Decentralized Finance or DeFi is a system of building financial applications on a decentralized peer-to-peer blockchain network like ethereum. These apps don't rely on centralized institutions such as exchanges, brokerages, banks, or any kind of financial institution. All the rules and regulations are governed by smart contracts instead.
Traditional methods of performing transactions rely on intermediaries like Visa, Paypal, Banks, etc. These intermediaries charge taxes for their services. Moreover, they also require many documents such as government ID, address proofs, income certificates, etc. before you can start using their services.
One of the biggest advantages of DeFi is that it allows people to buy, sell, lend or borrow funds by directly interacting with each other through a software-based interface rather than any company or human thereby cutting out the middleman.
How does DeFi work?
DeFi uses cryptocurrencies instead of fiat money. The financial institutions in traditional finance are replaced by smart contracts in DeFi.
Suppose you are buying a coffee at Starbucks. With traditional methods, you can pay the vendor with your Visa credit card. This gives visa control of your payments. Visa logs your payment data in their servers and also charges a fee to facilitate your payment
With DeFi protocols middlemen like Visa can be cut out of the picture. A smart contract can be deployed that receives payments from the buyers and sends a coffee token to the buyer after receiving the payment. It sends the money to the vendor’s ethereum wallet. The buyer can purchase the coffee with that token by sending the token directly to the vendor wallet.
Apart from buying/selling DeFi protocols can be developed for various other types of transactions such as crowdfunding, investing, fundraising, securities, etc.
DeFi vs traditional finance.
|You hold your own money.||Your money is held by institutions.|
|No need of intermediaries to validate the transaction.||Intermediary companies are required to perform the transactions.|
|Low Fees.||High Fees.|
|Transactions are pseudo-anonymous.||Complete identity reveal is required for performing the transactions.|
|Transfer of funds is more secure because of the decentralized environment.||Transfer of funds is less secure because centralized environments are more prone to hacking.|
|No downtimes. Markets are always open.||Markets can be closed if the mediator company is facing stability issues.|
Role of Ethereum in Defi
Ethereum is the de facto blockchain for building DeFi applications. If not all, most of the DeFi projects are built on Ethereum. The reason for ethereum's popularity in the DeFi space is its ability to execute smart contracts.
Some of the most popular DeFi projects e.g. MakerDAO, Compound, Uniswap, InstaDapp, etc. are built on ethereum.
The current stage of DeFi
Though emerging as a giant industry, DeFi is still in the development phase. New protocols are still being built to streamline the whole financing mechanism. However, the volume of daily trading and the money locked in smart contracts is growing steadily. DeFi is expected to revolutionise the ways of current financial systems in the future and lay the foundation of modern finance.