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

In most parts of the world, the Federal Reserve, Securities, and Exchange Commission (SEC) determine the rules for centralized financial companies like banks and brokerages, which consumers depend on to access capital and financial services directly. Meanwhile, Decentralized finance (Defi) challenges the centralized financial system by empowering individuals with peer-to-peer digital transactions. So, making it a big question as to what this daring solution to curb agencies monitoring transactions entails. Here we’ve carefully defined what decentralized finance is. More so, how it works.

Meanwhile, Defi removes the fees that banks and other financial institutions charge for using their services. This is one of the great benefits of the initiation of Defi technology.

what-is-decentralized-finance-defi-and-how-does-it-work

We urge you to take your time to read about all the dos and don’t of Defi on this page. Our group of professionals has painstakingly explained Defi using simple illustrations.

What is Centralized Finance?

On a short note, centralized finance simply includes having a central body governing the fluidity of finance in an economy. Thus, centralized involves organizations like banks and third parties that facilitate money movement between parties. However, each part charges its fees while using its services for transactions.

In centralized finance, the credit card charge begins from the merchant and moves to the acquiring bank, which forwards the card details to the credit card network. Thus, the network collects the charge and then requests a payment from the bank. Each body of the flow receives payment for its services, principally because merchants have to pay for the use of debit and credit cards.

In centralized finance, an entity oversees all financial transactions from loan applications to local bank services.

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What is Decentralized Finance (Defi)?

In a nutshell, decentralized finance is simply the contrast to centralized finance. It eliminates intermediaries in conducting financial transactions by allowing people, merchants, and businesses to do it themselves through emerging technology. Through peer-to-peer financial networks, DeFi uses the security protocol, software, software, hardware, and connectivity advancement

Furthermore, provided that there is an internet connection, individuals can trade, lend, and borrow using software that verifies and records financial actions in distributed financial databases. You can thus, access a distributed database across various locations as it collects and stores data from all users and uses a consensus mechanism to validate it.

Additionally, decentralized finance removes the need for a centralized finance model by allowing anyone to use financial services anywhere irrespective of who or where they are. Consequently, DeFi applications give users more control over their money with the help of personal wallets and trading services catering to them.

How Does DeFi Work?

Now we’ve given a brief disclosure of how decentralized finance (Defi) works. Defi uses the same blockchain technology used in cryptocurrencies. A blockchain is a shared and secured ledger or database. In the blockchain, we use applications called dApp to handle transactions and run the blockchain.

Meanwhile, In the blockchain, we record transactions in blocks and then approved them by other users. Once the users agree on a transaction, the block becomes closed and encrypted. While another block that has information about the previous block within it opens.

Nonetheless, blockchain simply includes blocks “chained” together through the information in each proceeding block, giving it the name blockchain. One cannot change the information in previous blocks without affecting the following blocks, so making it difficult to alter a blockchain. This theory, along with other security protocols, yields the secure nature of a blockchain.

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Uses of Defi

One of the core backgrounds behind Defi includes peer-to-peer (P2P) financial transactions. While a P2P Defi transaction means when two parties agree to exchange cryptocurrency for goods or services without a third party involved.

Also, in Defi, P2P can meet an individual’s loan needs, as an algorithm that matches the peer’s agreement on the lender’s terms, and the loan becomes validated and issued. However, some of the more elaborate uses of DeFi include;

#1. Accessibility:

Decentralized finance (DeFi) is easily accessible. Thus, anyone with an internet connection can access a DeFi platform. Hence, transactions occur without regard to geographic location.

#2. Low fees and high-interest rates:

DeFi facilitates any two parties to directly bargain interest rates and lend money through DeFi networks.

#3. Security and Transparency:

In DeFi anyone can review the smart contracts published on a blockchain and records of completed transactions without revealing their identity. Also, Blockchains are immutable, which means they cannot be changed.

#4. Autonomy:

DeFi platforms don’t depend on any centralized financial institutions. Also, they are not subject to adversity or bankruptcy. The decentralized nature of DeFi protocols reduces much of this risk.

Advantages and Disadvantages of Decentralized DeFi

Pros

  • Decentralized applications make it easy for individuals to transfer funds around the world
  • Investor’s ability to generate income
  • It has high level of security

Cons

  • Understanding the complexity of DeFi is difficult.
  • It has a high risk of fraud and scams
  • High level of volatility
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Frequently Asked Question About Decentralized Finance (DeFi)

What Does Decentralized Finance Do?

DeFi’s major goal challenges the use of centralized financial institutions and third parties involved in all financial transactions.

Is Bitcoin a Decentralized Finance?

Bitcoin is a cryptocurrency. While DeFi has a designed to use cryptocurrency in its ecosystem, so Bitcoin is not DeFi as much as it is a part of it.

What Is Total Value Locked in DeFi?

Total value locked (TVL) includes the sum of all cryptocurrencies loaned, staked, deposited in a pool, or used for other financial actions across all of DeFi. Meanwhile, it also represents the sum of specific cryptocurrencies used for financial activities, such as bitcoin or ether.

Conclusion

If you deeply want to engage in decentralized finance (Defi) beyond the basics of crypto trading, ensure you proceed carefully and work with a reliable counterparty. Also, ensure to consider other risks involved and avoid becoming so overwhelmed by the potential return.

Hence, always remember a decline in cryptocurrency markets can rapidly wipe out any small gains from yield farming. Even outright scams or theft could wipe out your crypto wealth just faster. So be careful. Meanwhile, if you have further questions do not hesitate to ask us in the comment box below.

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