What Is DeFi and Why Do We Need It?

by in Crypto 101, Cryptocurrency For Beginners


The concept of DeFi

DeFi is a big trend in blockchain technology nowadays and it’s moving upward and upward every month. Let’s see what is it all about and how we can use it?

The appearance of smart contracts was a real sensation. This type of executing transactions was considered to be the main advantage of blockchain for a long time. Then a new revolution started which was termed decentralized finance (DeFi). It’s the alternative of CeFi (centralized finance). They both describe the nature of financial activity foundations and how they work. Currently, the entire traditional banking industry is centralized controlled by companies or governments. On the contrary, the decentralized structure allows crypto users to recreate traditional financial implements without any intermediaries.

The primary task of DeFi is to suggest another option to traditional bank policy. In other words, to give access to non-centralized lending and new investment programs for a large number of people.

How does DeFi work and who controls the system?

First, let’s review the structure of blockchains, as decentralization is one of its pillars that makes this technology unique. Blockchain represents groups of transaction data linked together forming a chain of blocks. It means that instead of data being stored in one physical location as one computer or one building, data is stored in multiple locations on multiple computers all around the world.

Blockchain enables transaction data management to be decentralized on a chain of computers using open source software and any changes of this open-source software or blockchain order have to go through the consensus process. This is the essence of decentralization.

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The components of DeFi and how we can use it?

DeFi represents financial instruments in the form of services and applications produced on the blockchain. These aids include items such as savings and checking accounts, loans, asset trading, insurance, and much more.

The five main components of Defi are:

1․ Stablecoins. Each digital asset has a distinctive function or utility. The kinds of cryptocurrencies that peg their value to something with stable pricing like the US dollar are acknowledged as stablecoins. For instance, Dai is an asset that maintains the same value as the US dollar. This gives the token price stability and it stays at nearly one dollar per Dai. Stablecoins were invented to bridge the gap between fiat currencies and cryptocoins. They also minimize the evaporation associated with holding the majority of cryptocurrencies. Note that some stablecoins are not completely decentralized and trustworthy.

2. Exchanges․ In DeFi exchanges are known as dex. In dexes are financial forms that allow users to swap digital currencies for other types of digital currencies directly without an intermediary.

3. Money Markets․ These components simply represent lending and borrowing money. Decentralized money market users can loan and deposit their digital assets in exchange for interest. Lending your crypto coins in exchange for interest is a great way to earn passive income on idle assets you are holding for an expended time. DeFi money markets are completely transparent so anyone at any time can review the number of loans issued from a lending pool.

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4. Synthetics․ The financial instruments called Synthetics represent an asset designed to behave like another asset. In DeFi decentralized synthetics are tokens that follow the price of another token. They are used to simulate activities like funding, liquidity creation, and market access.

5. Insurance․ Decentralized insurance is used to protect costumers against the risks associated with using this new financial protocol. Unlike centralized insurance, which requires people to use insurance companies, in decentralized insurance users can choose to provide insurance in exchange for interest or they can buy it.

When can DeFi come to the rescue?

Let’s imagine we are going to get a loan from a bank and it’s not a secured loan essentially. They need to check our credit score, to verify the documents, and examine the eligibility. Bank balance, salary deposits also play a decisive role. All this is done to see if we’re fit to lend money to. Then, we make a contract and pay a certain amount of interest. Now let’s see how some of the Defi schemes like “Maker” or “Compound” can help us in this case. These loans are collateralized, which means that to borrow the money you must invest money first. This offers us quite an interesting solution. The borrowing process is much easier and is done without any intermediary.

In a conclusion, we can say that we need DeFi as an alternative to a regular financial policy as it offers new solutions and transparency. Let’s follow the development of this industry and see if it will dominate in the future.