What is DeFi?

The traditional financial system has always been associated with many limitations and drawbacks. As much as we were all aware of these pitfalls in the traditional financial system, we had no other option, so we had to stick to what we had. 

However, with the advent of DeFi in 2019 came a major breakthrough in the financial space. DeFi sought to bridge the gaps and loopholes in the traditional financial system, providing a more accessible and efficient system. 

DeFi is short for decentralized finance. DeFi is made up of two separate words: decentralized and finance. You already know what finance entails, so let’s see what decentralization is.

Decentralization connotes a system where there is no central governing authority. For example, you know that banks, other financial institutions, and even your finances in the bank are under the regulation of a central or governmental agency. 

They do not function independently of these authorities; at all times, they are answerable to them.  

Combining the two words(“decentralized” and “finance”), DeFi is a financial system under no governmental or central authority.

 DeFi is a financial technology based on a secure distributed ledger, just like the ones used for cryptocurrencies. 

Understanding Decentralized Finance (DeFi)

Centralized Finance (CeFi), which is traditional finance as we know it, has always had issues with accessibility and efficiency, among others. Now, DeFi came along as an attempt to fill in these gaps.

Decentralized finance comprises financial products and services that are accessible to anyone, anywhere and at any time, who has an internet connection. 

The decentralized Finance market operates without a regulatory body; your financial assets are not under the jurisdiction of any governing body with a right to withhold them from you for some reason. 

Decentralized finance also depends on blockchain technology, making transactions faster, cheaper, and, in most cases, more secure than traditional finance.

The DeFi model also includes the idea of decentralized exchanges (DEXs), which help people who want to buy or sell cryptocurrency connect and complete their deals. DeFi is also often linked to the idea of decentralized apps (dApps), which are mostly used in banking services.

How Does DeFi Work?

Earlier, we mentioned that Decentralized finance depends on blockchain technology to carry out transactions. This technology is often based on Ethereum in many operations. 

Using an Ethereum-based blockchain, smart contracts help the DeFi system work efficiently. 

Smart contracts spell out the rules and regulations required for a particular action. 

So, in the same way a central authority carries out a financial transaction, smart contracts have been programmed to enable financial transactions specified in the contract to be carried out effectively. 

With the use of smart contracts in DeFi, the terms and conditions of a transaction are clear and available as code. This means that anyone can audit and analyze the transaction carried out.

Because DeFi is a peer-to-peer system, there is no need for a central authority to enable the smart contracts to work. In this way, if two peers can agree to execute a transaction, the smart contracts automatically carry it out without needing a third party. 

Importance of Decentralized Finance

DeFi eliminates the need for intermediaries through the peer-to-peer system, which incorporates and permits decentralized banking, which wasn’t possible before now. 

The global financial crisis in 2008-2009 showed the world that intermediaries could not be trusted, given that customers are mostly unaware of the various rules and regulations governing financial goods and services. 

Decentralized Finance (DeFi) aims to create a trustless, open, and permissionless financial market. In the long run, it will improve customer experiences in the financial system. 

Benefits of DeFi

The benefits of decentralized finance are quite numerous, but we will discuss some of them below.

1. Transparency

The terms and conditions of transactions are made very transparent and accessible so that you can evaluate and understand every transaction in DeFi.

2. Decentralized

This is by far one of DeFi’s biggest attributes. The fact that there is no central authority overseeing the system and thus, the risks where the failure of a bank or an exchange can lead to loss of funds is totally avoided.

3. Anonymity

In as much as smart contracts are transparent on the blockchain, users do not need to be identified. In DeFi, Know Your Client (KYC) procedures do not specifically apply. 

4. Custody

In DeFi, assets are totally in the control of users, and the user keeps custody of the cryptographic private keys for digital assets safe.

5. DApps

Decentralized finance (DeFi) supports decentralized applications (DApps), providing users with financial services, games, social media, etc. 

Challenges of DeFi

Despite decentralised finance’s unique features and benefits in the financial system, it has challenges. Some of which we will discuss below;

1. Customer Service

Seeing that decentralized finance is without a central authority, the issue of getting customer service to ask for help is quite challenging.

2. Complexity

The complexity issue is most likely the most significant challenge decentralized finance has faced since its inception. 

Because of the sophisticated technologies put in place to ensure the smooth running of the system, many customers have been scared off due to the seeming complexity of the system.

3, Security

DeFi platforms have increasingly been targeted by cybercriminals in recent years. In August 2022, the FBI warned that assets worth more than $1 billion had been stolen in just three months in the DeFi space. 

4. Volatility

There is no central authority to control or slow down transactions or market movement in DeFi, so the system is prone to a lot of volatility.

Uses of DeFi

In our world today, DeFi has a wide range of use cases, some of which are;

• Lending
• Payments
• NFTs
• Yield farming
• DApps
• Stablecoins
• Decentralized exchanges 
• E-Wallets
• Flash Loans

How To Make Money With DeFi

There is an easy way to make passive income with DeFi: 

Just deposit your cryptocurrency on a DeFi platform that will pay you an annual percentage yield.

To lock tokens into a smart contract in return for more of the same token, you stake them. One more way to get more of the same or new token is to participate in yield farming.

To start, you will need to use a coin on-ramp to buy some cryptocurrency. This means that you will need to use cash to buy cryptocurrency. Before you buy your crypto, though, keep in mind that most of DeFi is based on the Ethereum blockchain, which means that BTC is taken sparingly.

Is it Safe to Invest in DeFi?

When investing, a token with a small market price is usually not a good idea. So, before you invest your money, check to see how liquid the tokens are. Before you spend, make sure you know how long a DeFi platform has been running and how much money it has in total deposits.

On its website, you can see if the business has done enough to lower its risks. You can also read news stories about how the procedure was hacked and what was done to make sure it doesn’t happen again.

To be clear, there is a risk with every DeFi platform. Conduct due research and seek counsel where necessary to ensure a safe investment.