By the time you would finish reading the article, many users would have transacted millions of dollars of cryptocurrencies on the blockchain for business or personal purposes.
Are you aware of blockchain and cryptocurrency?
A Blockchain as the name suggests is a collection of blocks, linked together for storing transaction data. Cryptocurrency on the other hand is a virtual currency that works on the principle of blockchain.
As the word ‘transaction’ is involved, we can’t let go of the idea of finances. Let us introduce you to the concept of Decentralized Finance which is popularly known as DeFi.
What is Decentralized Finance?
Defi is an open-source platform just like the concept of blockchain. The word decentralized itself explains there is no central authority indicating transparent financial services available to one and all. Defi is open to people who do not have access to the traditional financial system making it a better alternative to everyone.
Consider an example where you went to a movie and purchased the movie tickets through your debit card. The debit card is the property of a financial institution that has full control over your transactions. Defi cuts out regulatory financial institutions which were in the picture before.
Components of Defi
Broadly, the components of decentralized finance are the same as of traditional financial systems existing. The four components have a specific role to perform in the building of a Defi system.
- Settlement Layer: Layer 0 (or settlement layer) is the base layer upon which other Defi transactions are built. This layer consists of a public blockchain and cryptocurrency. Transactions occurring on Defi apps are settled using this currency, which may or may not be traded in public markets.
- Protocol Layer: Defi protocols can be used by multiple entities at the same time to build a service or an app. The main purpose of the protocol layer is to provide liquidity to the Defi ecosystem.
- Application Layer: This layer is for consumers to utilize the service which is built for them. DEXs (Decentralized exchanges) is one of the use cases of the application layer in the cryptocurrency ecosystem.
- Aggregation Layer: The aggregation layer connects various applications from the previous layer to provide a service to investors. It reduces the paperwork, cost, and saves time with the use of technology.
Why use Defi over the traditional financial system?
The traditional financial system has banks acting as an intermediary. They have to go to by the legalities and procedures which are not transparent to the people.
Defi applications are decentralized, i.e., no regulating authority, the pieces of codes have everything written to act when a point of dispute occurs.
Moreover, the blockchains are distributed over their peers spanning across locations. 51% is the brink point when a blockchain would tamper that is if more than half of the miners rewrite the ledger. Making it impossible!
Take an example of a financial institution, say a bank, which is a central authority. If by chance the banking institution is faced with theft of 70% of the funds.
Will the bank provide you the funds? Who is responsible for your loss?
With Defi in the frame, these questions are just as absurd as a blockchain easily tampers.
Applications of Defi
The use cases of Defi are not only limited to transactions, it has its root settled deep in the ground.
Manage your savings
Given a chance to earn more interest than banks offer, what would you do?
Using lending-pool platforms, you can earn significantly more than what traditional financial systems offer. Yield Farming is also gaining popularity as you can utilize your crypto assets in pools to earn interest on them.
Lending And Borrowing
Does your bank discard your loan application due to a low credit score?
With Defi in hand, you can borrow or lend your money by taking online collateral of digital assets. It not only executes within minutes but also has the trust of blockchain cryptography, making your money safe.
Aave token is one of the largest Defi coins by market cap where investors holding Ethereum can easily borrow or lend their cryptocurrencies without the need of a centralized entity.
‘Database of people leaked’ is the most common headline in today’s world. It poses a serious threat to people by having their identity on the threat. Defi protocols with blockchain have stricter rules so you do not have to worry about your information being compromised by hackers.
DAO (Decentralized autonomous organizations) works on transparent rules that are encoded on the Ethereum blockchain, thereby deleting centralized identity from the frame.
DEX (Decentralized Exchanges) as the name suggests, are cryptocurrency exchanges working in a decentralized manner, which allows users to transact peer-to-peer and have total control over their funds.
DEXs also give token projects access to liquidity without any listing fee, which often rivals centralized exchanges. Uniswap is one of the popular DEXs in the Defi space.
Ethereum-based games have become a popular use case for decentralized finance because of their built-in economies and innovative incentive models.
PoolTogether is a platform to purchase digital tickets from DAI coin that is pooled together and lent to the Compound money market protocol to earn interest.
Smart contracts and their role in Defi
You might be wondering what is a smart contract?
A smart contract is computer operated transaction protocol that automatically executes and controls the events described in the agreement. Traditional contracts on the other hand have courts as an intermediary which is a tedious, time-taking, and costly affair.
Decentralized finance requires the automated working of contracts that could execute themself after certain conditions are met. Smart contracts enable the reliable execution and automation of a large number of business processes that currently require manual supervision.
‘Time is money’, therefore smart contracts are a viable choice to be used in Defi applications.
Challenges in the way of Defi
No invention is perfect. Defi applications too have hurdles along their way.
Over the regular financial institutions, Defi applications that are built on blockchains have slow performance. This brings in an immediate need to work upon optimizing the process.
A bug or flaw in a piece of code can pose a major risk in implementing the smart contract which is proportional to loss of funds. A contract needs to be bug-proof for seamless transactions to happen.
Due to the lack of a proper system in the Defi, it is difficult for users to find the most suitable Defi application for specific use cases.
The applications of Defi have equally balancing pros and cons which could be a guiding factor whether to adopt the services. The advantage of having total control over your funds and transactions, transparency, permissionless behavior surely makes it the future of finances.
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