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What is Decentralized Finance

Decentralized finance (DeFi) is a novel financial technology based on secure distributed registries similar to those used in cryptocurrencies. For a better grasp of the essence, it's better to explain it in simple terms that decentralized finance (DeFi) applications aim to eliminate intermediaries in our everyday finances.
Reading time: 10-15 min
Updated: 26.02.2023
The basic idea behind decentralized finance is that a central authority dictating the rules, controlling transactions and storing assets is not required. In centralized models, there is an overarching authority overseeing transactions and having the ability to influence them.

For example, in the United States, the Federal Reserve and the Securities and Exchange Commission (SEC) establish rules for financial institutions such as banks and brokerage offices. Through banks and other financial institutions, consumers have access to finances and financial services.

DeFi is challenging this centralized financial system by giving people the ability to engage in peer-to-peer digital exchange (P2P). P2P stands for peer-to-peer or person-to-person. It's a technology for transferring funds online from card to card.

How Does DeFi Work?

Decentralized finance uses blockchain technology. For more information on blockchain technology, see our blog. Users interact with DeFi through software called dapps (“decentralized applications”). Unlike a conventional bank, you don't have to fill out an application or open an account.

The Most Prospective Uses of DeFi

Borrowing and lending

Open credit protocols are among the most popular types of applications in the DeFi ecosystem. Open, decentralized borrowing and lending have many advantages over the traditional credit system. These include no creditworthiness checks and the ability to secure digital assets. In addition, the lender can receive interest on a loan not once a month or even less often, but as often as every minute. Blockchain-based lending markets reduce counterparty risk and make loans cheaper, faster and more affordable for more people.
Obtaining a mortgage loan is expensive and time-consuming because of the large number of intermediaries. With smart contracts, the cost of legal services can be significantly reduced.
Blockchain insurance might eliminate the need for intermediaries and allow the risk to be shared among many participants. This could lead to lower insurance premiums for the same quality of service.

Decentralized marketplaces

Decentralized exchanges (DEX) are among the most popular DeFi applications. For example, Binance. These platforms allow users to trade digital assets without needing a trusted intermediary (exchange) to hold their funds. Transactions are made directly between users' wallets using smart contracts.

Profitability optimization

Decentralized DeFi applications can be used to automate and optimize the cumulative income generated by stakes and other interest-bearing products. For example, a smart contract can collect your commission, buy more asset base and reinvest it. This process can dramatically increase the crypto-asset owner's income. Of course, you can do this manually. However, smart contract saves time and optimizes the accrual of compound interest.

Smart contracts in DeFi

The majority of existing decentralized finance applications are associated with the fulfillment of smart contracts. A smart contract is an equivalent of an ordinary paper contract in the form of an electronic algorithm. A smart contract performs certain actions when the parties to the agreement fulfill certain conditions. For example, a smart contract can send money to a supplier for goods of proper quality delivered. Smart contracts allow for the secure exchange of cryptocurrency, fiat currency, and other assets directly between parties to the transaction, without intermediaries.

How to Get Access to DeFi?

To connect to DeFi DApps, you need to take a few steps:
● Have a compatible cryptocurrency wallet. You can use a wallet in the form of a mobile app or browser extension. MetaMask and Trust Wallet are great options.
● Cryptocurrency. Though seemingly obvious, it is worth mentioning that you need to have the appropriate cryptocurrencies to get started.
Basically, this is all you need to get started with decentralized finance.

DeFi Advantages

● Decentralization. The key advantage of DeFi lies in its very name. Due to decentralization, control is equally shared among many participants. There is no overregulation, transactions are transparent, execution is almost instantaneous, and there is no chain of intermediaries. This is convenient, for example, in lending. There are no intermediary banks, so the lender does not have to share the profits with the bank, which accepts deposits at one interest rate and gives credits - at a much higher rate.
● Transparency. All transactions are public; transactions are pseudo-anonymous by default.
● Accessibility. Most DeFi applications are accessible to any Internet user.
● Inclusivity. Unlike traditional financial sector, any user can create an application and use it.
● Smart contracts. Using smart contracts allows you to define clear, unbreakable rules and eliminate the human factor.

DeFi Disadvantages

● Blurred boundaries of responsibility. The basic principle is decentralized management, based on the assumption that all participants in the ecosystem are interested in its success and will make decisions based on their own benefit. However, this does not apply to blatantly malicious actions aimed at disrupting the system or seizing control.
● Smart contracts. Working with smart contracts eliminates the human factor and the issue of trust. At the same time, there is an issue of trust in the smart contract code written by a human.
Reliability of oracle data. DeFi is based on smart contracts. However, smart contracts may require data from sources outside the blockchain network, such as platforms that aggregate bidding and pricing data from multiple exchanges to calculate a fair price for a commodity. This data is provided to smart contracts by oracles. The information provided by oracles is a bottleneck. If an oracle provides skewed information, smart contracts will execute transactions with distorted values, which will lead to negative results

DeFi vs Traditional Finance

Most GameFi projects will require you to purchase their cryptocurrency tokens or in-game NFTs to get started. While the requirements vary game-to-game, you should always consider the potential income and general risks. Take care to estimate the time it may take to recoup your initial investment and start making a profit.

DeFi vs Centralized Finance (CeFi)

CeFi (centralized finance) is neither better nor worse than DeFi. The use of CeFi depends on the needs. By sacrificing a certain amount of control, one can often eliminate a portion of the responsibility for the execution of transactions. For example, one can manage all the stages of an investment in DeFi by oneself, or one can place bids through a centralized exchange like Binance.

The Future of DeFi

Web 3.0 and DeFi as one of its parts is still evolving. There are many questions about responsibility and control:
● Who will be enforcing the rules?
● Who will be investigating financial crimes outside of DeFi protocols?
● How will the stability of the equipment and its upgrades be ensured?
Once the basic DeFi rules have been worked out, they will not be as lax as they are now, but still provide new financial services unavailable in the classical financial system.
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