Decentralized Finance (De-Fi) is an emerging blockchain-based concept that endorses the rise of an open financial system. One of the key drivers of De-Fi’s popularity is its frictionless transactions that work beyond any centralized government or regulatory control. Its decentralized financial structure makes it an attractive alternative to the present financial system. This blog decodes what is decentralized finance, and its unique features, and offers tips on how to invest in an open-source economy.
What is Decentralized Finance?
Decentralized finance works on the same principle as cryptocurrencies’ distributed ledger technology (DLT). It eliminates the need for centralized intermediaries—banks, brokerage firms—and establishes stable Peer-to-Peer (P2P) networks for secure transactions. This makes the technology highly disruptive; it empowers individuals with an internet connection to directly participate in economic transactions with the relevant parties.
How Does Decentralized Finance Work?
Blockchain technology is the backbone of De-Fi. It is a decentralized or distributed ledger (database) that records transactions and stores them in blocks. Information strings together the blocks in chains—and hence the name ‘blockchain’.
Every block has an encrypted cryptographic signature and transaction data from the previous block; this makes them immune to any kind of counterfeiting. Whenever the blockchain encounters new transactions, it is duplicated and distributed across all the systems connected to the network. The blocks are then encrypted to prevent any further unauthorized alteration.
Decentralized Finance Examples
To under what is decentralized finance better, let’s look at these examples:
- Synthetic (SNX) is a popular Ethereum-based protocol of decentralized exchange that enables users to trade assets of different classes. SNX allows trading derivatives, fiat, cryptocurrencies, and even non-blockchain commodities such as silver and gold.
- Uniswap (UNI) is another Ethereum-based crypto-exchange and smart contract protocol. It ranked the highest in popularity among Defi platforms in 2020. Uniswap has its own native token, UNI, which also works in investing platforms outside the Defi network.
- AAVE—formerly ETHLend—is a major connecting platform for lenders and borrowers. This decentralized liquidity platform allows incentives for deposits, and lenders get easy interest without involving third parties. Its USP is its flash loan feature that comes without credit score verification, making it a ‘trustless’ network.
The Future of Decentralized Finance
According to a 2021 Gartner report, at least 20% of large organizations will shift to digital currencies by 2024 for payments, stored value, or collateral. Alexander Bant, Gartner’s Chief of Research, believes that the uptick of digital currency among C-level executives for business purposes and the emergence of Central Bank Digital Currencies (CBDC), will further boost the global blockchain infrastructure. Large enterprises will eventually incorporate blockchain within their applications and harness its ability to leverage high-yield investments.
The Role of Decentralized Finance
Decentralized finance provides autonomy and functionality to its users with a set of agile tools that curtails the operational risks of banks and brokerage firms. Its decentralized public blockchain governs every transaction within the sector, thus removing the cumbersome barriers of digital surveillance of operations.
How Does Decentralized Finance Challenge Traditional Banking?
Understanding what is decentralized finance also entails noting the challenges it poses to the traditional banking system.
A key upside of De-Fi is that it eliminates the financial bureaucracy of banks. Public governance enforces laws and licenses that limit the participation of the general populace within traditional finance. The absence of strict regulations in De-Fi means anyone with programming skills can engage with the blockchain ecosystem and innovate financial services.
The different legal bindings of financial institutions and countries hinder transactions across international borders. De-Fi on the other hand crosses all geographical barriers seamlessly
Additionally, data breaches and privacy issues in banks have been increasing at an alarming rate across the world. DLT, in this case, grants greater autonomy to personal data as crypto-trades do not always link to an identity.
How Decentralized Finance is Being Used Now
- Banking services: The rapid integration of DLT within applications bring billions of new participants to the realm of alternative banking.
- Minimization of economic uncertainty: DLT usage will witness a surge as the IMF predicts yet another global recession for the next two years. Blockchain investments could thus act as a buffer against hyperinflation and devaluation of traditional currencies.
- Independence and creativity: Today, digital ledgers have taken away the monopoly of FinTech development from the clutches of large corporations. Global democratic participation of the public enables decentralized finance to innovate modern concepts of exchange such as Non-Fungible Tokens (NFTs).
How to Invest in Decentralized Finance
- Create a digital wallet: A crypto wallet stores your crypto coins; many Ethereum companies also enable exchange features in wallets.
- Buy crypto coins: Similar to stocks, crypto coins are your initial investment in the blockchain market to partake in De-Fi protocols.
- Engage with the blockchain protocols: Charting different crypto protocols may seem daunting at first, but each of them comes with meticulous trading instructions. Innovative protocols pave the way for smooth crypto transactions—lending, buying, staking crypto investments for rewards, liquidity pools, and so on.
- Keep track of your decentralized investments: Similar to tracking shares in the stock market, tracking your crypto investments is central to building a formidable portfolio. It also helps you connect with upcoming trends in the market.
Key Benefits of Decentralized Finance
- Speed and efficiency: Lack of intermediaries coupled with superior blockchain technology enables secure and seamless transactions across geographical borders.
- Transparency and immutability: Decentralized finance has a fundamental transparent agreement between the parties involved which changes only with their consent, thus increasing transparency, trust, and security.
- Flexibility: Protocols and dApps (decentralized apps) integrate on deeper levels, resulting in superior automated solutions that are simply not conceivable in traditional financial systems.
Risks and Downsides of Decentralized Finance
As the blockchain market is still in its infancy, there are certain risks that inhibit its large-scale adoption. The technology underlying decentralized finance is still obscure and underdeveloped. This is a major concern for investors. The more important concern, however, is the large-scale deployment of unregulated open-source codes. In the absence of regulatory authorities, hackers in 2022 exploited the source code to steal close to $3 billion. Therefore, vulnerabilities abound in this new financial system.
Is Decentralized Finance Safe?
No one can deny the disruptive potential of De-Fi. If you code the De-Fi projects correctly, it is multiple times more secure than traditional financial systems and investments. Nothing changes in the blockchain without getting noticed by everyone connected to the P2P network.
Simply put, De-Fi enables the democratization of banking services minus the bureaucracy, underscoring its immense prospects for the future. You can upskill yourself in the world of finance to stay abreast with these constantly evolving paradigms by signing up for Emeritus’ online finance and fintech courses, in collaboration with top global universities.
By Bishwadeep Mitra
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