Technological advancements have resulted in a profound transformation of the financial landscape and the introduction of DeFi has changed how we used to interact with the financial system. DeFi has implemented a financial service among peers that automates transactions through smart contracts. By incorporating blockchain technology, cryptocurrency, and essential software, DeFi eliminates the requirement of third-party interrogation in transactions.
What is DeFi?
Decentralized Finance, abbreviated as DeFi is a financial system that allows business firms or individuals to transact money or cryptocurrency directly among each other without the need for a centralized authority like a bank.
By eliminating third parties DeFi aims to reduce the transaction cost and time along with avoiding the chances of human errors. With the launch of the Ethereum network, the financial industry has noticed one more term ‘smart contracts’ which laid the foundation for DeFi to provide services like lending, borrowing, trading, and more.
How does DeFi work?
DeFi uses smart contracts to facilitate financial transactions. By incorporating blockchain technology into its system, DeFi eliminates the involvement of third parties and promotes direct peer-to-peer transactions.
Without depending on a central financial institution, an individual can lock their asset to the smart contract as collaterals and borrow other assets. Smart contracts analyze the requirements of loans and automate the transactions once the predetermined conditions are met.
Advantages of using DeFi
The lack of requirements for an intermediary is the prime and utmost advantage of using a DeFi system. Other advantages include,
1. Accessibility: A DeFi platform can be used by anyone at any time without the restriction of geographical barriers. A user can access the benefits of a DeFi system with an internet connection.
2. Low transaction fees: Unlike banks or other financial institutions, a DeFi system doesn’t require third-party support, thus comparatively low transaction fees are applied. The interest rates are also low.
3. Transparency: Smart contracts integrated into the blockchain network can be viewed by the participants of the network, ensuring transparency to the system.
4. Security: Though smart contracts allow transparency, the robust security system doesn’t allow the disclosure of the identity of individuals. The immutability of blockchain prevents the altering of data.
5. Autonomy: Since there are no third parties, the transactions occur between peer to peer directly. The decentralized nature of DeFi protocols distributes the power evenly among the network.
How to take part in a DeFi system?
To take part in a defi system, one must own a digital wallet. After setting up a wallet, buy a cryptocurrency for some valuable exchanges and invest it in the wallet. Find a DeFi app to borrow or lend the assets, add the cryptocurrency to the app, and begin the transactions.
Key platforms of DeFi
1. Uniswap
Uniswap is one of the most popular decentralized exchange platforms that allows lending and borrowing without the involvement of an intermediary. It is built on the Ethereum blockchain and allows users to trade ERC-20 tokens from their wallets. By adopting the Automated Market-Making (AMM) model the platform ensures liquidity. It provides incentives for liquidity providers in the form of token rewards and fees.
2. Aave
Aave is a leading platform for lending and borrowing in DeFi. It allows users to borrow assets by keeping collaterals and earning interest from crypto assets. The flash loan mechanism used in the Aave platform allows users to borrow instantly even without the need for collateral under the condition that the loan is repaid within the same transactions. The advanced risk management features and elevated security measures increase the popularity of the platform.
3. Compound
The Compound platform is one of the leading DeFi spaces that supports lending and borrowing of cryptocurrencies. It allows users to earn interest by supplying assets and also permits borrowing of the supplied assets by providing collaterals. Based on the supply and demand, the platform’s algorithm adjusts the interest rate. The main advantage of Compound platform is the easiness it provides while integrating with other DeFi protocols.
Limitations of DeFi
Though DeFi offers a widened opportunity for financial services, it poses some limitations.
1. Performance
The processing of transactions through a DeFi system takes a long time. Etherium performs only 13 transactions per second, at the same time, the counter platforms allow thousands of transactions.
2. Immutability
Changes made to the blockchain can’t be undone or altered.
3. Mutual responsibility
Since DeFi is a decentralized platform, every participant within the network shares the responsibility of maintaining the network.
Final Thoughts
DeFi is a new financial system that allows users to borrow and lend assets. The main aim of the platform is to eliminate the interventions of intermediaries. By incorporating smart contracts and blockchain technology, the system automates secure and transparent transactions. Low optimization and bugs are the main limitations of the system, though they can be regulated over time.