What Is Decentralized Finance (DeFi) and How Does It Work?

What Is Decentralized Finance (DeFi)?

Decentralized finance (DeFi) is an emerging financial technology based on secure distributed ledgers similar to those used by cryptocurrencies.

In the U.S., the Federal Reserve and Securities and Exchange Commission (SEC) define the rules for centralized financial institutions like banks and brokerages, which consumers rely on to access capital and financial services directly. DeFi challenges this centralized financial system by empowering individuals with peer-to-peer digital exchanges.

DeFi eliminates the fees that banks and other financial companies charge for using their services. Individuals hold money in a secure digital wallet, can transfer funds in minutes, and anyone with an internet connection can use DeFi.

Understanding Decentralized Finance (DeFi)

Decentralized finance differs from traditional, centralized financial institutions and banking.

Centralized Finance

In centralized finance, money is held by banks and third parties who facilitate money movement between parties, with each charging fees for using their services. A credit card charge starts from the merchant and moves to an acquiring bank, which forwards the card details to the credit card network.

The network clears the charge and requests a payment from the bank. Each entity in the chain receives payment for its services, generally because merchants must pay for the use of credit and debit cards.

All financial transactions are overseen in centralized finance, from loan applications to a local bank’s services.

Decentralized Finance

Decentralized finance eliminates intermediaries by allowing people, merchants, and businesses to conduct financial transactions through emerging technology. Through peer-to-peer financial networks, DeFi uses security protocols, connectivity, software, and hardware advancements.

Wherever there is an internet connection, individuals can lend, trade, and borrow using software that records and verifies financial actions in distributed financial databases. A distributed database is accessible across various locations as it collects and aggregates data from all users and uses a consensus mechanism to verify it.

Decentralized finance eliminates the need for a centralized finance model by enabling anyone to use financial services anywhere regardless of who or where they are. DeFi applications give users more control over their money through personal wallets and trading services that cater to individuals.

How Does DeFi Work?

Decentralized finance uses the blockchain technology that cryptocurrencies use. A blockchain is a distributed and secured database or ledger. Applications called dApps are used to handle transactions and run the blockchain.

In the blockchain, transactions are recorded in blocks and then verified by other users. If these verifiers agree on a transaction, the block is closed and encrypted; another block is created that has information about the previous block within it.

The blocks are “chained” together through the information in each proceeding block, giving it the name blockchain. Information in previous blocks cannot be changed without affecting the following blocks, so there is no way to alter a blockchain. This concept, along with other security protocols, provides the secure nature of a blockchain.

Uses of DeFi

Peer-to-peer (P2P) financial transactions are one of the core premises behind DeFi. A P2P DeFi transaction is where two parties agree to exchange cryptocurrency for goods or services without a third party involved.

In DeFi, P2P can meet an individual’s loan needs, and an algorithm would matches peers that agree on the lender’s terms, and a loan is issued. Payments from P2P are made via a decentralized application, or dApp, and follow the same process in the blockchain. Using DeFi allows for:

• Accessibility: Anyone with an internet connection can access a DeFi platform and transactions occur without any geographic restriction.

• Low fees and high-interest rates: DeFi enables any two parties to directly negotiate interest rates and lend money via DeFi networks.

• Security and Transparency: Smart contracts published on a blockchain and records of completed transactions are available for anyone to review but do not reveal your identity. Blockchains are immutable, meaning they cannot be changed.

• Autonomy: DeFi platforms don’t rely on any centralized financial institutions and are not subject to adversity or bankruptcy. The decentralized nature of DeFi protocols mitigates much of this risk.

Advantages and Disadvantages of DeFi

The Future of DeFi

Decentralized finance is constantly evolving. It is unregulated and its ecosystem is riddled with infrastructural mishaps, hacks, and scams.

Current laws were crafted based on the idea of separate financial jurisdictions, each with its own set of laws and rules. DeFi’s borderless transaction ability presents essential questions for this type of regulation.

Who is responsible for investigating a financial crime that occurs across borders, protocols, and DeFi apps? Who would enforce the regulations, and how would they enforce them?

Other concerns include system stability, energy requirements, carbon footprint, system upgrades, system maintenance, and hardware failures.

The Bottom Line

Decentralized finance (DeFi) is an emerging financial technology that challenges the current centralized banking system. DeFi eliminates the fees that banks and other financial companies charge for using their services and promotes the use of peer-to-peer, or P2P, transactions.

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