What to know about decentralized finance?

Crypto markets rely on various forms of intermediation. While some forms of crypto intermediation have direct analogues in traditional finance, others – known as decentralized finance, – are fundamentally new and have recently gained popularity.

Decentralized finance provides financial services without centralized intermediaries, operating via automated protocols on blockchains. Decentralized finance is rapidly growing as a safer, more transparent and more efficient alternative to traditional financial services.

By eliminating the need for centralized financial institutions, we are creating a financial system more open and more reliable, and much more accessible. Secured by blockchain technology, decentralized finance will reduce the risk of fraud, corruption and mismanagement of your assets.

It will also make finance management much more cost-effective and efficient, with no more overdraft fee, more costs for electronic transfers and no more waiting during banking hours for a transaction to be verified.

In this other article, the team of Finance de Demain gives you a briefing on what you need to know about decentralized finance. Let's go

???? What is decentralized finance?

Decentralized finance, or DeFi ”, is an emerging digital financial infrastructure that theoretically eliminates the need for a central bank or government agency to approve financial transactions.

Considered by many to be an umbrella term for a new wave of innovation, DeFi is deeply connected to the blockchain. Blockchain allows all computers (or nodes) on a network to hold a copy of transaction history. The idea is that no single entity has control or can modify this record of transactions.

Most of the financial services that could be defined as DeFi are found on the Ethereum network. This network is theXNUMXnd largest cryptocurrency market. It also acts as a platform for other blockchain applications to be built.

Using decentralized applications, or dApps, two or more parties can trade, lend, borrow and exchange directly using blockchain technology and smart contracts without the involvement and costs of intermediaries. It's a fair, free and open digital market, at least in theory.

???? How to understand decentralized finance?

The term decentralized finance, or DeFi for short, describes a financial system that operates without traditional, centralized intermediaries. We're used to everything going through a bank and other financial institutions like a global exchange, but DeFi creates a system that can run on its own.

To understand decentralized finance and how it works, it helps to understand how centralized finance differs from DeFi.

🔰 Centralized finance

In centralized finance, your money is held by entities whose primary purpose is to make money. The financial system is full of third parties who facilitate the movement of money between parties, each charging a fee for usage of his services.

For example, let's say you buy a gallon of milk using your credit card. The fee is charged by the merchant to an acquiring bank, which passes the card details to the credit card network.  

The network clears the fee and requests payment from your bank. Your bank approves the charge and sends the approval back to the network, through the acquiring bank, to the merchant. Each entity in the chain receives payment for its services, usually because merchants must pay for your ability to use credit and debit cards.

All other financial transactions cost money; loan applications can take days to be approved; you may not even be able to use the services of a bank if you are traveling. However, with decentralized finance, things change.

🔰 Decentralized Finance

Decentralized finance cut out middlemen by enabling individuals, merchants and businesses to conduct financial transactions through emerging technology.

This is accomplished through peer-to-peer financial networks that use advanced security protocols, connectivity, software and hardware.

Anywhere you have an Internet connection, you can lend, trade, and borrow using software that records and verifies financial actions in distributed financial databases. A distributed database is accessible from different locations; it collects and aggregates data from all users and uses a consensus mechanism to verify it.

Decentralized finance uses this technology to eliminate centralized finance models by allowing anyone to use financial services anywhere, no matter who or where she is.

DeFi apps give users more control over their money through personal wallets and trading services that cater to individuals. Finally, we can say that decentralized finance accelerates financial inclusion.

???? How does decentralized finance work?

Rather than a bank facilitating transactions and services between parties, DeFi uses technology. However, two main components make a financial system work: an infrastructure and a currency.

In a centralized system, banks and financial institutions act as this infrastructure. Fiat currency, like the US dollar, acts as money. Decentralized finance must replace these components to offer a complete range of financial services.

🔰 Infrastructure

Ethereum is a platform for writing decentralized programs. Thanks to Ethereum we are able to create smart contracts.

Using these contracts, you can establish a set of rules for how a financial service operates and deploy those rules on Ethereum. Once a smart contract has been deployed, it cannot be changed.

Users can create decentralized applications on Ethereum to establish any financial service and allow smart contracts to manage these services autonomously.

🔰 Currency

In order to create a reliable and secure decentralized financial system, you need a stable currency. Bitcoin is not compatible with the Ethereum platform, and Ether – Ethereum’s own programmable cryptocurrency – is very volatile. So you need a stable currency or currency, the " stablecoin ».

A stablecoin is a cryptocurrency that matches its value with fiat currency. DAI is a decentralized stablecoin pegged to the US dollar. Which means that 1 DAI has a value equal to 1 USD.

DAI's value is backed by cryptocurrency collateral, rather than being backed directly by US dollar reserves. Due to its stability, DAI is the ideal currency for decentralized finance.

???? Decentralized financial services

The benefits of a decentralized financial system go beyond online payments, P2P payments. Money transfer is only one aspect of the traditionally centralized financial system.

Decentralized finance seeks to replace all aspects, including exchanges, the loans, the insurance and savings plans. Smart contracts on Ethereum allow these decentralized services to exist and operate in a fair and secure manner. Below are some of the financial services already supported by Ethereum:

🔰 Decentralized borrowing and lending

With centralized finance, lending and borrowing money revolves around the individuals involved. Banks need to know if you are likely to repay a loan before lending.

However, decentralized lending works without any party having to identify themselves. Instead, the borrower must provide collateral that the lender will automatically receive if their loan is not repaid. Some lenders even accept NFTs as collateral.

You could, through decentralized finance, get a loan in minutes. This, without having to go through a complicated or cumbersome application process.

Compound is an Ethereum-based application that facilitates decentralized peer-to-peer borrowing and lending. Compound automatically connects lenders to borrowers and autonomously manages loans using smart contracts.

This has led to a growing popularity of what is known as “yield farming”, as anyone can lend their crypto assets and earn interest in the process. You can also use Compound to post your cryptocurrency as collateral and borrow fiat money against it.

🔰 Decentralized Exchanges

The Decentralized Exchange (DEX) allows us to buy, sell and trade cryptocurrencies on the Ethereum platform. This without having to go through an exchange operator; without the need for registrations or identity verification; and no fees for withdrawing funds.

Urban artist exchange with DEX requires no initial deposit, unlike centralized exchanges. Transactions are executed autonomously, with the terms and process guided by smart contracts.

🔰 Decentralized insurance

Smart contracts in the decentralized financial system also make decentralized peer-to-peer insurance possible. In a decentralized financial system, you can connect with anyone in the world that wants to insure your assets.

At the other end, you can insure other people's assets for a premium, without ever having to go through an insurance company or agent.

Everything happens autonomously, with smart contracts guaranteeing a fair, secure and trustworthy process.

???? What future for decentralized finance?

We observe a quantum leap in new functional possibilities money through the innovation of distributed ledger technologies. For the first time in history, a global financial system for a global population is shaped by this same population.

Anyone can participate in the governance of DeFi protocols and take a seat at the table where the world of decentralized finance is actively being created.

The DeFi space is gradually catching up with the traditional financial system. Despite certain obstacles, the world of decentralized finance is on the path to prosperity. Over time, it is difficult to predict how this space will take shape when the power to build financial services is democratized.

However, as DeFI and fintech map out and merge, we will have an inflection point where nascent fintech is only part of a new financial system. The one who realizes the dream of being fast, safe, available and equal.