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What is DeFi? Decentralized Finance Explained

What is DeFi?

DeFi is short for Decentralized Finance and it’s an umbrella term used to refer to any financial services on public Blockchains. DeFi allows you to do pretty much everything that a bank would, such as earn interest, buy insurance, lend or borrow, trade assets or derivatives, and so on.

But unlike traditional finance, in theory, DeFi could work faster, it doesn’t ask you to deal with paperwork, nor does it rely on authorities like a bank or government to control everything. As is the case with crypto, DeFi is global, peer-to-peer, pseudonymous, and open to everybody.

 

DeFi Financial Instruments

DeFi has its own financial instruments which make it stand apart, such as the Universal Market Access, a protocol for Smart Contracts on Ethereum. This is a synthetic-asset protocol that allows anyone to recreate traditional financial products, exotic crypto-based products, and more.

Yearn.finance is an aggregator meant to maximize profits through yield farming.

But DeFi also has the same components as the already existing financial ecosystem, meaning it needs stable currencies and a large variety of use cases.

One of the most important features of DeFi are Decentralized Exchanges or DEXs. A DEX lets people trade digital assets in a non-custodial way without having to rely on the services of a third-party service provider or intermediary such as a bank.

DeFi uses stablecoins and services such as crypto exchanges and lending and borrowing services. Smart contracts are responsible for the framework needed for DeFi apps to function, as they encode the terms and activities needed for these services to work.

As an example, we can say that a smart contract code has a specific code that creates the exact terms and conditions of a loan between two individuals or entities. 

In the case that some terms or conditions aren’t met, collateral can be liquidated. This happens completely automatically, with the help of a specific code.

 

DeFi Versus Traditional Finances

There are several things that stand in direct opposition when we compare DeFi with traditional finance, with the most important one being the fact that:

DeFi allows you to hold your own money, while in traditional finance, your money is always held by a company.

In DeFi, a transfer of funds can last only a couple of minutes, no matter the amount you are sending, even if there is the equivalent of millions of dollars involved.

In traditional finance, a payment between different Banks can take several hours to be processed and moving large amounts of money through banks can be a very difficult process.

DeFi markets are always open, while traditional finance means that the markets get closed since employees need their break too.

In DeFi, transaction activity is anonymous, while in traditional finance, your financial activity is tightly connected to your identity.

Additionally, DeFi is open to literally everybody, while you must fill out an application in order to use conventional financial services.

Also worth mentioning is the fact that DeFi is built on transparency, which means that anybody can check the history of a product and its data, how it works etc. 

Traditional financial institutions are closed to the public, as only the Bank and the Tax Administration are allowed to see loan history and the management of such assets.

 

DeFi Advantages and Risks

DeFi comes with certain advantages such as not having to deal with human error as smart contracts take charge. 

It also allows you to receive a crypto loan using only a few clicks, any time during the day or night, unlike the services of a bank. 

Furthermore, DeFi uses permissionless operation – instead of waiting for approval from your bank to withdraw any sum of money, DeFi lets you do this without permission.

But, of course, DeFi has its own drawbacks such as uncertainty – for example, in the case that a Blockchain hosting a DeFi project is not stable, the project won’t be stable either.

Scalability is another problem for DeFi since in the case that a Blockchain is crowded, transactions will take longer to be confirmed and they also become more expensive.

If a smart contract has a flaw in its code, there is a chance funds will be lost. Other problems DeFi has to solve are over-collateralization and low interoperability.

 

Conclusions

DeFi is an all-encompassing term that refers to transactions happening on a Blockchain.

With DeFi, you can do most of the things that one can do with a bank, like borrow, lend, earn interest, trade assets and derivatives etc.

The difference stems from the fact that DeFi is global, peer-to-peer, anonymous, doesn’t use a centralized system, and is open to all.

Meanwhile, the risks of a bank blocking your account or putting an embargo over it for various reasons are much higher.

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