Key Takeaways
- Decentralized finance (DeFi) is designed to use blockchain-based smart contracts to replace traditional financial institutions.
- DeFi promotes a more accessible, open, and transparent financial system without third parties.
- DeFi thrives on four fundamental principles: decentralization, inclusivity, transparency, and programmability.
- By eliminating third parties, decentralized finance brings transparency with the potential to disrupt traditional financial systems by introducing efficiency and inclusivity.
Decentralized finance is now a buzzword after emerging as a system that integrates blockchain technology, cryptocurrencies, and financial services. The total value of digital assets locked in the DeFi space rose from $700 million in December 2019 to around $200 – 220 billion in January 2022. It remains at around $130 billion in 2024 and growing, having fallen as crypto prices fell. This article discusses decentralized finance, what it is, and why more people are turning to it.
What is DeFi?
Decentralized Finance (DeFi) refers to several applications in the blockchain and cryptocurrency sectors that aim to disrupt the financial industry by eliminating intermediaries. The idea behind DeFi is the technology behind cryptocurrencies like Bitcoin, where copies of the history of transactions are held by numerous entities and not a single central source. This differs from the traditional centralized systems where human gatekeepers control systems and can limit the speed and intricacies involving transactions. DeFi distinguishes itself by expanding the use of blockchain to involve complex financial use cases.
DeFi applications imitate traditional financial systems, including trading, credit lending, and asset management. In DeFi, blockchain-based technologies replace the conventional need for financial third parties like banks, lending institutions, and advocates so users can enter into transactions directly via software protocols known as smart contracts. Users don’t transact under their names but rather use blockchain addresses, described as pseudonyms, which are publicly visible.
Main Features Making Decentralized Finance Appealing
One of the primary goals of cryptocurrencies, and DeFi, in particular, has been to encourage financial inclusion to ensure that over 1.7 billion unbanked people worldwide have access to benefits people with bank accounts enjoy. To ensure that people previously excluded by traditional finance systems can participate in financial issues, DeFi leverages blockchain technology to enable anyone with a smartphone to enjoy financial services. Among the reasons DeFi has become so successful and appealing include the following:
Accessibility
Traditional financial systems have many entry barriers, including extensive paperwork, stringent eligibility criteria, and geographic restrictions. When it comes to decentralized finance, the DeFi platforms are universally accessible; meaning anyone with an internet connection and a crypto wallet is free to participate. Moreover, the system leverages blockchain technology to promote direct peer-to-peer transactions. Besides streamlining the processes, this opens up financial services to previously unbanked or under-banked populations.
Easy to Use
While crypto and DeFi may have looked like intimating sectors at the beginning when they were the domain of only the tech-savvy, things have changed now so that users can exchange fiat currency into crypto and vice versa via decentralized exchanges and gain access to high yields offered by DeFi platforms.
Open to All
DeFi platforms initially concentrated on individual investors, but as the sector continues to grow, it has designed products that have seen institutional investors access the decentralized market. Some DeFi platforms maintain high levels of oversight while remaining compliant with government regulatory and security requirements.
Sky-High Returns
Among DeFi’s most appealing attributes is the yield that investors receive. Since all transactions are peer-to-peer and there are no expensive intermediaries, participants, especially lenders, take the total yield and don’t share their returns with gatekeeping third parties.
Speed and Reliability
DeFi replaces gatekeepers with smart contracts, eliminating manual validation and the possibility of human error during processing and verification. Smart contracts make DeFi processes faster and more reliable than traditional financial service procedures. Since it is available 24/7 as long as there’s an internet connection, investors can trade during the hours when banks open and close their doors.
Safety
Don’t let the absence of a centralized authority to guarantee or oversee transactions make you doubt the safety of denaturalized finance systems. Unlike centralized systems vulnerable to fraud or institutional malfeasance, DeFi operates on a decentralized network that distributes data across multiple nodes. Decentralization makes it difficult for a single individual to falsify the system, thereby enhancing its security.
Low Fees
DeFi platforms are renowned for lower overhead costs because no third parties are involved. Since transactions occur in a direct peer-to-peer mode for users on a blockchain, eliminating an intermediary translates to removing fees associated with intermediaries. The system operates at lower transaction fees, providing more accessible and affordable services.
Autonomy
DeFi operates an autonomous system that allows users to have total control of their crypto assets. The user holds and manages their assets directly through a crypto wallet. Since the user directly controls their private keys, they become entirely responsible for their funds, unlike the traditional system where the funds are held in the custody of a third party. Moreover, autonomy promotes flexibility and innovation since developers can continually introduce new DeFi products that suit the diverse needs of users. This dynamism ensures that decentralized finance platforms are at the forefront of innovation.
New Investment Avenues
Previously, yield farming was only accessible to large institutions and wealthy individuals. However, the introduction of DeFi has enabled anyone who owns even the smallest amount of cryptocurrency to join these lucrative markets and generate passive income.
The Impact of DeFi on Cryptocurrency
The first cryptocurrency was designed purely as a decentralized alternative to traditional currencies, but money is only a simple instrument within the modern financial industry. The exponential growth of DeFi applications, most of which run on the Ethereum blockchain, has stimulated activities regarding developing “efficiency-oriented tools” that run on top of Ethereum. The result has been faster, cheaper, and highly scalable blockchains.
DeFi’s noncustodial smart contracts have eliminated the need for intermediaries from complex transactions by introducing code that locks tokens in a user’s digital wallet until certain conditions are met. The result has been the introduction of new decentralized exchanges that are steadily grabbing the market share of erstwhile established centralized exchanges. Moreover, DeFi’s fully automated nature has facilitated the creation of new financial instruments within the crypto sector. A good example is “flash loans,” where users can take out funds, convert or trade them, and repay within the same transaction.
That cryptocurrencies are no longer a fringe asset is an open secret, as several banking institutions have been looking for ways to integrate them into their existing systems. By introducing financial inclusion, DeFi has the potential to popularize significantly or support cryptocurrency adoption. Besides promoting crypto as the foundation upon which it is built, DeFi is using crypto to reshape how people manage their finances by showing you no longer require an intermediary like a bank to deal with money in a way that blockchain already does.
Conclusion
While it may be too early to judge the true impact of widespread DeFi adoption in the cryptocurrency space and traditional finance, it’s already apparent that consumers are decentralizing their financial issues. Decentralizing one’s finances via DeFi has created an environment that has brought attitudinal and behavioral shifts toward the entire cryptocurrency sector. Consumers have since learned that beyond trusting their “primary banks,” they can safely supplement banking services using Fintech firms or digital wallets and manage financial relationships via a smartphone.
