Decentralized finance (DeFi)

Updated on 2023-08-29T12:01:38.277536Z

What is decentralized finance?

Decentralized finance (DeFi) is a network where financial products are publicly available on a decentralized blockchain network. These products are made available to all, thus avoiding the middlemen like brokers and banks. These systems are introduced to remove the intermediaries between buyers and sellers of financial products.

For instance, smart contracts use blockchain to automate the sale and purchase agreement between buyers and sellers of a financial product (like cryptocurrency) without any broker or bank involved.

DeFi is a budding industry whose infrastructure is still under construction. It is expected that DeFi will take over modern finance, but as of June 2021, the regulations are minimal or absent around it.

Some of the uses of DeFi technology are mentioned below:

• Asset management: Using DeFi technology, many company companies have successfully developed asset management applications like Gnosis Safe, Argent, etc. These applications help in managing digital assets.
• Know-your-transaction (KYT) mechanism: Implementation of KYT using DeFi technology aims to understand the participating user's behavior, assisting in identifying the user's fraudulent activities, if any. In contrast, under traditional finance, know-your-customer guidelines focus on the identity of the participating user to identify terrorism and fraudulent activities.
• Decentralized autonomous organizations (DAOs): DAOs are organizations introduced to decentralize and utilize blockchain protocols. They help eliminate human error and manipulate funds by delegating decision-making power to the automated system.
• Risk management and data analysis: DeFi offers transparency around the data or network, which helps in risk reduction and assessment. It also helps in analyzing the data and predict the potential risks. Some of the applications built around this are Defi Pulse, Codefi Data, etc.
• Infrastructure development: Using DeFi technology, any developer can build their blockchain project. This helps to develop and compile the algorithms to make blockchain solutions.
• Decentralized exchange: Decentralized exchanges have made trading cryptocurrencies easier without asset manipulation and losing control over the assets. It has also helped in increasing the liquidity of cryptocurrencies.
• Insurance: DeFi technology has benefitted insurance industries by introducing zero paperwork, automated claims, and audits. It also ensures transparent and highly secured insurance claims. For instance, Nexus Mutual, founded in 2017, uses blockchain technology and Ethereum, allowing people to share insurance risks from all over the world.
• Online marketplace: Many buyers and sellers are making hassle-free transactions from one place to another. One can directly purchase from the brand.
• Payments: One can send and receive money from anywhere in the world without the intervention of any middlemen.
• Tokenization: A token is a digital asset holding a value within a blockchain network. Tokens can be used to transact with one another.
• Savings: Unlike traditional saving accounts that credit interests into the bank accounts only to a certain level, DeFi technology helps save faster with great interest policies. Applications like PoolTogether provide no-loss saving options.

Frequently Asked Questions (FAQs)

1. What are the challenges faced by decentralized finance technology?

Some of the challenges faced by decentralized finance technology are as follows:

• High user error: A person using the DeFi network is responsible for his/her own transactions and data. There are no intermediaries involved to take responsibility for transactions and funds. If an error is made in a transaction, it is irreversible.
• Bad user experience: DeFi technology is relatively new, and it is hard to understand how it works. Users might have to put in extra effort while utilizing such applications. To bring this technology as an essential element in the global economy, it has to offer some additional benefits.
• Scattered ecosystem: Developers have introduced many applications for a single task, making it difficult for users to identify their best use. There is an urge to formulate a strategy to guide all the users in choosing the best applications or lowering the options.
• Smart contract bugs: Many developers launch DeFi based applications without performing proper quality checks and testing or cross-checking the faulty codes leading to a bad user experience. At times, these faulty contracts can also trigger cyber-attacks.

2. What are the advantages of using decentralized finance technology?

To increase transparency and security, most of the DeFi based technology companies use public blockchain principles. The below mentioned are the benefits of DeFi technology.

• Zero tamperings: Applications made using DeFi technology are immutable. It is impossible to change or delete the data once stored, like blockchain technology.
• Transparent network: DeFi technology follows every single aspect of blockchain technology. It comes with a high level of transparency as the users can verify the transactions, and all the data is broadcasted.
• Permissionless access: Using DeFi technology, an individual can access data from anywhere across the world. He can make use of the facilities without any permission.
• User empowerment: In DeFi technology, individuals have sole custody of their digital assets and personal data, unlike traditional finance.

3. How does decentralized finance vary from traditional finance?

Decentralized finance can be considered a more advanced model of traditional finance. The fundamental differences between decentralized finance (DeFi) and traditional finance are:

• Code transparency: While using traditional finance/banking applications, an individual cannot see the code. However, in DeFi, technology-based applications codes are freely available to help in verifying and auditing the codes. An individual is aware of how the contract functions and on which code they are working.
• No human intervention: DeFi does not require banks and employees to facilitate the transactions. In this environment, everything operates on codes, and all the tasks are automated using them.
• Accessibility: Under DeFi, there are no restrictions on account creations or applications developments. Unlike traditional finance, there are no strict guidelines and restrictions on exercising financial rights. Anyone can have a crypto wallet and utilize smart contracts or other features of it.
• The emergence of decentralized applications: DeFi technology has helped develop several decentralized applications (dApps) accessible globally. There are no geographical restrictions, and the DeFi networks may be accessed from anywhere.
• Open-source algorithms: Algorithms used to build dApps are available publicly, and anyone can make their own app. This is another limitation in traditional finance.