Decentralized Finance aims to replace the traditional financial system and in that regard, it has already started making inroads in major ways.
Decentralized Finance or DeFi as it is commonly known is one of the most important use cases for blockchain technology. Most of the industry experts from blockchain technology and many in the traditional financial world believe that in the long run, DeFi is going to usurp centralized financial systems like banks and other financial institutions.
And today in this article we will learn all there is to about what DeFi is and what separates decentralized finance (DeFi) from centralized finance.
Let’s dive right in.
Decentralized Finance (DeFi) Definition
At first glance decentralized finance might sound like a complicated terminology. But it is nothing but simply an umbrella term for peer-to-peer financial services.
In simpler words, it means that it directly connects the two parties willing to undertake any financial transactions such as lending, borrowing, payment, investments, trading, etc. without the need for any middlemen or financial institutions. For example, if a party/person wishes to borrow some money from another person/party. Using DeFi, they can simply do so by signing an auto-execution smart contract without the need for any guarantors or financial intermediaries in between.
One of the most significant advantages and powers of DeFi is that it makes these financial services available to anyone with an internet connection and a decentralized wallet. To learn more about what DeFi is go to CoinStats’ ultimate guide to DeFi “What is DeFi”.
How Does DeFi Work?
Decentralized Finance (DeFi) works on the DIstributed Ledger Technology(DLT) or blockchain. It means that financial transactions can happen in a permissionless manner over the blockchain as long as the pre-approved underlying conditions in the smart contract governing that transaction are satisfied.
DeFi exists over a trustless network on which the users are given complete autonomy and control over their assets without the need for approval or authentication from any third party. DeFi makes it possible to have stablecoin trading, yield farming, lending, insurance, decentralized exchanges, etc.
DeFi transactions and services happen using decentralized apps (DApps) that act as the platform where users/parties can connect with one another.
The DApps are similar to your conventional banking apps with the only difference being that they exist over the blockchain with no central control over them. The need for intermediaries is done away with by smart contracts that are self-executory in nature. The terms and conditions underlying the smart contract are agreed upon between the two parties and when they are met, the transaction goes through and is added to the blockchain.
What are the Risks and Downsides of DeFi?
DeFi is gaining a lot of popularity and use cases in recent years. More so in the past couple of years, it is still a pretty nascent technology with its fair share of risks and downsides. Some of the most common risks and downsides of DeFi are:
- Since the entire DeFi ecosystem is unregulated, it is prone to hacks, scams, and infrastructural and operational issues.
- Since smart contracts govern the transactions in the DeFi ecosystem, wrong or faulty transactions such as sending to the wrong blockchain or address may result in permanent loss of funds. This is because there is no centralized authority to rectify the errors.
- Smart contracts by themselves can be prone to bugs and other technical issues which can be a big hindrance if both the parties involved in the DeFi transaction are not well versed with the smart contract technology.
- Since the prices of cryptocurrencies are very volatile and can go up and down within a matter of seconds. The transactions such as borrowing, lending, etc. can result in huge losses to either one or both parties.
- While in principle the transactions occurring over the DeFi protocols should not have very high transactional fees or gas fees as it is commonly called. The present ecosystem is such that most of the DeFi protocols are built over the Ethereum network, and the gas fees on the Ethereum network are known to be very high.
Apart from these above-mentioned risks, there are some other risks associated with DeFi such as losing the private keys would result in permanent loss of the assets stored over the Non-Custodial Wallet used in DeFi, etc. This is one of the reasons why the CoinStats Wallet is one of the most secure DeFi wallets in the world.
What is the Difference Between Decentralized Finance and Centralized Finance?
While centralized finance relies on the middlemen such as banks, hedge funds, stock exchanges, etc. to access financial services, decentralized finance has no such requirement and anyone with a mobile phone and internet can access the DeFi Services.
|Decentralized Finance(DeFi)||Centralized Finance|
|No central authority or middlemen||Financial institutions such as banks etc are the central authority.|
|Does not deny access to any individual||The central authority can deny access to any individual they deem unfit|
|Total control over the funds, assets, or investments||The control lies with the central authorities|
|The transaction fees are supposed to be minimal||The transaction fees are usually high|
|The transactions are almost instantaneous||The transactions can take anywhere from hours to days to weeks.|
While the whole world is getting into the crypto space and is recognizing the power of DeFi, it is still in its nascent stage and carries with it substantial amounts of risks. The dividends and benefits of DeFi are still much higher than those of centralized finance, but so are the risks involved. But there is no doubt that decentralized finance (DeF) is the future of finance in the coming years.