A BASIC INTRODUCTION TO THE CONCEPT OF DECENTRALIZED FINANCE (DeFi)
DeFi which is short for Decentralized finance, came to change the original trend of traditional financial institutions. Originally, financial institutions controlled the financial activities of individuals e.g how they lend and borrow, how deposits are made and how cash can be transferred.
They were able to control the monetary activities through currency because they had the trust of people and people therefore used their services. But as time went by, given the high interest rate on amount charged, high cost of transaction, delayed transactions and the lack of some form of individual control over their assets, people gradually began to lose trust in the system.
DeFi came as a solution to the problem, providing users with a system that was both decentralized and permissionless.
In this article we would be able to address:
- The meaning of Decentralized finance (DeFi) ?
- How it works
- The use of blockchain technology in DeFi
- What a smart contract is
- Blockchain oracles
- The Advantages of DeFi ?
- Risks involved in DeFi?
- Decentralized applications?
- Decentralized exchanges?
- DeFi staking ?
WHAT IS DECENTRALIZED FINANCE (DeFi)?
DeFi is generally seen as the management of large amounts of money, its provision, channeling of currency or credit to where they are mostly needed without the use of an intermediary or regulatory body.
This means that finance is no longer concentrated in the hands of a single centralized authority, but has been redistributed to involve all individuals interested in participating. Here, all participants have a say in how their finance would be handled.
This upgrade in the finance system could apply to and be used by all individuals who have access to the internet. Defi allows for trustless banking and peer to peer payment through blockchain technology.
It is explicitly seen as a cover term for the different applications and projects that go on in the blockchain space and it is geared towards a trustless finance system that is inspired by blockchain innovations.
Defi allows investors and participants to become their own banks by giving them the opportunity to save, lend, stake, invest, earn interests, and perform other financial transactions by themselves. Transactions, in the DeFi ecosystem, are easily performed regardless of location.
HOW DOES DEFI WORK?
To be able to fully understand how DeFi works there should be an understanding of the concept of blockchain technology and smart contract as these are the building blocks of DeFi and they are what facilitates the workings of the system
The Blockchain is a public ledger that permanently records all transactions on a given platform. Blockchain-based companies use smart contracts when building financial applications that run on the blockchain.
Explaining Smart Contracts:
Smart contracts are feasible codes or programs that can store blockchain and cryptocurrency at a particular predefined condition and would run if these predefined conditions are met.
So we could say that smart contracts automatically perform transactions among participants when the contract terms and conditions are met.
Most smart contracts offer “turing complete programming languages “ that gives different groupings the opportunity to directly interact with each other.
Smart Contracts facilitates DeFi as it performs the intermediary roles that banks perform thus giving investors leverage to easily perform these activities at a profited rate.
Decentralized finance consists of applications and peer-to–peer protocols developed on decentralized blockchain networks that require no access rights. Decentralized applications (called DApps) are used for performing financial activities like lending,borrowing or trading of financial tools.
Although most DApps are built using Ethereum, many other public networks are coming up with characteristics that are superior e.g Algorand and Solana.
The function of a Blockchain Oracle is to link and associate blockchains to the outside world to convey real world facts and details to the blockchain and also transmit and convey facts from the blockchain to the real world.
Software oracles that transmit to public mechanisms that enable two software components to connect to each other using a set of protocols (APIs) are used. Hardware oracles with physical sensors can inclusively be used.
ADVANTAGES OF DEFI OVER CENTRALIZED FINANCE
- Reduced possibility of error during transactions : Ordinarily in the system of centralized authority there is alway an event of error that occurs during transaction by the intermediaries. This error is totally crossed out in decentralized finance because they are facilitated by smart contracts which are immune to these excesses.
- The permissionless and trustless nature of DeFi: Decentralized Finance is both permissionless and trusless. It does not involve any form of intermediation to grant access.
- Flexibility and ease of use : DeFi is both flexible and offers easy lending and borrowing platforms
- Difficulty in manipulating records on blockchain: This is made possible by the application of some consensus process like the proof of work.
- Opportunity to earn higher income: Ability to earn higher income through DeFi activities like staking, yield farming, etc.
RISKS ENCOUNTERED IN DECENTRALIZED FINANCE
- Low liquidity rate: Compared to Centralized Finance, there is always the risk of low volume of cash being locked and this acts as a disadvantage for the system.
- Mistakes in the DeFi ecosystem are irreversible as Defi protocols do not take blame for human mistakes. This makes individuals who do not really have a concise understanding of the process employ professionals to help in managing the seemingly hard transaction issues.
- Without knowledge on what DApps and cryptocurrencies are, people can lose huge amounts of money.
- Some DApps charge high gas fees and ignorance of these DApps result in money loss.
- There is the risk of theft and loss of owned assets due to vulnerabilities in the smart contract’s code.
- Users can automatically lose access to their crypto assets if they lose their private keys
This is a type of an open sourced program that runs and exist on a peer to peer blockchain network of different computers.
DeFi is carried out using Decentralized applications (DApps) and these applications are developed for different purpose e.g settling of contract terms between the participants involved , movement of asset to either a decentralized exchange or to a decentralised lending platform.
DECENTRALIZED EXCHANGES (DEX)
One of the core activities behind the defi is the peer to peer activities that is facilitated by smart contract, as participants can perform peer to peer activities amongst themselves regardless of location.
Peer to peer transactions are evident where participants decide to exchange cryptocurrency without any form of intermediation as these transactions are strictly between the two parties that are involved .
Peer to peer lending : This is where participants can freely enter in their loan needs and a method would exist to meet or match their needs with peers that meets the need. It doesn’t necessarily mean that there would be no interest rate charged but it does open the participant to varieties of options to choose from and then they get to choose from the peer that presents the most suitable terms to them. Onces a consensus process approves the transaction and the transaction is recorded on the blockchain, participants involved get their loan and when the planned interval for which the amount was loan is reached repayment starts.
Generally defi staking refers to all kinds of defi activities where crypto assets are committed for a particular temporal period of time. While it specifically refers to the staking of crypto assets to become a validator in a layer 1 blockchain or a defi protocol.
By staking crypto assets we refer to putting away a given amount of cryptocurrencies, token, fungible or non -fungible token (NFTs) into smart contracts to become a validator in a proof of stake ,this is in an effort to earn more of these tokens or coins.
Individuals and participants become part of the network’s validators when they stake their cryptocurrency assets in a decentrlized finance setting. With the view of safeguarding the particular ecosystem’s security every proof of stake relies on these validators .therefore those who have fixed a portion of their their tokens to help secure the network are compensated through staking reward, and it also help to provide liquidity for particular trading crypto pairs while maintaining and securing the value of specific cryptocurrency and projects.
Defi staking is an important concept for not just participants or users who stalks but also for the staking platforms and the tokens, protocols being stalked in the following ways
For participants who stakes:
- It gives stakers the opportunity to earn more income by the reward they would earn from staking their tokens
- An increased rate of return that is more than the amount stalked.
For Staking Platforms:
- It increases the liquidity for these platforms.
- It provides yields for the network.
For the token protocol:
- Defi staking helps maintain a token liquidity.
- It offers a much reduced energy take up for validating blocks.
You can also check out ;The basics of Web3 technology: An introduction to the blockchain technology
DeFi -Decentralized Finance on dark blue abstract polygonal background. Concept of blockchain, decentralized financial system.