DeFi, or Decentralized Finance, is a major change in the way we use money and the way financial services are provided. Rather than having to rely on banks, brokers, or other traditional financial intermediaries, the DeFi system uses blockchain technology to provide an environment for creating financial services that operate automatically and also to provide transparency to these financial services.
The underlying premise of DeFi is that there are three primary components. First, there are smart contracts, or codes, that execute themselves when the conditions of the contract are met. Second, there are decentralized protocols for the operation of the DeFi system. Finally, DeFi operates on crypto tokens, which are digital representations of value or ownership.
As an example of the above are lending platforms like Compound and Aave. These platforms are automated lending systems where you can lend cryptocurrency and earn interest or borrow cryptocurrency by providing collateral. In both cases, the process occurs without a loan officer's review of your application and without the bank holding your funds. The smart contract enables these transactions and enforces predetermined rules.
How DeFi Works: From Smart Contracts to Decentralized Protocols
It is not difficult to understand how DeFi works. It works in a straightforward manner through a streamlined workflow that eliminates the need for any human middlemen, known as gatekeepers, between the parties involved in a financial transaction.
To use a DeFi service, all that is needed is for a user to connect their digital asset's "wallet" (e.g., a wallet like MetaMask) to the DeFi platform they wish to use. This wallet acts as an individual's identity in the DeFi ecosystem; no usernames or passwords are required. Any time an individual would like to perform an action such as making a transaction, exchanging tokens, or receiving a loan, they do so through the application's platform.
Types of DeFi: Key Categories Every Crypto Trader Must Know
DEXs (decentralized exchanges) provide individuals with the means to directly trade cryptocurrency with other traders. The two biggest decentralized exchanges are Uniswap and SushiSwap, which allow the trader to exchange cryptocurrency directly from their own wallet instead of through an intermediary such as a centralised exchange (CEX) where the company that operates the exchange stores the funds.
Automated lending and borrowing services such as Aave and Compound allow users to act as banks by depositing their crypto and earning interest or pledging it as collateral for loans against other digital assets. The interest rates on Aave and Compound are set via smart contracts based on supply and demand and do not require any human intervention or approval to adjust them.
Advantages of DeFi: Why Traders and Investors Should Care
"True Decentralization" essentially means that no single entity or organization controls your funds. The bank can suspend your account, reject your transaction, and/or potentially go out of business. DeFi executes the transactions using computer "codes" and does not utilize any corporate discretion. Unless you, as the owner of funds, choose to transfer them, your funds do remain your funds.
Future Trends of DeFi: Why It Will Reshape Global Finance
DeFi has not yet reached its full potential. The evolution of DeFi will be drastic over the next few years, with many new features on DeFi platforms that will make the current platforms appear very basic by comparison. The introduction of decentralized derivatives such as Complex Options Strategies and Synthetic Assets will bring the same level of sophistication found on Wall Street to everyone who has an internet connection.
Tokenizing real-world assets will create a new frontier for DeFi. Real estate, stocks, bonds and commodities will be traded on a 24/7 basis on Blockchain Technology and fractional ownership will allow retail investors to own fractions of asset classes that are currently only available to large institutions.
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