How Decentralized Finance Works

Decentralized exchanges (DeFi) are used to complete transactions and store assets. Proponents see it as the future of finance, while detractors see it as particularly vulnerable to hacking and volatility. Learn more about decentralized finance (or DeFi) and its impact on today's monetary system.

What Is DeFi?

"DeFi" stands for "decentralized finance." It refers to the growing number of platforms, cryptocurrencies, and protocols that enable ordinary people and investors to engage in financial services without the intervention of central authorities or intermediaries. Most Bitcoin (or BTC) trades and purchases, for example, take place between two individuals or entities who have access to the same blockchain. In contrast, traditional finance requires a third-party bank or lender for many transactions.

How Does DeFi Work?

DeFi works by utilizing blockchain technology to connect providers and consumers. People conduct transactions with each other by trading their NFT or crypto assets on open-source blockchain platforms, rather than using a bank as an intermediary.

Assume someone wants to buy something new with their cryptocurrency. This transaction would then be verified by these users as part of the same blockchain ledger. After that, algorithms encrypt both the transaction and the currency used to make the purchase.

Many platforms offer smart contracts to ensure that everyone walks away from a deal with what the other person promised them. This increases the security of these transactions. Crypto staking, also known as verification, adds another layer of security and validation.

Advantages of DeFi

One day at a time, DeFi is transforming the financial system. The following are just a few of the benefits of utilizing technology:

Direct connection: DeFi applications enable anyone with an internet connection to conduct financial transactions with another interested party via direct connection. Individuals and institutions can buy, trade, and sell directly from each other rather than relying on a bank to facilitate these transactions.

Increased flexibility: Because DeFi technology is accessible to anyone in the world, it provides users with far more options than is typical in traditional finance. For example, you could contact vendors and lenders on different continents and countries to conduct direct cryptocurrency transactions. In other words, your own national borders (and currency) do not have to prevent you from conducting international business.

More control: While banks can set interest rates and stipulations to control your money, DeFi allows you to control your own currency. Many DeFi enthusiasts, for example, engage in yield farming, a practice in which people rapidly transfer and exchange assets in order to compound and increase their returns.

Disadvantages of DeFi

DeFi carries significantly more risk than traditional finance. Consider the following disadvantages before diving headfirst into technology:

Increased volatility: The financial products and assets that people use in the world of decentralized finance are highly volatile. The total value of your cryptocurrency, as well as your access to liquidity, can fall precipitously. Proponents may argue that great risk comes with the potential for great reward, but critics argue that great loss awaits most DeFi enthusiasts as well.

Lack of regulation: Regulators and watchdogs have yet to exert significant influence over the DeFi ecosystem. The lack of strict DeFi protocols and laws is a selling point for some who want to use the technology for financial transactions. Others believe that the lack of regulation makes the technology too dangerous.

Less security: Hackers may find it easier to steal your decentralized digital assets than they would a bank (either in person or online). Some blockchains are as secure as traditional financial institutions, while others put your derivatives and holdings at risk.

DeFi vs. Traditional Finance

The traditional financial system has been significantly disrupted by DeFi. Here are some key distinctions between DeFi and traditional finance:

Authority: There is no centralized exchange or central authority in DeFi. Blockchains are simply ledgers, not institutions that make rules and regulations or lend your money at their discretion. Banks, both private and central, rule the roost in traditional finance.

Currency: DeFi primarily uses cryptocurrency to facilitate transactions, whereas traditional finance uses fiat currency. Some DeFi users invest in stablecoins that are pegged to the value of fiat currency in order to get the best of both worlds. For example, at any given time, the cryptocurrency Dai has roughly the same value as the US dollar (USD).

Scope: Decentralized applications (or dapps) give users access to the peer-to-peer blockchain technology required for financial transactions anywhere in the world. This allows people to avoid cross-border fiat currency exchanges as long as they use the same cryptocurrency. Traditional finance has a narrower scope, allowing only transactions involving the exchange of one nation's fiat currency for another's.