Decentralized finance or DeFi for short is used to describe a financial system that removes the control banks, financial institutions and other third parties have over money and other financial products and services. This technology is quickly rising as a more secure and efficient alternative to traditional financial services.
Backed by the blockchain technology, decentralized finance will reduce the cost of transaction and other downsides associated with the traditional banking system. It also helps to speed up transactions and do away with limitations of international money transfer. It is noteworthy that decentralized finance is always available provided there is an internet connection unlike the traditional banks that have dedicated working hours.
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HOW DOES DECENTRALIZED FINANCE (DEFI) WORK?
Decentralized finance makes use of a new emerging technology to do away with the control third parties have over financial systems and services. This new technology is known as the blockchain technology. A number of public blockchains such as Ethereum, Solana, Polygon and many others are being developed, forming a framework for DeFi to operate on. Codes known as smart contracts and decentralized applications (dApps) form the backbone of decentralized finance.
To offer a full range of financial services, decentralized finance needs an infrastructure and a currency to operate with. In the traditional financial system, the banks provide the needed infrastructure while fiat such as the US dollar acts as the currency. In decentralized finance, a smart contract compactible blockchain acts as the infrastructure while a cryptocurrency is used as the transacting currency.
- INFRASTRUCTURE: To provide financial services, an infrastructure is needed for deployment of smart contracts and developments of dApps. Fortunately, the Ethereum blockchain provides a good environment for development and deployment of smart contracts. Different sets of rules can be written in smart contracts to determine how financial systems will work. Asides the Ethereum blockchain, other blockchains such as Solana, Polygon, Fantom, BSC and many others are compactible with smart contracts and allow development of dApps on their network.
- CURRENCY: In order to create an efficient decentralized finance system, a currency is needed. In this case, cryptocurrencies are used to replace the regular fiat currencies used in the traditional financial systems. Traditional cryptocurrencies such as ethereum, solana and polygon are highly volatile and are not well suited for certain kinds of transactions due to the price volatility. This has led to the adoption of stable cryptocurrencies that combine the ease of transaction of normal cryptocurrencies and the stability of fiat currencies. Stable cryptocurrenies are in most cases pegged to fiat or other assets such as gold. Some examples of stable cryptocurrencies include USDT, USDC and BUSD.
DECENTRALIZED FINANCIAL PRODUCTS/SERVICES
One of the benefits of decentralized finance is that it has helped to reduce the limitations and paper works associated with the traditional financial system. Unlike in the traditional systems, in the decentralized financial system, we do not need to wait in long bank queues or fill out complicated application forms before accessing a particular service. Everything is written in smart contracts and once certain conditions are satisfied, transaction easily takes place.
Decentralized finance looks to replace major areas of finance such as money transfer, lending, exchanges and even savings. Some notable decentralized finance services include:
- DECENTRALIZED EXCHANGE: Decentralized exchanges are exchanges that do not require third party involvements to complete transactions. They function completely through the use of smart contracts. Pancakeswap is the biggest decentralized exchange in the Binance smart chain network. Being a DEX, it needs no sign up or KYC process before use. This has helped to protect the identities of users especially in countries whose regulations are not crypto friendly. With DEXs also, money can be sent internationally in a matter of seconds without having to join long bank queues or take part in different verification processes. Other notable decentralized exchanges include; uniswap, sushiswap and spooky swap.
- DECENTRALIZED BORROWING AND LENDING: As opposed to standing in long bank queues and filing out complicated applications forms, users can make use of decentralized borrowing and lending dApps to quickly access loans and give out loans to other users on the platform. These platforms in most cases operate on a peer to peer model. Some examples of decentralized borrowing and lending dApps include Aave, Compound, Alchemix and Venus.
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BENEFITS OF DECENTRALIZED FINANCE
Some of the key benefits of decentralized finance include:
- Reduced cost of transactions by removing the charges incurred when using services of banks or other financial institutions.
- Users have complete access to their money since the money is stored in users’ wallet. In the traditional banking system, users have to deposit their money with the banks and on some occasions, banks restrict users from accessing their funds due to certain reasons. This does not occur in decentralized finance because each user is responsible for storing his assets.
- Speed and ease of transaction. With decentralized finance, the process of sending and receive money internationally is quite easy and can be completed in a matter of seconds.
CONCLUSION
Having experienced the limitations and restrictions associated with the traditional financial system, it is evident that decentralized finance is a good bet. With the total value locked in DeFi rising over $200B IN 2022, it is easy to believe that a lot of individuals and even institutions are adopting decentralized finance. DeFi in simple words is about to change the world of finance and everything money for good.
