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What is Decentralized Finance (DeFi)?

Decentralized finance (DeFi) is an emerging model for organizing and enabling cryptocurrency-based transactions, exchanges, and financial services.

The basic principle of DeFi is that there is no centralized authority to dictate or control operations. It is a different approach to traditional funding models for Fiat money or centralized finance (CeFi) within the cryptocurrency markets. With centralized models, there is a basic fundamental authority that can influence and control the flow of transactions. The central authority is often also responsible for the custody of the assets.

With DeFi, there is no central authority. Instead, authority is distributed in a decentralized approach that aims to give more power and control to individuals. In the DeFi model, all buying, selling, lending, and paying transactions with cryptocurrency can occur without a central authority in a peer-to-peer (P2P) approach.

Custody of assets is a fundamental part of any financial model. In the DeFi approach, individual traders are in control of private cryptographic encryption keys, which enable custody of cryptocurrency assets. Financial transactions within the DeFi model are enabled with smart contracts which are often supported on Ethereum block chains.

The DeFi model also includes the notion of decentralized exchanges (DEXs) that operate with the purpose of helping connect and enable individuals seeking to execute cryptocurrency transactions. DeFi is also often closely associated with the concept of decentralized applications (dApps), typically for financial services use cases.

How does DeFi work?

DeFi relies on the use of a blockchain, which is often based on Ethereum in many DeFi operations.

A blockchain is a form of immutable distributed ledger that cryptographically secures inputs, which are used for transactions. Blockchains are also the basis of cryptocurrencies, which are tokens created in a blockchain that have value.

With an Ethereum-based blockchain, smart contracts help the DeFi model work. A smart contract is an application that runs on a blockchain using the inherent distributed ledger and cryptographic encryption capabilities. The smart contract specifies the terms and conditions for performing a given operation.

Instead of a central authority allowing a transaction to occur, a smart contract is programmatically activated to perform the financial transaction specified in the contract. A smart contract can contain cryptocurrency assets that can be sent from one entity to another.

With DeFi smart contracts, the terms and conditions of a transaction are also transparent and available as code, meaning they are visible to others for auditing and analysis. There is no need for a central authority to activate a smart contract with DeFi as the system operates in a P2P model. Thus, if two peers can agree to execute a transaction, it can be done without the need for a third-party central authority.

In the DeFi model and its use of smart contracts, the focus is on empowering the individual user. Custody of cryptocurrency assets relies on the control of private and public encryption keys. With the decentralized approach, custody in the form of the private cryptographic encryption keys is held by the individual.

CeFi vs. Challenge

With cryptocurrency-related financial services, two predominant models are used today with CeFi and DeFi. Comparing CeFi vs. Challengeit is important to note that there are similarities and differences between the two approaches.

Both models allow traders to buy, sell, and lend cryptocurrency assets and have an exchange concept that can help facilitate transactions. Blockchain-based technologies are also central to the CeFi and DeFi models.

The two approaches differ with spectacular results in organization and management. The CeFi model relies on a central authority to govern transactions. The central authority also holds custody of the assets.

In contrast, the DeFi approach relies on smart contracts and a decentralized P2P approach to enable financial services. Instead of asset custody being the responsibility of centralized exchanges, individual users hold custody of their own cryptocurrency assets.

Advantages of DeFi

DeFi offers users a number of benefits that can help improve trust, security, and trust in cryptocurrency-based transactions and applications, including the following:

  • Decentralized. Because it is decentralized, DeFi is not subject to the inherent risks of CeFi, where the failure of an exchange can lead to a complete collapse and the loss of user funds and accounts.
  • Without authorization. As a decentralized model, there is no need for a central authority to approve or authorize a transaction. Instead, the model is permissionless because the programmatic logic of smart contracts defines what is possible.
  • Transparency. The smart contract model can allow users to understand the terms and logic of a transaction in a transparent model without hidden code.
  • Anonymity. Although smart contracts can be transparent on the blockchain, there is no need or requirement for users to be identified. With DeFi, Know Your Client requirements, which are common to centralized and regulated models, do not specifically apply.
  • Keep. In DeFi, users control assets and custody of the cryptographic private key for cryptocurrency tokens is owned by the user.
  • DApps. DeFi supports dApps, where users can benefit from financial services applications and other use cases, such as games and social media.
  • Costs. Without a central authority, DeFi offers users the promise of lower fees than transactions executed in the CeFi model.

DeFi Challenges

While DeFi has its fair share of benefits, it also presents several potential challenges, including the following:

  • Complexity. The perceived complexity of DeFi is probably the model’s biggest challenge. DeFi operates in a P2P model, with smart contracts and sophisticated algorithms that can be difficult for the uninitiated to fully understand. This complexity can also lead to confusion about how a service or application works.
  • Customer service. Without a central authority or service to call for help, customer service with DeFi can often be a challenge.
  • Volatility. There can potentially be more volatility in DeFi approaches as there is no moderating central authority to control or limit transactions or market dynamics.
  • Security. In recent years, DeFi platforms have been increasingly targeted by attackers. A Federal Bureau of Investigation Alert published in August 2022 warned that over $1 billion in assets had been stolen in just three months.

Uses of DeFi

There is a wide range of use cases in which DeFi is implemented today, including the following:

  • Payments. DeFi can enable P2P payments without the need for a central authority.
  • Ready. The ability to lend and borrow cryptocurrency assets is a common use case for DeFi.
  • NFT. Non-fungible tokens allow users to own tokens that can be traded.
  • Stable coins. An increasingly common use of DeFi is stablecoins. The purpose of a stablecoin is to help limit cryptocurrency volatility by pegging the value of a coin to another asset, commodity, or currency.
  • Yield farming. For those using DeFi as an investment vehicle, yield farming allows individuals to earn interest income on cryptocurrency assets.
  • DApps. DApps run on DeFi and enable multiple types of use cases, including financial services and gaming.

There are several DeFi services and platforms available today, including the following:

  • Avalanche. The avalanche is a proof of stake blockchain to support DeFi smart contracts. It also has its own token with the AVAX cryptocurrency.
  • DYdX. DYdX is a DEX that enables cryptocurrency trading.
  • Index Cooperative. Index provides several features, including the DeFi Pulse Index, which tracks the performance of DeFi assets and cryptocurrencies.
  • ManufacturerDAO. MakerDAO is a decentralized autonomous organization to govern cryptocurrency operations and created the Dai stablecoin, which is pegged to the US dollar.
  • TrueFi. TrueFi provides a lending credit protocol, as well as the TRU token.

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