A Beginners Guide to Understanding DeFi
Written by Tudje Gabriel
If you have ever applied for a loan at the bank then you would understand why a lot of people don’t like the current financial system. With the current financial system, applying for a loan is tiring, time-consuming, and almost a wasteful endeavor. Also, sending money to someone in a case of emergency is sometimes not feasible because the bank network might be down, and you might not be able to lay complaints if something goes wrong during the weekend.
But operating in a decentralized financial system like Zeroloss would make you have total control and access to your money anytime. This article explains what DeFi is, how it works, it’s advantages and limitations, as well as it’s potential use cases.
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.
Centralized finance vests too many powers and authority on financial institutions like the banks. With centralized finance, third parties are involved in transactions, high fees are charged, services are not available 24/7, cyber-attacks are possible anytime, and access to services is not reliable due to server downtime. Also in centralized finance, too many documents are required for you to get started and you are at the mercy of these financial institutions.
But DeFi is a lot different from centralized finance because it aims to take power away from central financial systems and give such power back to the users.
DeFi is built on the blockchain, hence, it plays down the power banks have on money, and financial services. In DeFi, users interact with the system in a peer-to-peer fashion and with decentralized applications (Dapps) which are powered by smart contracts.
The main goal of DeFi is to reduce transaction time and increase access to financial services without needing to pass through intermediaries or pay extra charges.
DeFi is so powerful that it has become the center of attraction for investors who want to control access to their money. The interesting thing about DeFi is that as long as you have an internet connection, you can lend, trade, and borrow money from anywhere in the world and at any time.
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.
In blockchain technology, users or participants of the network verify transactions which are then added to a new block and encrypted by cryptographic technique. The new block is then chained to the previous block before it, making it tamper-proof. Hence the name blockchain technology.
This concept, along with other security protocols, provides the secure nature of the blockchain which defines the way DeFi works.
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.
DeFi removes the extra fees that banks and other financial institutions charge for using their services, It holds your money in a secure digital wallet instead of keeping it in a bank and you can use it without needing approval as long as you have an internet connection.
DeFi allows you to transfer funds within split seconds and it protects against a single point of failure, making it resistant to cyber-attacks and potential network downtime. DeFi gives access to individuals who don’t have access to any traditional financial services in their region or country, thereby allowing low-income individuals to benefit from a wide range of financial services.
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.
Also because of the number of intermediaries involved in centralized financial systems, the process of getting a mortgage is expensive and time-consuming. But with the use of smart contracts that powers Dapps, legal fees may be reduced or completely scrapped out.
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.
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.
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.