Today, our financial system is totally centralized. To operate with money or make use of financial services, we go to banks, address financial institutions, make investments and trade through brokerage organizations, and so on. There is always someone in charge of all processes running in a place. Far and wide, we’re facing fraud, corruption, and mismanagement. Here is where a new digital economy in the form of Decentralized Finances comes into play.
DeFi stands for Decentralized Finances and was initially started in 2017 with MakerDao technology enabling various financial services with cryptocurrencies on the Ethereum blockchain. There was also a movement of individuals of the same name working on collateral and generating income. Gaining popularity through the years, Decentralized Finances now represent an opportunity to enjoy financial services and manage money with no agent under no control. Sounds amazing, doesn’t it? Anyway, let’s delve deeper.
Something to know about DeFi
- We all know what Centralized Finances (CeFi) bring us. Banks, agents, third parties – all decisions are made by officials, managers, regular white-collar workers which in no way can refer to a DeFi system. No central authority controls the money you send or receive. There are only two players on the stage – a sender and a receiver.
- DeFi platforms have no one who calls the shots but there’s a set of rules managing all processes running. This set of rules is called a smart contract, which is comprised of an automated code allowing for decentralized platforms running. Once written, this code cannot be changed. Smart contracts control DeFi services and determine the rules for how they will work. In fact, smart contracts are the very component making DeFi platforms operate without an agent.
- Thinking of DeFi, most people recall Bitcoin right away. Stereotypically, Bitcoin is associated with decentralized money. However, it’s not always the case. Say that, when you turn to a centralized financial platform, you can’t make transactions with BTC under no control indeed.
Building a DeFi system
Basically, a DeFi system has a ‘lego structure’ so it is possible to make one by mixing and comprising different blocks. Above all, a financial system needs infrastructure, money, and services. Well, let’s build one!
Actually, most DeFi platforms are built on Euthereum. Ethereum is a DIY platform for programming DeFi apps (DApps) based on smart contracts. As mentioned above, to manage processes running in a decentralized financial system, we should write a set of rules. An automated code secured in a smart contract on the Ethereum blockchain will be just that. When we implement these rules into a smart contract, we will no longer be able to change them so nobody could get control over them.
To maintain and settle transactions, we need money. Many might think: “That’s right, BTC is the very asset'' ! Tut-tut, that’s clearly not the case. Why? The technology Bitcoin is built on has got left behind over the years. Despite being the first established cryptocurrency, Bitcoin is highly volatile, less programmable, less advanced, and is not compatible with the Ethereum platform. What to use as a form of money then? As of now, there are many alternatives to BTC including ETH as such. However, when we’re building a reliable and solid financial system, we turn to more stable assets – stablecoins.
Compared with other cryptocurrencies, stablecoins are pegged to real-world assets such as gold, U.S. dollar, yen, euro – whatever exists in our traditional centralized financial system. They are less volatile since they don’t change much in value daily or hourly. A flashy example of a popular stablecoin is USTether (USDT) which equals 1 U.S. dollar. This means that USDT is a fiat-collateralized stablecoin. Besides, there are also crypto-collateralized assets such as DAI, stablecoins backed by real estate, bonds, metals, etc., and non-collateralized ones. Anyway, that’s a different topic whatsoever, and let’s go ahead.
As we have settled on infrastructure and money, let’s supply our decentralized financial system with financial services. With hindsight on the CeFi world, we use loads of them every day, for instance, transfer of funds, money exchange, insurance, loans, savings plans, stock market, and others. DeFi offers the same and even more but in a decentralized manner. Some services are not properly developed yet, insurance is realized automatically due to the smart contract system, and one of the most common and popular services featured on DeFi platforms is DEX.
DEX is a decentralized exchange that allows for trading crypto with no intermediary. It works according to smart contracts and resides on different networks (most of them operate on Ethereum). DEXs have no financial agent managing user funds, so transactions occur directly between traders which are called a peer-to-peer cryptocurrency transaction. To trade on a DEX, you don’t need to deposit funds into your account, you don't need to sign up, verify your ID, or pay withdrawal fees. It turns out that you just trust strangers when operating your money with no intermediary. You might get into a rage asking “Are you kidding me?”. Yes, it might sound insane unless you remember about smart contracts which determine the rules, settle transactions, and manage funds when necessary.
We now own infrastructure, money, and services – our DeFi system is ready to operate!
DeFi: Pros & Cons
DeFi has a plethora of strengths as well as weaknesses. A decentralized financial system is transparent and equal for everyone. You manage your money and you don’t have to pay any fees which intermediary institutions usually charge you with. Also, it’s very flexible and constantly evolving, sometimes though ahead of the curve. Once you decide to work on collateral on a DeFi platform, calculate all risks, get familiar with any issues that might happen to your principal.
Whilst smart contracts might look secure, they can also get exposed to hacking. Any system can be breached, and DeFi proves the rule here. Hackers, scammers, and other cybercriminals will always find the way to possible holes. So, before investing your money in a DeFi, make proper and careful research. Size up the network you invest in, start with small sums and always stay sharp.
When all said and done...
Let’s sum up that DeFi is a decentralized financial system that provides users with full control over their money. Like a non-centralized system, DeFi has its own infrastructure, a form of money, and services. Gaining popularity in years, DeFi is still being implemented and promises way more opportunities than it does currently. DeFi can become beneficial for a lot of people presently suffering from financial discrimination, high fees, fraud, and other drawbacks of centralized institutions.
With its virtues and flaws, you should remember that nobody is going to help you if any troubles come up. All processes are regulated by smart contracts and you will not have an opportunity to call on an office and make a complaint. So, make yourself aware of any issues that might occur to your funds. Being careful and keeping an eye out, you can make a profit on this new digital realia, earn income and enjoy non-intermediary financial services. Can it potentially give the current economic structure a shake? Good question so far.
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