DeFi, or decentralized finance, is a "permissionless" way of making transactions between two parties. These transactions use public blockchains that allow open access to validation and mining. They are also used to buy, sell and trade digital assets, like Bitcoin.
DeFi projects use dApps (decentralized applications) that anyone can develop and customize.
How DeFi Works
Like Bitcoin, DeFi's software runs on a blockchain that makes every transaction immutable, tamper-free, pseudonymous and public. All nodes on the network accessed by dApp keep an accessible record of transactions between cryptographic addresses.
DeFi operates primarily on the Ethereum blockchain, but there are projects that run on other networks, such as Binance. Additional networks that include Cardano, Solana and Polkadot are also emerging as DeFi adoption grows.
DeFi eliminates the need for an intermediary or agent through smart contracts, while removing technological and regulatory barriers to entry.
Smart contracts are automated, blockchain-based protocols that are fulfilled when certain conditions are met. Anyone with a network connection can make or enter into a financial transaction with another user through a smart contract.
This removes third-party and centralized controls, making financial transactions borderless and free from regulatory mediation.
Multi-chain protocols are likely to dominate the growth of DeFi, as users develop and execute smart contracts across different blockchains. dApps with cross-chain compatibility are also likely to emerge as favored instruments for financial transactions.
DeFi Benefits
DeFi is inclusive and borderless because any user can enter into an agreement and develop a smart contract through dApps. The tedious "Know Your Customer" process, used by banks and brokers to ensure transaction authenticity, is completely avoided. This allows anyone to enter into a financial agreement.
There are no mediating agents or middlemen, significantly lowering financial transaction fees. Transactions also process faster, bypassing the lengthy verification process often required by banks and brokers.
The flexibility and options available in DeFi are also advantageous, allowing users to choose between several dApps or develop their own, based on the nature of the transaction and preferred features.
Loan Collateral And Income Generation
DeFi supports several methods of using assets as collateral for loans. Users can transact through a stablecoin like Tether, or the native token of a DeFi blockchain like Ether. Even real-world and physical assets are accessible through securitized tokens as collateral for loans.
Bad debt is a major banking risk that can take weeks to identify and mitigate. However, a DeFi network can identify bad debt instantaneously, thanks to the digital distributed ledger that dApps use.
dApps can also interact with each other, helping users find ways of generating income from their digital assets on a DeFi network. For example, it is possible to convert Ether to the stablecoin Dai cryptocurrency and place it in a DeFi protocol. This allows the asset to earn interest.
Alternatively, users can place the stablecoin into a liquidity pool, earning transaction fees.
Since fiduciary processes do not exist in DeFi, financial tools that were not available without a bank account are now within reach. This is another way in which DeFi makes finance inclusive.
In addition, Ethereum or a similar blockchain preserves transaction history, making it is faster and cheaper to verify the financial instrument's authenticity.
