A Beginners Guide to Understanding DeFi

Image by Tamim Tarin from Pixabay

What is DeFi or Decentralized Finance?

For you to understand DeFi you need to understand the limitations of centralized finance and why DeFi was created.

How Does DeFi Work?

Decentralized finance works using blockchain technology which is a distributed, decentralized, and secured database that records financial transactions. DeFi uses smart contracts to power Dapps which are used to handle transactions and run the blockchain.

What are the Advantages of DeFi?

One advantage of DeFi is that it does not need any intermediaries during the processing of transactions. Another advantage is that the users maintain control over their funds at all times, which reduces the costs and allows for a more effortless financial system.

What Can DeFi be Used For?

DeFi has a lot of potential uses cases that make it unique, different, and a perfect solution to the traditional financial system. Below are some of the uses cases of DeFi.

Borrowing & Lending

DeFi allows for more robust borrowing and lending services which have many advantages over centralized finance. With DeFi, you can borrow funds while using your cryptocurrency as collateral, and also settle transactions instantly. Because DeFi is built on the blockchain, it reduces counterparty risk, making borrowing and lending with DeFi very cheap, faster, and easily accessible to people.

Monetary Banking Services

Monetary banking services can include the allocation of stable coins mortgages and insurance. Because of the volatility of cryptocurrency, decentralized stable coins which are digital cash could be adopted for everyday use. Stablecoins bring stability to DeFi lending and borrowing services.

Decentralized Marketplaces

One of the most important DeFi use cases is a decentralized exchange (DEX). Decentralized exchanges are platforms that allow users to buy and sell digital assets without the need for a trusted intermediary to hold their funds. The trades activities are made directly between users with the help of smart contracts. Decentralized exchanges typically have lower trading fees than centralized exchanges.

What are the Limitations of DeFi?

One of the limitations facing the DeFi ecosystem is that they are built on blockchain technology. However, below are some of the limitations of DeFi.

Reduced Performance and Inefficiency

Because DeFi is built on blockchain technology, they are slower than centralized finance. This reduces the performance of the system leading to inefficiency.

Users Take Responsibility for any Mishap

In DeFi, users and not intermediaries are responsible if anything goes wrong. For this reason, it is necessary to use and create tools that prevent human errors in the DeFi space. But because many users are not used to this system of finance, it has led many to lose their funds.

Over-Collateralization

DeFi borrowing and lending are the most attractive for investors. But the problem is that over-collateralization may occur when the value of the staked asset is relatively higher than the loan amount itself.

Final Thoughts

DeFi allows for a more open and reliable financial system that could potentially prevent restriction and discrimination all over the world. DeFi in course of time will take power from large centralized institutions and put it in the hands of the users. But whether that will create a more efficient financial system will be decided once DeFi is ready for widespread adoption.

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