Tuesday, September 27, 2022

Understanding Decentralized Finance (DeFi)

Decentralized Finance (DeFi) is a fast-growing technology in monetary finance that is posing a big challenge and revolution to the provisions and business model of organized banking.

As part of the traditional financial framework, banks do not adhere to the principles of decentralization, and thus have complete control over the global supply of money, and as a result, people’s lives are managed by central banks or other designated monetary authorities

Although there is the current decentralized financial structure of which the western world has seemingly adapted, we still find a whopping number of 1.7 billion unbanked adults (according to World Bank statistics from 2017) who do not have the potential to profit from any form of monetary welfare and so do not match the current financial system or systems that can directly affect their lives, businesses, and economy in general.

Access to the traditional financial system is heavily restricted by a wide range of factors and life situations for many people. Consequently, they are unable to participate in global economic activity and have fewer options to transact.

Approximately five years ago, the concept of Decentralized Finance (DeFi) was formed in the minds of the developers of Compound, Dharma, dYdX, and MakerDAO, among other projects, and the distance between the traditional financial system and DeFi began to close.

What Really is DeFi?

DeFi is a typical financing concept and system with a decentralized management structure. Blockchain-based DeFi is a permissionless infrastructure that allows people and businesses to conduct transactions directly with each other, without the need for financial institutions to act as intermediaries.

As a result, the system is accessible to everyone who has access to the internet, and it intends to provide, or at least attempt to provide the same range of financial services available in the mainstream monetary economy.

There are three main elements of the concept viz; openness, the interconnectivity of financial assets, and permissionless transactions. Financial transactions, including lending, borrowing, and trading, may now be completed at a considerably faster rate and with a lot less cost.

As with the banks, there is a lot of hidden information from the borrower (fees, conditions, repayment rules, and more). In making a difference, DeFi makes it possible for all parties involved to check the blockchain and make sure nothing is being held back. The system allows anyone who needs, wants or is interested in participating in financial transactions to seamlessly do so.

Remember to factor in the interest you’ll be charged by banks if you take out a loan, as there are bad credit loan rates as high as 30% for example. The figures are absurd and out of reach for the majority of potential borrowers, but with DeFi, debtors’ fees are lowered to less than one percent, making the loan as bearable as possible.

A public blockchain and smart contracts (automated enforceable agreements) ensure that DeFi’s openness to users is maintained. Because of blockchain’s structure, it is possible to reduce the number of middlemen in every financial transaction, allowing only Peer-2-Peer (P2P) engagement in any transaction.

Decentralized Finance Mechanisms

Decentralized Finance uses the same blockchain technology that is utilized by cryptocurrencies to run, and so everyone can use a blockchain because it’s a decentralized, secure database or ledger. Decentralized applications (DApps) manage blockchain transactions and are also in charge of the blockchain’s general administration.

When a specific set of conditions is met, the smart contract concept is automatically carried out, developers can then create apps that make use of these functionalities by refining and interconnecting these basic conditioning rules. This is how DApps operates.

The term “decentralized” refers to the fact that there is no single server in charge of the creation and operation of an application. Apart from that, because they are running on the open DeFi platform, the DApps contain open code that can be utilized and developed by any other developer.

Examples of Decentralized Applications

Take, for example, InstaDapp, which demonstrates how it is achievable; its developers took the fundamental DeFi capability (access to protocols) and elevated it to a higher level by providing a more user-friendly user interface and user experience.

Drawing on its inherent capabilities, InstaDapp promoted other Dapps and DeFi products while simultaneously raising $2.4 million for the purpose of extending and upgrading its service. Even if peradventure, InstaDapp does not rank among the greatest Dapps in subsequent years, its locked value remains high enough – more than $100 million – to ensure its long-term viability.

The purpose and mission of DApps today are straightforward and are centered on rethinking the technological world in order to make financial operations more accessible to anyone in need.

Beyond InstaDapp, there has been the emergence of numerous DApps including but not limited to Compound Finance, Aave, and MakerDAO.

How Smart Contracts Work

Smart contracts are responsible for delivering the DeFi functionality. They have been used to perform a variety of base finance activities, including exchange, lending, and borrowing, throughout the course of the last four years.

A smart contract can be implemented in a variety of ways, in the Ethereum blockchain (the first cryptocurrency to use smart contracts), it can neither be destroyed nor terminated, and transactions in the Ethereum blockchain cannot be reversed. As a result, Ethereum can be considered a decentralized blockchain protocol.

Since the launch of the Ethereum blockchain, its capability has been engineered to advance the course of autonomous transaction platforms with smart contracts one of the most prominent expressions.

As with the internet itself, smart contracts only provide functionality and can work as ‘Lego blocks,’ allowing innovations to be constructed on top of one another, much way the internet itself is built atop a variety of protocols (TCP, IP, SSL, HTTP, SMTP, www, pop, etc).

Prominent DeFi Protocols

These protocols are small, self-contained programs developed to deal with specific problems in the traditional financial sector that have risen through time. According to DeFi standards, over half of the world’s population does not have access to a bank account.

Financial items will be introduced in the near future as DeFi standards continue to evolve, and considering how much more important DeFi protocols have grown, the opportunities for DeFi-related business owners have become plainly evident.

There are two key categories of DeFi protocols including Layer-1 and Layer-2 protocols respectively.

Layer-1 and 2 Protocols

Decentralized Finance protocols can be divided into two categories in a decentralized environment. Generally speaking, a blockchain is considered to be a Layer-1 protocol with the likes of Ethereum, Binance Smart Chain (BSC), and Avalanche (AVAX) the prominent examples.

A third-party integration that may be utilized in combination with a Layer 1 blockchain is considered to be a Layer-2 protocol and Polygon (MATIC) is a prominent name in this regard.

It is critical to note the difference between the two. Layer 1 protocols serve as the foundational security levels for cryptocurrencies such as Bitcoin (BTC), Ethereum, and the more recent offerings from other emerging protocols extending to Terra (LUNA) and Solana (SOL), as well as other blockchain protocols.

However, as the number of users increases, the transactional capacity of most Layer-1 blockchain protocols begins to fill up, resulting in a bottleneck. As a result, transaction fees are raised, with scalability and throughput significantly reduced.

In order to increase transaction speed while decreasing fees, the Layer-2 protocols are designed to sacrifice some centralization and security. This is done with a focus to also engineer unique scalability and a reduction in centralization and security.

Ethereum

Ethereum continues to hold the lead in the DeFi race, having locked up more value than any other blockchain, totaling over $116 billion, spanning over a thousand projects.

Binance Smart Chain

Binance Smart Chain (BSC) is a blockchain protocol that is compatible with Ethereum Virtual Machine (EVM) and associated smart contracts. To maintain Binance Chain’s high throughput while including smart contracts remains the blockchain’s primary goal.

Terra

When it comes to DeFi, NFT markets, and Web, Terra has seen a significant increase in relevance. Terra is one of the fastest-growing cryptocurrency ecosystems.

According to the total value locked in, Terra is now the second-largest blockchain for DeFi protocols in terms of Total Value Locked (TVL).

Avalanche

Described by its creators as an “open, programmable smart contracts platform for decentralized applications.” AVAX, the Avalanche currency, is used to pay transaction fees and can be staked to safeguard the network, much like Ethereum and Bitcoin.

Avalanche can power stablecoins, DeFi systems, and non-fungible tokens.

Fantom

According to DeFiLlama’s research, Fantom has overtaken Binance Smart Chain (BSC) as the third-largest DeFi ecosystem.

Fantom DeFi in blockchain initiatives is gradually increasing as few developers prefer to host their products on less expensive networks. According to Fantom’s Total Locked Value, this is clearly evident.

Decentralized Finance Products and Offerings

That the Decentralizedf Finance ecosystem is still in its infancy does not imply innovators are sitting on their oars as a lot of products have been launched to benefit users in the space. While DeFi seeks to copy the lending and savings-investment models in traditional finance, we have also seen some slight modifications in the form of flash loans, yield farming, and much more.

A popular expression of Decentralized Finance is also the emergence of Decentralized Exchanges (DEXes). These are trading platforms that make use of the Automated Market Maker (AMM) transaction model to fulfill users’ demand to exchange digital assets. While it may appear more like a primitive version of mainstream exchanges like Binance or Coinbase, the technology driving DEXes is unique and echoes total control for the user.

Conclusion

Decentralized Finance looks promising, it’s new and very much innovative. It has the ability to cut costs and speed up payments by mitigating the complexities of technology, contracts, and coordination between numerous parties involved. It is also useful in helping organizations to put resources and money to good use by investing in digital assets rather than sitting in a bank account.

True, the system has significant shortcomings and security gaps but considering that it has only been in operation for a little more than a decade, the results are very impressive. We can agree that Decentralized Finance is much more than simply a trendy buzzword, it is a serious rival to traditional financial technology solutions, particularly in the banking industry.

Ayo Alabi
Ayo Alabi is an experienced writer and Fintech enthusiast, passionate about educating people and helping businesses that want to see their Google search rankings surge. Her articles have appeared in a number of e-zine sites, with focus on balancing informative with SEO needs–but never at the expense of providing an entertaining read.

Related Articles

Stay Connected

0FansLike
0FollowersFollow
2,050FollowersFollow

Latest Articles

%d bloggers like this: