations. Since there is no moderate central authority to control or limit trading or market momentum, DeFi approaches can be subject to greater volatility.

• Security Question. In recent years, DeFi platforms have increasingly been targeted by attackers. An FBI alert issued in August 2022 warned that more than $1 billion in assets had been stolen in just three months.

Why Is Defi So Important?

DeFi takes the basic premise of Bitcoin, a digital currency, and expands on it to create a complete digital alternative to Wall Street, but without all the associated costs. This has the potential to create more open, free and fair financial markets that can be accessed by anyone with an internet connection.