Blockchain technology has been a total changer for people worldwide. It is no surprise that more people have become interested in cryptocurrency and blockchain. Early adopters have claimed that investing in crypto assets has allowed them to grow their wealth significantly.
One of the basic concepts you must understand when it comes to the blockchain is decentralized finance or Defi. What is Defi, and how come it has become so relevant? This article will delve into the significance of Defi applications in the world today. It might even entice you to explore Defi applications yourself.
What is decentralized finance?
Decentralized finance, commonly known as DeFi, is an autonomous system that processes financial transactions without the help of an intermediary body. Instead of using financial institutions like banks in traditional finance, DeFi uses an application through blockchain technology. This is also known as the Defi protocol, connecting users directly. The products and smart contracts of DeFi applications ensure the fulfillment of all agreements.
While users can build DeFi apps on different blockchains, the Ethereum network has become the most popular and accessible option in recent years. DeFi apps skyrocketed in popularity in 2020, and their momentum continues to this day. The value of assets tied to DeFi contracts has increased exponentially in a few years.
What are smart contracts?
Smart contracts are essential in the world of decentralized finance. Why? They make it possible for users to create Defi apps on top of the blockchain. Smart contracts are computer programs or transactional protocols that automatically execute when relevant events are tied to a particular agreement. Ethereum is closely knit to smart contracts because this network was programmed to create smart contracts.
What makes DeFi so important?
If society shifts its attention and resources to Defi apps, the financial system and traditional financial institutions will be impacted as a whole. Many third parties like traditional banks are involved in the current financial system.
Most people store their fiat currency in savings accounts in a local bank. They usually use a financial institution to transfer fiat currency to family and friends digitally. Most financial services take a lot of time and can be expensive because of their transaction fees.
When it comes to DeFi platforms, you don't have to go through these processes and pay all the necessary fees. Thus, decentralized finance (DeFi) can help many people save money in the long run.
How does Defi differ from financial institutions?
Traditional finance is highly regulated, so many institutions such as the government are involved in keeping things running smoothly. Hence, there are many expenses involved. While the financial products of DeFi are close to the typical financial system, some key differentiators make DeFi unique.
First, there's a higher level of autonomy regarding financial transactions made through the DeFi protocol. DeFi platforms are not tied to the government; thus, permission is not needed to conduct transactions. Deals can be pursued without long waiting periods.
Next, there is better transparency when it comes to fees and transactions. Before a smart contract is made, all parties must agree to the terms. Thus, everyone is made aware of the costs involved in each transaction.
In addition, there is a greater trust in the technology involved in blockchain technology. Your bank account can be rendered vulnerable in the traditional financial system. DeFi protocols have a very sophisticated technology that makes it near impossible to get hacked. Thus, you are assured that your digital money is safe in a secure digital wallet.
However, the perks of the DeFi space are not without risks. DeFi is still in its early stages. With new territory comes new possible threats.
How come decentralized finance is so popular today?
The beginning of DeFi can be traced back to MarkDao, a platform launched in 2015. This platform allowed users to use crypto assets as collateral for loans.
Like traditional cryptocurrency, DeFi protocols promise to eradicate unnecessary intermediaries like a local bank. You would need a stable internet connection to access DeFi protocols. Traditional financial institutions have many costs, and you can bypass all the lengthy processes using a smart contract.
In 2009, Bitcoin was introduced as an alternative to traditional finance and financial authorities like banks. While digital assets like Bitcoin function as money, they still have limitations. The functionality of Bitcoin relies on a network of new centralized finance bodies that regulates transactions.
While these authorities have been helpful, they still held power over critical aspects which impeded the process. These include customers accessing their services, listed assets, and many more. A genuinely decentralized finance system should be run by the public alone.
When it comes to DeFi protocols and decentralized exchanges, there are no central authorities. All protocols are run by smart contracts designed to eradicate foul play and fraud. DeFi works as an open financial network that is decentralized and trustless. This transparency has attracted many investors. That is why assets in DeFi protocols have ballooned to billions in value today.
What are DeFi applications?
Now that we've established the nature of DeFi and relevance to the financial system, it's time to discuss Defi apps. First of all, decentralized finance already has dozens of different financial applications. More decentralized applications will inevitably be developed in the years to come. This is because the limits of DeFi are only defined by how well the smart contract is crafted.
Some users even utilize contracts to create prediction markets where people worldwide can make wagers on things like election results and sporting events. Some of the most significant modern DeFi services are coins, stablecoins, tokens, wallets, liquidity, mining and staking, trading, borrowing, lending, and saving.
As more blockchain networks that use DeFi space are introduced, they usually develop governance tokens to incentivize users to frequent their platform. These tokens are good as fiat currency, meaning they have value people can use for crypto transactions. They're digital currency tied to a blockchain network.
Some of the most popular coins today are Ether (ETH), Cardano (ADA), Solana (Sol), and Polkadot (DOT). The value of these coins is very volatile, which is why many people view them as a good investment.
Price fluctuations are common when it comes to a digital asset. This is why volatility has become the primary risk for cryptocurrencies.
The most popular solution to the system's volatility is stablecoins. A stablecoin is fixed to the value of an underlying asset, like fiat money or other exchange-traded commodities. The value of stablecoins is less likely to drop below the value of the asset it is tied to. There's less fluctuation in stablecoins, which adds to their appeal.
Although the volatility of crypto assets is attractive to traders, this can turn routine transactions such as digital purchases are risky endeavors for the buyer and seller. After all, most merchants don't want to suffer losses if the price of a crypto asset plummets after they are paid in that currency.
Stablecoins are more trustworthy alternatives for mediums of exchange. The price of stablecoins is maintained through the maintenance of reserve assets as collateral or algorithmic formulas intended to control supply.
Tokens are similar to cryptocurrency coins. These can also be a type of cryptocurrency. These tokens represent tradeable or fungible assets that exist in their blockchains. Crypto tokens are often used for fundraising for crowd sales, but they can be used for other things.
The main difference is that tokens are created on a pre-existing blockchain network. One can say that all coins are considered tokens but not all tokens are considered coins in the crypto industry. Tokens can represent myriad real-world uses, such as NFTs, stablecoins, and gaming.
While crypto coin transactions are done by blockchain, tokens rely on smart contracts. When a token is spent, it physically moves from one place to another.
Non-fungible tokens, or NFTs, are a unique type of token representing an asset with value like a song, video, or artwork. An NFT is a synthetic asset whose value derives from its underlying asset and tokenizes the relationship instead of a contract. NFTs are a way to demonstrate one's ownership through the blockchain.
There's no way to prevent other people from viewing or saving an underlying asset on their own devices. However, no one can make copies of the NFT itself. Only one person has the rights of an NFT, and anyone can verify their ownership through the blockchain. While the ownership of a certain NFT can be transferred, NFTs allow creators to earn royalties every time someone sells their NFT.
Most crypto transactions are usually done on a centralized finance institution because the typical crypto exchange is centralized and uses a third-party supplier to execute transactions. You understand what you're getting into when you purchase your first digital asset. In addition, the crypto wallet holds the key instead of you.
Likewise, DeFi wallets like Coinbase Wallet and Metamask Wallet are non-custodial. You still have possession of your crypto, but you're responsible for the private keys that allow you to access these wallets. When it comes to a DeFi wallet, you cannot simply request a new one like you would with a bank account.
Liquidity mining or DeFi mining should not be confused with proof-of-work mining. This type of mining involves pairing your digital assets, like coins or tokens and storing them in a liquidity pool. The purpose of doing this is so other users have the liquidity to facilitate trades between the two.
Yield farming is the process of locking up your crypto assets in exchange for a reward. When you're involved in yield farming, you borrow or lend crypto on a DeFi platform to grow your digital currencies in the long run.
Staking is a way for users to participate in the consensus algorithm in a proof-of-stake ecosystem. This process is similar to how miners create new blocks in a proof-of-work system. Both methods are essential in building blocks for a blockchain network.
However, staking assigns mining power based on a user's ownership stake. The more money you stake, the more returns you can enjoy. Staking is more environment-friendly than crypto mining, which adds to its overall appeal.
DeFi trading apps allow users to engage in crypto investment trading without going through centralized exchanges. As of now, the majority of cryptocurrency is centralized, just like how the stock exchange works.
A decentralized exchange is a crypto market that relies only on smart contracts and blockchain technology for trades to be executed. Hence, people can buy and sell from each other directly.
Borrowing, lending, and saving
Smart contracts facilitate exchanges so people can borrow or lend their cryptocurrency to other users worldwide without using human intermediaries.
DeFi savings account functions like a traditional bank account but offers higher interest rates. You can observe the return in real-time, and the payout can be done daily, weekly or monthly; the payout period depends on your platform.
What are the advantages of decentralized finance?
The financial products in DeFi have many advantages. First, transactions don't require permission. Traditional banks are expensive to run, which is why many fees and processes are involved. DeFi opens the financial system to everyone, regardless of race, location, or wealth. You need an internet connection and can connect to DeFi apps easily.
In addition, DeFi allows you to grow your income more than you would in a typical savings account. The interest rates in DeFi are much higher than in traditional banks.
When it comes to DeFi, you can have more control over your finances. While you must deposit your funds into a platform, you can choose what happens to them. A smart contract bypasses the need for intermediaries to do the job for you.
Lastly, the advantage of decentralized finance lies in transparency. Since most DeFi protocols are built on a public ledger, all activities are available to the public. Anyone can view transactions.
What are the disadvantages of decentralized finance?
On the other hand, DeFi has some security risks. First, smart contracts are open-sourced, and the design allows users to review them before investing their assets. Most DeFi protocols give their smart contracts to security firms for auditing purposes. These people might miss out on flaws, which can be exploited in the future.
Another disadvantage is that blockchain protocols can't access off-chain data. That's why most use oracles, third-party suppliers that provide access to external information. Oracles create a central point of trust in trustless and decentralized setups. If an oracle broadcasts false information, the consequences can be severe.
Lastly, while the technology may be sophisticated, it is not immune to hackers. Some hackers have successfully laundered money from people's crypto wallets.
In short, decentralized finance is not perfect, but it provides users with cost-efficient and fast options to conduct digital transactions. As with any investment advice, there are risks, but the rewards can be significant. The future looks bright as more people have embraced the world of cryptocurrency.