Home Business “DeFi”-ying Financial Systems: Decentralized Finance.

“DeFi”-ying Financial Systems: Decentralized Finance.

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Source: https://commons.wikimedia.org/wiki/File:Blockchain_Illustration.jpg

Wall Street never sleeps because the world of finance itself never stops growing! It takes a month or two to catch up to what’s going around – given how quickly this space evolves. One such evolution or groundbreaking concept is Decentralized Finance. However, before we dive deep into this topic, it is important to understand a few terminologies.

Blockchain Technology

Source: Wikimedia

At its core, Blockchain Technology is a method of recording information in such a way that there is no way for it to be hacked, or manipulated. For facilitating this, there is a storage mechanism popularly termed a “Digital Ledger”. In other words, it’s almost like a spreadsheet that records information line-by-line basis transactions. How does it secure your data? Well, every transaction in this “ledger” is authenticated using the digital signature of the owner.

Decentralization

Along with Blockchain, it is also important to understand Decentralization(in the context of Blockchain). As the word says, decentralization is when the control is transferred from one entity to a distributed network. In addition to this, decentralization ensures that each person on this network would have a copy of their own in the form of a “distributed ledger”. If in case the data is altered in any one of the distributed ledgers, the entire network falls.

DeFi: Decentralized Finance

Source: Wikimedia

Now, coming back to Decentralized Finance – this concept comes alive when financial systems are built using blockchain technology. Ultimately, the goal is to create a transparent financial system. This way, unlike traditional financial systems wherein financial institutions like banks, act as an intermediary, there would be none. We, ourselves, would be able to transact without the need for a middleman. Eliminating an intermediary would mean less time and saving money. On top of this, since DeFi would be built on blockchain tech, there would be no compromise when it comes to data security.

How does Decentralized Finance work?

Yes, we did say DeFi is based on Blockchain technology. However, for running this blockchain tech, dApps(decentralized applications) are employed. Each transaction would then be recorded in blocks – subsequently verified by other users. Once all users verify it, this block would be closed and encrypted. For a better footprint, the next block created would have information about the previous one.

Decentralized Exchanges

Source: Uniswap Labs

Decentralized Exchanges, or DEXs in short, are one of the most popular applications of DeFi. Using this platform individuals can trade cryptocurrencies without a centralized exchange. Smart contracts form the basis of this tech, using which the trades are executed automatically. These smart contracts also ensure minimal transaction costs without trading off on data security. Some examples of DEXs include Uniswap, PancakeSwap, Kyber and dYdX.

Lending and Borrowing platforms

Decentralized Finance would change the outlook of traditional lending and borrowing platforms. Since applying DeFi would eliminate the need for an intermediary – the corresponding change would be seen in interest rates. Ideally, the interest rates for a platform built on a DeFi space would be much lower than traditional financial institutions. For P2P lending – a request would need to be raised by an individual. Post which, the algorithm would match your terms with potential lenders. Once it finds your match, the payment is made via a dApp.

Caveats

Source: Edwin Images

There is no good without evil, and there is no tech without bugs. Though DeFi might sound foolproof, there are many risks associated with it – one of the biggest is smart contract bugs. There would still be hackers out there trying to manipulate and break into the system. To give you some idea, in 2022, Cybercriminals siphoned as much as $2.8 Bn in cryptocurrency by tapping into various exploits.

What’s next?

If there is a tech that would make someone truly “financially independent”, Techies would figure out a way around the bugs. Maybe that’s why despite the risks associated, this sector is growing immensely. The growth can be attributed to the interest amongst institutional investors, NFTs and the popularity of Cryptocurrency. In terms of numbers, we are looking at around $100 Bn total value locked into DeFi applications in 2021. This is a jump from $1 Bn in 2019. That is 100x growth in less than 2 years.

Source: Ramy Majouji

However, it is not yet clear whether we would have something like DeFi replacing the existing financial system, or whether it would be integrated into it – as support. Regardless of which, decentralized finance would definitely shape the new world of finance. It won’t be too long until we see financial institutions taking a step back and letting the tech do their job. Of course, the consequences of this would be immense – not just in terms of finance, but people being replaced by machines etc.

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