DeFi has continued to grow with the latest developments taking place in the sector every day. This article shares the foundational tenets of De Fi and its fundamental inner workings.
What is Decentralized Finance (DeFi)?
DeFi is short for decentralized finance. It is a financial services market that comprises of decentralized projects such as blockchains, decentralized exchanges, and other virtual currency projects. Decentralization is the quality of a financial service to exist without depending on a centralized entity such as traditional banks and government regulators.
Bitcoin blockchain introduced decentralization in the financial sector by introducing a digital ledger that can perform verified online transactions without using the traditional modes of payment.
How does DeFi Work?
The core component of decentralized finance is blockchain. Blockchains are able to remain decentralized as their operations are not dependent on direct human labor. All transactions on a blockchain are encrypted and it is not possible for miners or validators to discriminate towards a particular transaction based on its origin.
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At the same time, blockchains are largely automated meaning that they perform functions of traditional banking system such as teller using software. Blockchains store their data on any computer that is called a node that prevents single point of failure.
Smart contract is one of the most popular types of software that DeFi entities use that trigger functions when specified conditions are met. At type of popular DeFi entity is DAO or Decentralized Autonomous Organization that works as a fully automated organization that automates decisions and enables digital currency transactions.
DeFi projects such as Bitcoin incorporate consensus model such as PoW to validate the transactions on the platform. Blockchains are also decentralized as their circulatory supply is spread across the globe with no big commercial players having massive reserves.
Key Features of DeFi
Here are some important features of DeFi:
DeFi entities bring more financial inclusion for a greater number of people. Bitcoin adoption in El Salvador has allowed the largely unbanked population of the country to access digital currencies as a means of investment.
At the same time, DeFi projects are permission-less meaning anyone can participate in them without registration or approval.
One of the most important features of DeFi is Peer-to-Peer trading option. Investors can now directly trade with each other without the presence of a third-party investor.
There are many DeFi protocols that have smart contracts to ensure compliance from participants by creating a trading contract. In this manner, DeFi bring safer, cheaper, faster, and secure p2p trading options for cryptocurrency investors.
Low Transaction Fees
People around the world can face many hurdles when they are sending fiat currencies from one nation to another. However, this problem is eliminated when using DeFi services. DeFi is essentially borderless.
Cryptocurrency investors in DeFi can send and receive tokens to and from any part of the world as long as they have a working internet connection and a working digital wallet. At the same time, the remittance cost for digital currencies is much cheaper in comparison to existing traditional alternatives.
DeFi entities have made digital transactions secure than ever before. On account of the consensus mechanism and use of encryption technology, it is near impossible to duplicate, fake, or manipulate transaction records.
This is one of the reasons that many Central Banks and financial entities are upgrading their current payment channels with blockchain tech.
It is impossible to know what a bank or private financial firms do with the funds of their consumers. However, blockchains are usually open-sourced and public entities meaning that anyone can check the transaction records on them.
Some exchanges have introduced Merkle Tree system that allows their investors to cross-check their reserves to ensure that they have sufficient liquidity to remain operational.
Banks and governments may be able to freeze the reserves of a person who is at odds with the authorities. However, DeFi systems prevent censorship as miners or validators on the blockchain do not know the origin of a given transaction. It grants greater financial autonomy to investors.
DeFi offers many advantages such as faster and cheaper international transactions, financial inclusion, and robust security, etc. However, there are some visible risks associated with DeFi such as complexity, fraudulent activity, and massive volatility.
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