Lesson 9 of 10
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9. What is DeFi (Decentralized Finance)?

DeFi, or decentralized finance, is definitely the innovation of this decade – a financial revolution that started to be widely talked about in 2020 (it first appeared in 2017). 

DeFi removes the control of banks and financial institutions over money, financial products and services. It allows you to avoid having your funds in the hands of a third party who can lock up your money at any time, as happened in Canada with the Freedom Convoy protesters in February 2022.

How does decentralized finance work?

Think of a situation when you don’t have to go to the bank to invest your savings or take a loan. Make fast and cheap transfers to the other side of the world, and when you have full control over your funds, regardless of where you live. DeFi doesn’t discriminate, it has equal rights for everyone, it is based on Blockchain and Smart Contracts. Therefore, every transaction is immutable and irrevocable, thus secure. 

Decentralized finance is based on several important pillars:

  1. Blockchain – anyone can trace the transactions in it or know the contents of the wallet. 
  2. Cryptographic system – or encryption. This is the way in which the data in the blockchain network is secured so that it does not fall into the wrong hands. The ciphers are known only to the sender and receiver of the cryptocurrencies.
  3. Smart contracts (smart contracts) – is a code-secured contract written on a distributed and decentralized blockchain network. It contains the terms and conditions upon which a buy-sell transaction is based. It enables a trusted transaction to take place. 
  4. Yield farming – additional blockchain for cryptocurrencies by liquidity providers. At the same time, it provides liquidity for DeFi. 
  5. SWAP – a very fast exchange of currencies, based on an agreement between the user and the liquidity pool. This equalizes the value of the currencies involved in the exchange. Something like a currency exchange office. Examples are PancakeSwap, SushiSwap or Uniswap.
  6. Staking – we put the cryptocurrency we own into a wallet and force it to earn because the blockchain “engages” it to work. Such a coin uses a proof of stake algorithm.
  7. DApps – decentralized applications. Their operation is based on a network of computer nodes. The nodes have their programming language. 

Nowadays, the vast majority of financial services provided are very centralized. All issues related to funds are largely dependent on banks, institutions, or stock exchanges. Consequently, such a functioning system often encounters inefficiencies in its operation. In addition, all the costs associated with the system are passed on to users. Decentralized finance (DeFi) excludes the above-mentioned entities that control the system. Automatically programmed cryptographic systems create exchanges or financial systems that are not controlled by third parties. This gives great autonomy and anonymity to its users.

Supporters of this system strongly believe that it is smart contracts that will be the basis of future financial infrastructure. The entire legacy system – banks, brokers, exchanges-will be replaced by a whole new generation that will use Blockchain. It will be reliable and transparent. 

Of course, apart from the fact that DeFi brings many benefits, like any system, it also has its downsides; we can include low scalability and low system performance. This makes it difficult to be available at certain times. The system is constantly evolving, which makes it vulnerable to attacks by fraudsters. It is worth bearing in mind that in case of problems with its functionality, or in case of loss of funds, as a user of the system, you have no right to direct your claims to anyone.

The decentralized finance system is already widely used at this stage. It is speculated that as it grows, the use of the system will be even greater. It is used to streamline most of the financial systems in the world. Blockchain helps in streamlining all financial institutions, while smart contracts automate their operations. This effectively eliminates the presence of third parties. Simple? Trivial. Where can we encounter this technique? 

Below are some examples:

  • ICO (Initial Coin Offering) – thanks to this solution, companies and corporate entities changed their bank accounts into smart contracts and tokens, based on blockchain technology. Thanks to this they could raise millions of funds, e.g., for the development of their startup without having to deal with a dozen bureaucrats and paperwork.
  • DEX exchanges – or decentralized exchanges. They are characterized by the absence of a supervisory authority. Using it, you do not set up special accounts or verify your identity documents. An additional advantage is the absence of commissions on the deposit and withdrawal of your funds. DEXes also do not require you to deposit funds. Everything works by connecting your wallet to the exchange. Our funds are 100% safe anyway because we make the exchange directly from the wallet. Of course, these exchanges also have their downsides. Always make sure what cryptocurrency you invest in because anyone can add a new token to the exchange, which may turn out to be a scam. The second aspect is phishing sites that can impersonate exchanges.
  • Lending platforms – are based entirely on blockchain technology. It is the equivalent of pawnshops, only fully automated. Using smart contracts, you store your cryptocurrencies there and lend them to other users, with no proof of creditworthiness. 
  • Yield Farming Protocols: these are platforms where you can borrow liquidity on DEX in exchange for often high-interest rates.
  • Bridges: allow you to transfer cryptocurrencies between different blockchains, the main ones being Multichain and Portal (Wormhole)

If you’re already considering investing in decentralized finance, take a look at our tips that can save you from costly mistakes:

  • Always verify the app and the site you want to use. 
  • Make sure the transactions you make are transparent. 
  • Verify that you are on the DEX exchange or a copy of it. 
  • Check information on trusted sites or ask more experienced ones. 
  • In the world of DeFi, hackers never sleep! 

DeFi industry is very promising, but of course financial institutions and nations are afraid of its development. The United States and the European Union want to regulate its use, and China is banning its use. But can decentralize finance be stagnated, and, should we? DeFi can eliminate many of the problems of the current system and has great potential to be exploited in the future. Considering the fact that 2 billion people don’t have access to a bank account but mostly own cell phones, it’s an ideal solution.