As people migrate more and more of their lives online, financial dealings and transactions have undergone a necessary revamp. While bank customers already have myriad ways through which to complete digital transactions (via the internet, apps, etc.), many of these methods remain inefficient in comparison to other virtual transactions. For instance, some payment services and digital wallets still take several days to complete a basic transfer.
According to Investopedia, “Decentralized finance (DeFi) is an emerging financial technology based on secure distributed ledgers similar to those used by cryptocurrencies. The system removes the control banks and institutions have on money, financial products, and financial services.”
Decentralized finance is a viable—and perhaps better—alternative to current banking methods.
How Decentralized Finance Works
Decentralized finance relies on pieces of code called “smart contracts,” which run on blockchains. Smart contracts are transaction protocols that automatically execute and store users’ financial or legal activity. Through this technology, users can complete transactions autonomously, without the assistance of an intermediary (such as a bank or other financial institutions).
In general, DeFi refers to an alternative financial ecosystem in the cryptocurrency world. It is a term that encompasses all apps and software products that provide users with non-traditional financial solutions. To date, DeFi refers to over 534 crypto applications that allow users to complete financial activities such as lending, borrowing, and asset management.
There are currently two branches of blockchain-based finance: decentralized and centralized. While both branches give the average person more access to and autonomy over their financial dealings, centralized finance relies on people, while decentralized finance does not. For instance, a person might use centralized finance to collect interest or take out loans on their digital assets (e.g., Bitcoin; USD coins). The platform they use to complete these actions is managed by people, or in some cases, by an entire company.
DeFi Building Blocks
There are several components to DeFi that make up the financial ecosystem. These components include:
- Borrowing and Lending
- Prediction Markets
Stablecoins are a type of “backing” within the DeFi ecosystem. They belong to a class of cryptocurrency that is backed by an institution or entity, or they are tied to a physical currency or commodity (e.g., the dollar or gold). Stablecoins also play a role in price stability. Users use Stablecoins because they are efficient and convenient like cryptocurrency, but also less volatile than tangible currency. Their price stability comes from collateralization or a process of trading reference assets or their derivatives.
Exchanges constitute the transactional component within the DeFi ecosystem. They are the crypto equivalent to financial powerhouses such as the New York Stock Exchange or NASDAQ, but they are not based on traditional order books. Instead, exchanges rely on Automated Market Making (AMM). AMM is the underlying mechanism that facilitates autonomous trading and DeFi exchanges.
Borrowing and lending, along with trading, are other major components of the DeFi ecosystem. Since borrowing and lending are two of the most common behaviors among those operating within the financial world, it makes sense that people would primarily gravitate to DeFi to complete such actions more autonomously. DeFi technology effectively provides automated banking solutions that allow users to circumnavigate the inconvenience—and cost—of dealing with an actual bank.
Lastly, prediction markets are exchange-traded markets that allow the average person to capitalize on their accurate predictions of future events. These types of contracts are tied to the outcomes of everything from exchange averages to gross box office movie ticket sales and everything in between. Some people view this kind of prediction as a type of gambling; however, since the payoff depends upon the accuracy of the prediction, people are more motivated to forecast as accurately as possible. True gamblers, on the other hand, rely on a 50-50 process with no means of accurately predicting outcomes, and without taking external conditions into account.
Advantages and Risks of DeFi
In general, cryptocurrencies and blockchain technology always come with some amount of volatility and risk, and DeFi is no exception; however, there are definite advantages to using DeFi apps and software. A few of these advantages include cost, speed, and innovation.
First, DeFi transactions are free compared to traditional bank transactions. Most banks take a certain percentage of transfers simply for serving as the “middle man,” which can be relatively low-cost but also quite steep over time, especially for users making international transfers.
Second, traditional bank transfers and even some modern app transfers take several days to complete; when users transfer funds via Venmo, for instance, these funds typically take up to three days to appear in a bank account. DeFi technology eliminates the need for an intermediary, and blockchain mechanisms make instantaneous transfers possible, completely free of charge.
Finally, DeFi software applications can connect people together in order to help them carry out more complex transactions. As these applications open a door to new opportunities, the future financial world will become increasingly innovative and creative.
Alternatively, risks of DeFi include software bugs, accessibility issues, and exploits of poorly designed smart contracts. The technology that DeFi uses depends on public blockchains to validate transactions, which can leave applications temporarily inaccessible in the event of blockchain downtime. Additionally, DeFi apps are not entirely decentralized, which means that developers can technically access any funds deposited in or transferred from the platforms. This access can result in detrimental security breaches for DeFi users.
Where to Buy DeFi Tokens
To get started with DeFi, users must purchase tokens. These tokens represent user funds but are also a type of cryptocurrency that has been created on a pre-existing blockchain. With these tokens, crypto investors are able to make DeFi transactions that bypass the more traditional routes for financial transactions such as bank transfers.
DeFi tokens can be bought on apps such as Coinbase, Gemini, eToro, and Voyager. These apps are some of the most popular means by which people invest in cryptocurrency, so users can count on them to secure their money.
Many crypto traders recommend that new investors purchase DeFi tokens with Gemini. In comparison to the other application, Gemini software gives users a better opportunity to passively grow their income via interest, which is especially beneficial for those crypto users who plan on investing in any type of cryptocurrency over the long term.
The Bottom Line
Decentralized finance is a viable—and increasingly popular – alternative to current banking methods. DeFi is possibly the latest and most significant milestone in the evolution of internet-based finance and digital assets. Despite being a fast-growing area in the financial sector, unresolved economic, operational, and technical issues have limited this growth. DeFi could potentially transform global finance, but digital asset holders have mainly focused on leverage, speculation, and yield generation in their use of the technology. DeFi’s ultimate success or failure depends on whether crypto inventors can carry through on their promise to provide financial services that are open, non-custodial, and trustworthy.
How do you feel about DeFi? Let us know in the comments below!