Defi technologies is a growing financial system that enables transactions between people or businesses, often without an intermediary such as a bank, using software that runs on a blockchain, a digital public ledger that records a list of transactions.
The guiding principle of DeFi is to cut third parties, such as banks, out of the financial system, slashing fees and transaction times.
In the United States, the Federal Reserve and the SEC have defined the rules for centralised financial institutions such as banks and brokerages that consumers use to access capital and financial services directly. DeFi threatens this central financial authority by fostering peer-to-peer transactions among individuals.
How Defi Technologies Works
DeFi works on the security protocols, connectivity, software, and hardware developments facilitated by peer-to-peer financial networks. This does away with middlemen such as banks and other financial services firms.
These businesses are paid by businesses and customers who are using their services, without which they could not operate in the present framework. DeFi leverages the technology underlying blockchains to cut out the middlemen in between.
1. Blockchain
A blockchain is a decentralised network and secure database or ledger. Transactions are recorded in a blockchain in files called blocks and are verified automatically. If a transaction is confirmed, the block is “closed” and encrypted; a new block is created, including information about the previous block and new transactions.
The blocks “chain” all together; the name comes from the structure of the blocks. Previous blocks of information cannot be altered without changing all subsequent blocks, so blockchains are usually extremely secure as long as they have large and quick networks. This, coupled with other security measures, forms the very secure nature of a blockchain.
They aren’t. Anyone with a “sending” system, or wallet, that can pass data to a blockchain holds a private key to tokens or cryptocurrencies that operate as passwords. These keys allow them to tap into virtual tokens that themselves have value.
The keys themselves are ‘controlled’ by the computers, owners don’t have a key that can be copied, the way the key system works, if you need to ‘send’ someone some of your tokens via a wallet (which is each wallet then actually generates a different private key for the wallet). This cements their possession of the token and the blockchain system, which makes the transfer irreversible.
2. Applications
DeFi applications are built to talk to a blockchain so that people can use their money for buying, borrowing, gifting, trading, or whatever else they want without the intervention of a third party. These are programs on the device itself — such as a personal computer, tablet, or smartphone — that help to simplify using it. DeFi would survive without the apps, but customers would have to be comfortable and accustomed to interfacing with the command line, or terminal, the operating system that runs their machines.
DeFi apps essentially function as an interface that enables users to automatically transact with each other through financial options. If you want to give somebody a loan, with interest, you can pick the option on the interface and type in terms such as interest or collateral.
If you want a loan, you can try to find someone who will extend one to you, whether or not you are creditworthy, which could be a bank or an individual who will lend you bitcoin, so long as you agree to their terms.
Some apps also allow you to select the service you are seeking, input information about the issue you are experiencing, and then be matched with another user. That is also because the blockchain is a global network — you can send financial services to, or receive financial services from, anywhere in the world.
Goals of Decentralised Finance
Peer-to-peer (P2P) financial transactions are one of the core premises behind DeFi, where two parties agree to exchange cryptocurrency for goods or services without a third party involved.
Using DeFi allows for:
- Accessibility: Anyone with an internet connection can access a DeFi platform, and transactions occur without geographic restrictions.
- Low fees and negotiable interest rates: DeFi enables any two parties to negotiate interest rates directly and lend cryptocurrency or money via DeFi networks.
- Security and Transparency: Smart contracts published on a blockchain and records of completed transactions are available for anyone to review, but do not reveal your identity. Blockchains are generally immutable, meaning they cannot be altered.
- Autonomy: DeFi platforms don’t rely on centralised financial institutions. The decentralised nature of DeFi protocols mitigates the need for and costs of administering financial services.
How to Get Involved in DeFi
Becoming involved in decentralised finance might seem intimidating at first, but there are many ways to do so. The first thing you should do if you want to get into DeFi is to research the activities that interest you the most. You’ll need a wallet, but because there are so many to choose from, you’ll need to learn more about them and find the one that appeals to you.
Once you identify your wallet and activity, you can find a reputable exchange that provides the activity you want to get involved in or use, buy some cryptocurrency, and get started. For example, if you chose Coinbase, you’d take the following steps:
- Set up a wallet that accepts DeFi apps (Coinbase Wallet already does)
- Add cryptocurrency to your wallet by purchasing some on an exchange
- Find a DeFi app for borrowing, lending, liquidity, yield farming, or other activities
- Add your crypto to the app to begin
What is an Example of DeFi?
DeFi is an all-inclusive term for any application that uses blockchain and cryptocurrency techniques or technology to offer financial services. Some of these applications can provide anything from basic services like savings accounts to more advanced services like providing liquidity to businesses or investors.
One of the more notable DeFi service providers is Aave, which is a “decentralized non-custodial liquidity market protocol” that allows anyone to participate as a liquidity supplier or borrower.
Aave lets you stake any of your crypto assets to earn interest income from users who might borrow your assets.
The Bottom Line
DeFi, or decentralised finance, is a budding new concept in financial technology that disrupts the established central banking system. DeFi aims to do away with the fees that banks and other financial service providers charge and to encourage peer-to-peer transactions.
DeFi is only a few years old, and like the blockchains and cryptocurrencies that it’s built on, they’re still all just babies. There is a lot of heavy lifting to do before it could replace the current financial system (which has problems of its own, which aren’t easily surmountable).
Finally, these financial service companies and banks are not just going to roll over and disappear — if there is a way for them to make money off of the transition to a blockchain-based financial system, they will figure it out and make sure they have a seat at the table.
