DeFi is short for decentralized finance that includes digital assets, protocols, smart contracts, and dApps built on blockchain.
We can think of DeFi as an open financial ecosystem where various small financial tools and services can be built in a decentralized way.
These can be combined, modified, and integrated according to your needs.
For people, taking care of their finances is one of the most important things on a day-to-day basis. Searching for new forms of investment is somewhat complicated and more if you do not have someone close to you who really understands market fluctuations. The trend in the world is to decentralize finances and it represents a challenge. Therefore, DeFi is a trend in the crypto space. But... What is DeFi? How does it work? Here, a little guide.
Current economic outlook
The traditional financial market is centralized. The central authorities issue the regular currency that drives our economy and is used for every business, such as the government and banks. Therefore, the power to manage and regulate the flow and supply of such currencies in the market resides in them. We also pass control of our assets to various financial organizations, such as banks, with the expectation of obtaining higher returns. The funds are centralized, the risks too.
What if central bodies decided to print more of this kind to deal with a financial crisis and it failed? Take the case of the Venezuelan government: its poor monetary policies, including printing large amounts of money amid falling oil prices, resulted in inflation in excess of 1,000,000% according to IMF data. This has destroyed their economic balance.
You leave the money in banks and other financial institutions to save and often make fixed and recurring deposits for profit. These organizations invest that money in equity markets and make loans at high-interest rates for huge profits. But only a small fraction of that is returned to depositors. With the global inflation rate hovering around 3.64%, the real value of this yield becomes even lower.
The answer to this is investing. You look for financial brokers to advise you on schemes, mutual funds, and stocks on the market, in exchange for a cut in your performance. The return here is more, but it is risky, as advisers can also make mistakes or not see market risk. So you receive only a fraction of the investment money.
Bitcoin and other cryptocurrencies have offered a form of secure peer-to-peer trading without the need for intermediaries, such as a bank, for trade settlement. This gives users complete control over their assets.
However, keep in mind that these cryptocurrencies have not really decentralized the financial system. They have just decentralized the issuance of money and its storage. There are a couple of issues that prevent blockchain from making the financial system truly decentralized. While cryptocurrencies are decentralized, they can mostly be accessed through centralized access points like exchanges. In turn, the projects are managed through centralized companies.
What is DeFi?
DeFi is short for decentralized finance. Decentralized finance includes digital assets, protocols, smart contracts, and dApps built on the blockchain. Given the flexibility and the amount of development, the Ethereum platform is the main choice for the DeFi application, but that does not mean that it is the only blockchain platform.
Think of DeFi as an open financial ecosystem where various small financial tools and services can be built in a decentralized manner. As these are applications built on a particular blockchain, they can be combined, modified and integrated according to your needs.
DeFi gives people control of their own assets. Although many banks and new-age fintech companies promise to provide more control to users, in reality, they still manage your funds. DeFi's goal is to give you full control of your assets - it's all achieved from decentralization and blockchain technology. Also, many financial app developers are adopting open-source protocols to trade through decentralized exchanges.
The fact that all the protocols are open source allows anyone to create new financial products on top of them. Developers around the world can collaborate with each other to create new products that lead to faster innovation and a secure network. Anyone can safely store, trade, and invest their blockchain assets and get a much higher return than the traditional financial system. As there are no intermediaries to manage your assets, the same person has full control over your investments.
The various products involved in DeFi are also collectively known as open finance, as it is an ecosystem in which blockchain, digital assets, open protocols are integrated with conventional financial structures.
Open loan protocols
It is a digital money lending platform built on a blockchain. Open lending protocols have become the most popular among other open finance sectors in recent years, thanks to the recent extensive use of Dai, Dharma, and Compound Finance.
Like a bank, users deposit their money and when someone else borrows the digital assets, they earn interest. However, instead of intermediaries, here smart contracts dictate loan terms, connect lenders and borrowers, and take care of spreading interest. Due to the inherent transparency of the blockchain and the absence of intermediaries, the lender makes higher profits and more clearly understands the risks.
The open lending protocol is strictly based on a public blockchain like Ethereum, and due to the importance of its ability to lend digital assets, it can be widely adopted globally.
It offers several advantages over traditional loan / credit services: integration with digital asset loans or loans; collateralization of digital assets in the event of loan default; instant transaction settlement and new guaranteed loan methods; standardization and interoperability that can also reduce costs with automation, and without credit checks, which means broader access to people who cannot access traditional services.
MakerDAO has become the most prevalent decentralized loan protocol. Other protocols of this type are Dharma and BlockFi. The latter allows users to borrow and lend digital assets, but employs credit models known as credit checks and a company that processes loan applications on the backend.
In the crypto space, it is said: "A system is decentralized only as its most central component." This is partly true, as decentralization exists sequentially and at multiple levels. The degree of decentralization in DeFi services varies as not all components can and should not be decentralized.
Some DeFi tools have undergone security audits; for example, Dai has received four security audits so far. In addition, there are companies such as Nexus Mutual that have taken the initiative to develop insurance to cover problems such as the breach of smart contracts.
The DeFi market is small compared to traditional finance, but it has accelerated rapidly since last year. With more projects and financial dApps, we can hope to achieve a genuinely decentralized financial reality where the traditional financial market inter-operates with digital assets and blockchain in perfect synchronization.