Anyone who’s ever bought or sold anything knows that most (if not all) financial transactions are mediated by banks, with the rest usually happening through another centralized service like PayPal or Cash App. But what if you didn’t need to send money the “traditional” way? That’s what decentralized finance (DeFi) seeks to achieve.

Read on to learn more about DeFi, how it works, and the potential benefits and drawbacks of participating. 

What Is Decentralized Finance (DeFi)?

Decentralized finance, or DeFi, refers to all financial applications and services available on public blockchains. Through decentralized exchanges, users can swap digital assets, apply for loans, and even park their digital money to withdraw at a later time – much like with regular banks with fiat currencies. However, unlike traditional financial systems, all these transactions occur without a centralized authority. 

That means you don’t need to provide any identifying document or even declare what the transaction is for. This unmatched level of privacy is combined with the verifiability of the blockchain, making it an exciting alternative to what’s currently on the financial market. On top of this, users are afforded a borderless transaction ability (meaning affordable transaction fees even when sending currency abroad). 

In short, DeFi can do everything traditional banks do while giving users near-total control of their experience.

How Does DeFi Work?

Now that we know how DeFi harnesses blockchain technology to influence the future of money, it’s crucial to understand how it works beyond the blockchain and smart contracts. Here are a few primary functions of DeFi.

Stablecoins

DeFi can’t be the future of finance without being related to centralized systems somehow, so stablecoin (such as Tether or USD Coin) serves as a bridge between the two systems. But how does it do that? The short answer is that these relatively stable trade assets have their values tied to the US Dollar.

For example, in the case of USD Coin, one USDC is minted every time a user makes a purchase and burned when it’s withdrawn to users’ bank accounts from a crypto wallet. As a result, folks can trade USDC for other crypto assets instead of buying through other centralized blockchain startups like Coinbase or Binance, which can take days before the transaction is completed. 

Lending And Borrowing

The modern financial market is built on the back of lending and borrowing, but there’s a significant risk on both sides. DeFi seeks to mitigate these risks through the use of smart contracts. But what do smart contacts do?

When users want to loan out blockchain cryptocurrency to other users, they need to find decentralized applications or borrowing platforms that can facilitate the trade, like AAVE. Afterward, the lender deposits their coins or virtual currency into the cryptocurrency market to earn interest. This is then reflected in the blockchain application’s smart contract, which ensures that the lender will always receive their currency plus interest, even if the borrower doesn’t pay it back.

But what about the other side of this trade? The borrower needs to “over-collateralize” their loan, meaning they leave crypto (usually ETH) in the AAVE markets equivalent to their loan amount.

Decentralized Exchanges

Decentralized exchanges are marketplaces where users can trade out one currency for another. This is similar to currency exchange booths in traditional banking, except token holders can expect minimal fees for trading. In addition, since exchange fees are written onto a blockchain project, they’re usually immutable and can’t be changed on a whim. 

In short, the billions of dollars locked into these liquidity pools can’t be controlled by a single entity or digital currency group, resulting in a freer, more open market.

The Benefits Of DeFi

Because the term DeFi encompasses all financial applications on the blockchain, it can be cumbersome to list all their benefits. That said, these services usually share a few key features. Namely:

• Open: Unlike traditional banks, you don’t need to provide any documentation or payments to partake in the crypto market. All you need to do is find yourself a wallet and connect to one of the many dApps on the blockchain.

• Flexible: Trading on dApps is permissionless, meaning you can do it anywhere, anytime. There’s no need to file a request to move funds from one wallet to another.

• Fast: Bank transfers take a while, but transferring crypto does not. On top of relatively low fees, you can send crypto to anywhere in the world within minutes.

The Drawbacks Of DeFi

Since the blockchain and crypto, in general, are still in their infancy stage, there are a few drawbacks that new users need to know before investing. Here are the two main ones.

• Volatile: Cryptocurrency is volatile. It can grow exponentially or lose half its value in a single day, and there’s no reliable way to tell when it will happen.

• Complicated: Understanding the technology that facilitates transactions is one thing, but bringing that knowledge into the real world can be complicated. As legislation around cryptocurrency develops, users may also need to familiarize themselves with complex taxation rules. 

Final Thoughts On Decentralized Finance

Decentralized finance is a game-changer for many folks. It can empower the individual user to take control of their finances while also affording them quick and cheap transactions. However, the growing legislation around cryptocurrency exchanges can make things complicated for folks moving large volumes of crypto around. 

So if you’re looking to start dabbling in DeFi, make sure you know your local laws and do thorough research before jumping in.