In recent times, centralized finance has been the ruling method of banking where a particular body or institution has complete access or control over the production, distribution of money for the public.
This banking method is starting to prove obsolete as decentralized finance begins to have a higher advantage over the system due to apparent advancements.
Decentralized finance, shortly known as DeFI, is an entirely new financial ecosystem that is permissionless and open to all. It is a new finance system that makes banking available and accessible to all without a centralized authority. When we consider the rate at which this banking system progresses, it is safe to say that decentralized finance is the digital currency’s future. The method continues to attract a tremendous amount of capital and investors to its market while becoming a safer alternative to traditional financial services and institutions.
So what is the big deal about DeFI?
The DeFI movement proves to be a lot more reliable, providing loads of benefits to customers and investors. Due to its autonomous nature, it is not prone to corruption, fraud, and money mismanagement.
The DeFI technology relies heavily on Cryptography, blockchains, and smart contracts to function. These technologies allow individuals to assert complete control over their assets and also relate with the financial system with ease.
The DeFI system is an umbrella for many projects that are solving problems in the world of finance. Let us look at these projects and see how beneficial they are to the financial services industry.
Lending and borrowing
Lending and borrowing is one essential element in a financial institution. The DeFI space enables peer-to-peer lending and borrowing solutions, bringing substantial benefits to all end users.
In the concept of lending and borrowing, the lenders are the depositors. They provide funds for borrowers, getting a considerable amount of interest in return. The borrowers on the other end are willing to pay interest on the amount they want to borrow. These services come with cryptographic certification mechanisms and smart contracts that terminate the need for any intermediary of a third party during transactions.
Lending and borrowing are made accessible through DeFI protocols and projects like Aave, Compound, and MarkerDAO. These systems work by creating a money market for a particular token such as ETH, stable coin like dai,usdc, or another token.
Users supply their tokens to a particular money market and start receiving interest on their tokens according to the current supply APY (annual percentage yield). The token provided is sent to a smart contract and made available to other users to borrow.
Lending and borrowing are some of the largest verticals in the DeFI space. The process is cheap and relatively fast while ensuring that all parties involved in the transaction are protected.
Most cryptocurrencies are meant to serve as a medium of exchange and store value. A stable coin aims to provide cryptocurrency that isn’t volatile. Its value is pegged to a real-world value, called fiat currencies. A stable coin seeks to reduce cryptocurrencies’ volatility and consolidate the case for using blockchains as payment options.
The most significant advantage of a stable coin is its ability to convenience and stability in decentralized finance.
Decentralized exchange(Dex) is one of the essential functions of DeFI. It operates according to rules that allow users to buy, sell, or trade tokens with other assets without intermediaries. They are built on the etherium platform, without a central authority or custodian.
There are no account operators, no sign-ups, no identity verification required. It runs on a strictly autonomous basis. It is a pair to pair online service that allows direct cryptocurrency transactions between two interested parties. Here, smart contracts ensure that the transactions are entirely self-sufficient.
The decentralized finance space has created an opening for the development of decentralized exchange tools and protocols. We have seen from practical platforms like Uniswap that this platform is user-friendly, relying on liquidity protocols and DIY mechanisms.
The decentralized money market is the service that connects the lenders to the borrowers in the decentralized banking system. It combines the depositors with the borrowers while they get interested in these deposits. Borrowers also get to deposit their crypto as collateral and obtain the amount they want. The money market facilitates the autonomous management of loan terms.
In place of the centralized institutions having total control over how funds are used, the decentralized money market focuses on smart contracts, with a substantial assurance that tokens cannot be improperly used. It also that the users keep having custody over when and how their tickets can be withdrawn.
DeFI and centralized authority
Centralization is a process in which all activities involving planning and decision-making in an organization are concentrated on a particular individual or leader. It revolves around a central body, and all decision-making processes can be traced to a single authority. Decentralization involves the transfer of control of activities to several local authorities rather than a single one.
The activities involved in decentralized banking are the exact opposite of a centralized banking system.
The defining difference between both methods of finance is the involvement of intermediaries. In centralized finance, the system is regulated by intermediaries, whereas decentralized finance is technology-dependent. Due to the participation of intermediaries in CeFI, funds are kept safe and solely controlled by them.
Contrary to that, the DeFI eliminates the need for these intermediaries, cutting them off.
Decentralized finance eliminates the risks involved in centralized finance. Some of these risks involve:
- Delays in work: The CFI technology relies on communication from the top to the bottom. This process results in delays in work as records are sent to and from the head office. This means that the transmission between all sectors will lead to less productivity and all employees have to wait long periods to get guidance on their new projects. DeFI terminates the need for these sectors as all activities are performed independently based on technological developments.
- Bureaucratic leadership: Centralized management allows for a dictatorial form of leadership. This means that employees cannot contribute to the decision-making process; they are merely implementing decisions made by higher-ups. In most cases, these decisions cannot be advantageous to everyone. In DeFI, every party is responsible for the decision-making process. Banking is made open and accessible to all, and no central body has control over the rules and how services will work.
What are the advantages of DeFI over open banking?
The traditional financial institutions that we are most familiar with are primarily centralized. Banks process interactions and also act as intermediaries. With the technology of DeFI, there are numerous advances to this method of banking.
The technological advancements of decentralized finance provide a public blockchain’s availability, ensuring that it doesn’t rely on any authority or entity. No proper infrastructures are needed; all transmissions occur online and are accessible to everyone in every part of the world as long as there’s internet access.
With DeFI comes complete autonomy and transparency. All transactions take place on the blockchain network and are shared by everyone. Data is made publicly available for inspection and is made open to all. The decentralized infrastructure ensures that everyone determines the rules as to how services will work; no central body has control over them
From recent innovations, we can say that DeFI is changing the world of finance. The drive for improvements and upscaling has accelerated so much, improving performance. With new technologies and innovations popping up in the world of decentralized finance, it is no news that the financial space is close to having a revolution. This banking method improves daily and keeps gaining immense traction and satisfaction in the finance and blockchain arena.
Risks involved in DeFI
Much has been said about how great this financial system is, but as an evolving banking system, there are also several known risks associated with the DeFI ecosystem.
- DeFI is still in its developing stage: Decentralized finance is still in its infancy stage, things can still go wrong. The smart contract has had issues in previous times where people did not interpret the rules correctly, and hackers found ways to exploit the loopholes and steal money.
- Some of the services are only partially centralized: Although the label remains DeFI, some of the benefits remain partly centralized, posing a threat. If you decide to invest in any of the existing system DeFI services, ensure that you do cautiously with the amount of money you can afford to lose if anything goes wrong.
There is no doubt that the decentralized finance system can benefit many populations that suffer from inefficiency in fund management and the risks attached to CeFI. But It is necessary to research carefully any service you intend to invest in; so you can be aware of issues that are liable to come up in the process.
Given the consistent growth of DeFI, it’s difficult not to feel optimistic about this space’s prospect. Although, challenges continue to rise. New opportunities will also arise.