What id Defi: A Comprehensive Guide

05-Nov-2024

If you are aware of cryptocurrency and blockchain technology, you must have surely heard of DeFi. With the meteoric growth of technology and its intervention in the financial sector, the world today is experiencing a new and advanced methods of conducting financial operations. DeFi, an acronym for Decentralized Finance, is an emerging that enables users to conduct their financial activities via cryptocurrencies without the intervention of a third party. The advent of cryptocurrencies and blockchain technology has significantly popularized and propelled the market for DeFi.

In this blog, let us learn about DeFi in a comprehensive manner, by exploring its general characteristics, how it works, how it is different from the traditional banking and financial activities, the technology behind DeFi, risks involved, etc. 

What is DeFi?

DeFi in simple terms is "Decentralized Finance", where any financial transaction starting from the basic simple transfers to complex operations are done without the involvement of a third party. Here, in this method, the control of the finance is distributed among the users of the network. It allows the use of cryptocurrencies for conducting financial transactions like that of the traditional banking activities with fiat currency. However, all the activities are carried out without the interference of a third party. DeFi is known to be simpler, cheaper, and quicker and offers several other advantages and differentiated services. With DeFi, users can easily access their assets via a secure digital wallet. Users enter into smart contracts to perform transactions. There are numerous services available with DeFi, including peer-to-peer lending for trading, etc. 

How is DeFi Different from Centralized Finance?

DeFi is unlike its counterpart-Centralized Finance, which is the default method of conducting financial activities that is used by the world today. In the centralized finance ecosystem, all the financial transactions are carried out via third parties and middlemen with heavy supervision from local regulators. Users have limited access to financial services and not everyone is allowed to open a bank account. Centralized Finance means control and central authority, where the third party like a bank has complete control over all financial decisions and activities.  In Centralized Finance, the banks offer small interest on the amount a user deposits by loaning it to another customer at a higher interest rate, and extract profit on the differences.  In DeFi, users earn full amount of interest paid by borrower. DeFi- Decentralized Finance is powered by the idea of eliminating these middlemen and make financial services highly accessible. Thus, DeFi is far more accessible, cheaper and flexible given there is no limitation in transaction or trading hours unlike its counterpart- centralized finance. 

The Technology that Powers DeFi

DeFi is powered by blockchain technology that enables users to perform financial transactions free of regulatory oversights and easy handling of ones own finances on a peer-to-peer level. It is built on DLT- Distributed Ledger Technologies. The DeFi applications are designed to interface with blockchain and are installable on multiple devices, including smartphones, personal computer, laptops or tablets. The DLT application provides on-chain financial transactions and products like lending, borrowing, investing or exchanging assets in cryptocurrencies. 

How Does De-Fi Work?

DeFi leverages smart contracts to conduct transactions. In DeFi, there is no requirement for a guarantor to perform financial transactions, rather participants/users transact among themselves and interact with one another directly. All the activities and transactions are secured by blockchain technology and allow users to take control of their own asserts. Users can access their funds/ finance by leveraging a secure digital wallet. Whenever a user wants to perform a transaction, they can initiate the transaction using smart contracts. This action means the user and the other participant enters into an agreement with a number of determined conditions. 

Characteristics of De-Fi Applications 

Decentralization: In place of centralized institutions, in De-Fi, codes serves as the only intermediating agent in the process. Changes to the code are typically made democratically, endorsing voting through community governances.

Open and No-permission required: The accessibility is open and there is no border. Any interested individual can access their existing account and create their own DeFi application. The only tool required is to have a device with strong internet connection. 

Transparency: Every user of the blockchain has access to code that serves as the controlling agent, which allows transparency of the operation and transactions. This transparency feature allows users to audit and verify their transactions and services at will.

User-centred: The DeFi application is more user-centric as it incentivises the users directly for their participation in the service such as offering liquidity for lending, etc. Users have the freedom to access their service from a publicly hosted device or from their individual custom interface.

Cross-chain Interoperability: This is another significant characteristic of DeFi application, whereby services are interoperable, meaning users can exchange messages and token across different networks, powered by the cross-blockchain network.

Composable: Powered by broad interoperability, numerous unique De-Fi accounts and services can be used in tandem to provide enhanced user experience or to enable composing of net-new applications offering more value to users.  

Risks associated with DeFi

While DeFi serves as a cheaper, quicker and more accessible alternative to the traditional financial system, it comes with several challenges and risks. Owing to less regulation, DeFi lacks the protection level that is usually provided by regulated service providers. Users must be mindful of the risks involved and consider some of the following points before engaging with DeFi:

• Absence of regulation on who can use DeFi, thus any individual can have a Crypto wallet
• Be mindful of not investing more than what you can afford to lose
• Absence of DeFi consumer protection, so users may not have the chance to get their money back in case of a wrong transaction
• Presenting collateral in digital assets to the blockchain for borrowing funds. 
• Requirement of private key for accessing digital wallet, known only to user. Hence, in case a user loses the key, there is no chance for accessing their funds

DeFi is evolving rapidly, and almost every public blockchain today is prioritizing DeFi. Some real-world examples of DeFi are DeFi Stablecoins, DeFi Currency exchanges, DeFi lending, etc. Like any other technological growth, there are many opportunities that DeFi presents. However, leveraging it will come its share of positives and negatives. Investors only need to be knowledgeable to use. 

What id Defi? Characteristics of De-Fi Applications Risks associated with DeFi How does De-Fi Work?