What is DeFi (Decentralized Finance)?

DeFi is the abbreviation for decentralized finance. It’s different from traditional financial systems because it doesn’t need financial intermediaries (banks, insurance companies, stock exchanges, etc…) or government IDs to complete transactions like trading, mortgage lending, or insurance compensations . DeFi uses blockchain technology to solve two main problems in traditional financial systems: the identity authentication process and increased costs due to transaction fees to intermediaries. Using this technology, new financial products have been developed and are becoming very sought after. In this article we’ll explain how DeFi solves problems we encounter in traditional finance and why it’s gaining popularity.

On the blockchain, having a private key represents that a user has an account. If a user has many private keys, then it means that they have multiple accounts. This then means that as a user, they can have an endless number of accounts. As long as the user has the correct private key for an account, then they can sign off on any transaction involving that account. As a result, there is no need for identity authentication on the blockchain, because any user that has the correct private key to an account will have full access to the corresponding assets. This mechanism allows for 2 advantages:

  1. It avoids the cumbersome process of identity authentication
  2. It creates an ecosystem that doesn’t discriminate based on wealth, profession, age, or status. As long as the user has the correct private key, then the user is the owner of the account, and can take part in DeFi (decentralized finance.)

Furthermore, blockchain relies on distributed ledgers to achieve decentralization. Anyone can download the blockchain ledger and take part in updating the ledger. Crypto mining is resource-intensive and requires robust hardware and heavy electricity usage, but it is not an impossibly high entry barrier. With decentralized systems as an underlying architecture, transactions don’t need to go through a centralized institution. This reduces overhead costs and other bottlenecks that can be found on centralized systems. Applying this technology to specific blockchains, such as Ethereum’s smart contracts, has allowed for new financial products to emerge in DeFi form. Some of these products are loans, mortgages, insurance, and crowdfunding.

Smart contracts are computer programs that are executed on the blockchain. With smart contracts, everyone has the opportunity to develop a wide range of financial products. These can range from simple agreements to complex decentralized exchanges. Even more, derivative financial products can be combined to create a “DeFi Lego”. For example: a user can borrow some stablecoins using excess Ether they have on hand, and then lend stablecoins to earn interest. Every transaction on the blockchain is visible to everyone, even the source code for smart contracts are available to the public. This allows for the smart contracts to be audited, which increases transparency and minimizes the risk of fraud or illegitimate transactions.

With that in mind, can we say that DeFi is a foolproof, low-risk, high-reward financial product? Not precisely. The value of many Ethereum DeFi projects have been growing exponentially and many users have profited off of them, but it is not an easy task. The first step in embarking on any investment–learning to recognize a good and safe product–already has most users stumped. Further research on wallet security or financial derivative options are confusing and deter users from adopting this new technology. In the next couple of articles we will introduce and explain concepts like wallet security and DeFi operations to help you have a better understanding.

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