The decentralized finance movement aims to accelerate cryptocurrency’s promise to ease payments and make money accessible globally to anyone, no matter where they are.
This article will help you break down and understand everything about decentralized finance and how it works.
Decentralized finance, commonly known as DeFi, is an open, global financial system that gives you visibility and control over your money or assets. Decentralized finance unlocks financial services to anyone connected to the internet and is primarily owned and maintained by its users.
Decentralized finance is based on secure distributed ledgers similar to cryptocurrencies, and it connects directly to users through applications that use blockchain technology, known as DeFi protocols.
Unlike conventional finance, where the responsibility of your money and assets is held by a central authority like a bank or company, DeFi operates by completing financial transactions without interference from a governing body or middleman.
Understanding how and what makes centralized finance different from decentralized finance would help you better understand how DeFi works.
During centralized financial transactions, a corporation or bank holds your money and assets whose underlying aim is to make money and increase profit.
The traditional finance world is highly regulated and full of intermediaries, each charging a fee for the use of their services. Decentralized finance erases the need for intermediaries by facilitating financial transactions for people and businesses through emerging smart protocols.
The difference between decentralized and centralized finance comes down to whether or not you can trust the management of your assets to people or a permissionless smart contract accessible to all.
In layman’s terms, smart contracts are self-executing computer programs running on the Ethereum blockchain. A smart contract is automatically executed when both parties meet the pre-agreed conditions of trade.
A smart contract can also document events and control actions that fall within an agreement or contract terms.
Smart contracts can also be used to automate workflow, and when certain conditions are met, they trigger the next line of action. They also reduce the need for intermediaries or central authorities during financial transactions.
The agreements and code contained within a smart contract exist across a decentralized network. These codes, while being irreversible and trackable, control trade execution.
A smart contract is a type of account on Ethereum, which means that it can send transactions. However, no one user controls a smart contract; instead, they get deployed and run as preprogrammed.
A smart contract can hold multiple stipulations needed to convince the participants of a satisfactorily completed task.
Decentralized finance and cryptocurrencies utilize the same blockchain.
A blockchain is simply a distributed secure ledger or database. A blockchain is run by decentralized applications (dApps), which oversee transactions.
In a blockchain, records of transactions are kept in ‘blocks,’ which other users verify. A block is encrypted and closed once the verifiers agree; a different block is created, which houses the previous block’s information.
These information blocks are ‘chained’ jointly, which bestows the name ‘blockchain.’ A blockchain cannot be altered, as information within a previous block cannot be modified without affecting tbs information in the next block.
Defi cannot function without a decentralized infrastructure; this is where the Ethereum blockchain comes in. The Ethereum blockchain is a setting for dApps (decentralized applications), as most decentralized finance protocols run on the Ethereum blockchain.
There are several reasons why Ethereum is the perfect dwelling for decentralized finance.
- Ethereum and its smart contracts do not belong to just one person; this gives everyone an equal chance to utilize defi.
- Every defi product utilizes Ethereum, which means that each product functions seamlessly together.
- Every Cryptocurrency and token is built into the Ethereum blockchain, and its shared ledger means that ownership and transactions can be kept track of.
- Ethereum enables total financial freedom.
To better understand how decentralized finance works, you can imagine it in building blocks or layers. Each block creates a software pile with one layer atop another. Each layer works simultaneously with another to forge defi and its applications that attend to users in diverse ways.
The following layers make up DeFi
- Settlement – This is the foundation of a blockchain and its native asset. For instance, Ethereum is a blockchain network, with ether as its cryptocurrency. This settlement layer contains the history of all transactions and the state of each account.
- Assets – This refers to cryptocurrencies such as ETH and all tokens and assets native to the specific blockchain in use.
- Protocols – The smart contracts that deliver functionality and set guidelines.
- Applications – The products used to access and manage the protocols, with a consumer-facing user interface.
- Aggregation – This layer comprises the aggregators connecting the numerous protocols and dApps which form the foundation for financial services like lending and borrowing.
Ethereum’s smart contracts and its ability to build applications allow defi to be used in the following ways:
- For lending – DeFi offers peer-to-peer lending and borrowing
- Exchanges – Users can trade cryptocurrencies with each other on decentralized exchanges
- Bets – where the probable result of specific events is bet on.
- As a stablecoin – Stablecoins connect cryptocurrencies to conventional fiat money like the US dollar to increase stability and reduce price volatility.
Decentralized finance is a comprehensive economic ecosystem that aims to extract the need for intermediaries and enable users to conduct financial transactions with each other.
Cryptocurrencies and the DeFi world at large have garnered a lot of hype. However, it would be wise to consider the reward and the risks involved before you begin trading.