Imagine a world free from banks, credit card companies and government authorities controlling how you spend and use money. A world where you can receive loans without providing collateral and receive decent interest rates for your savings. It sounds impossible, right?
Millions of people use a concept called decentralized finance or DeFi to access these benefits. Read along as we explore what DeFi is and how it works.
What is DeFi?
DeFi is a term used to describe financial services developed on blockchains — a system for recording information in a way that makes it difficult or impossible to change, hack or cheat.
DeFi provides services that you’ll typically associate with banks — such as savings, insurance, lending, trading and more. It is generally faster, cheaper and more flexible than the traditional banking system.
Why do we need DeFi?
For centuries, we’ve relied on a system of centralized finance where the banks and government control the flow of money. Centralized finance is expensive for the average person and largely beneficial to an elite few with the money and resources to take advantage of existing financial services.
DeFi changes things by opening financial services to everyone within a free and fair system. For example, banks typically ask for high-value assets as collateral before granting loan requests. With DeFi, you don’t need huge collateral to receive loans as all the information required is recorded on the blockchain.
What are the key features of DeFi?
DeFi has a few features that make it stand out from traditional finance. Some of these include:
Transparency: Since DeFi is built on the blockchain, anyone can track and view all transactions. This provides transparency and trust, eliminating the need for middlemen to serve as guarantors for transactions.
Accessibility: DeFi eliminates the long process of registration involved in traditional finance. You don’t need to provide personal details like your name and address. All you need is a crypto wallet to access financial services on different DeFi solutions.
Affordability: Cryptocurrencies play a massive role in DeFi. As you may know, cryptocurrencies allow you to move your assets without paying expensive fees. With DeFi, you can transfer large amounts of money for a few cents in contrast to your traditional money transfer system that is expensive.
How does DeFi work?
As earlier mentioned, DeFi services are built using blockchain and can be accessed via special software called dApps (decentralized apps). dApps are similar in function to the traditional finance apps but only require your wallet, which serves as your account on the platform.
Here are some activities that you can engage with on DeFi
Savings: You can save your crypto into a DeFi savings platform and earn higher interests (3–5%) than what you’ll get from a bank (1%).
Borrowing Loans: DeFi simplifies the process of receiving a loan. No paperwork is required, and loan interest rates are extremely low ( less than 5%).
Lending: Lending is a popular activity in DeFi. You can lend your crypto and earn interests and rewards.
Trading: DeFi also supports trading services. You can trade different cryptocurrencies without paying huge transaction fees.
Limitations of DeFi
Despite the massive potential of DeFi, it is a new concept and has some limitations. Some of these include:
Insurance:
Insurance plays a vital role in traditional finance as it protects investors in the event of fraudulent activities or hacks. In DeFi, insurance is uncommon.
Volatile markets:
DeFi is highly dependent on cryptocurrencies which are highly volatile digital assets.
Uncertain regulations:
DeFi regulations are unclear and differ from region to region.
Looking into the future:
The DeFi market has grown rapidly in less than a year, from $20 billion in November 2020 to its current value of more than $250 billion.
We are still at the beginning of a massive DeFi wave, and there’s a growing belief that the advantages of an open and decentralized financial system are too compelling to ignore.
You can also check out these recommended resources to learn more about DeFi:
A beginner’s guide to getting started in DeFi
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