Decentralized Finance (DeFi) is a blockchain-based financial system. Instead of relying on centralized intermediaries like banks, stock exchanges, or brokers, DeFi financial services use smart contracts to record transactions and transfer funds.
DeFi systems remove the middleman (financial services companies) that can cause bottlenecks and roadblocks when financial transactions are centralized. While traditional methods of authenticating transactions require proof of identity, such as a government-issued ID or social security number, anyone can participate in a DeFi system. By making transactions public and peer-to-peer, DeFi is able to bypass many of the logistical issues that can negatively affect international transactions, for example.
In order to ensure all transactions are valid, DeFi uses smart contracts, which are public records that everyone can inspect and audit for authenticity. The records keep track of which crypto accounts in the blockchain have funds, how much, and where they came from. Each time accounts exchange funds, the changes in balance are written in the record, preventing any single individual or party from manipulating it or sending funds they don’t have.
The importance of DeFi lies in its decentralization. Instead of leaving all the financial power in the hands of a few institutions, DeFi enables community monitoring and gives users complete control over their finances, including how they trade them and where they store them.
The concept of a decentralized financial system is relatively new. MakerDAO is credited as the first DeFi platform to receive sufficient use and credibility. While the platform itself was founded in 2014 as a concept, it allowed users to buy, exchange, and borrow a cryptocurrency known as Dai, which wasn't released until late 2017. Unlike other cryptocurrencies, Dai is tied to the US dollar, making it one of the most stable coins to trade with through the Ethereum blockchain.
The Components of a DeFi System
Numerous layers and elements can be implemented to make a DeFi platform more efficient and user-friendly. However, every DeFi platform requires two core elements: an infrastructure to function on and a currency to function with.
- DeFi Infrastructure: An infrastructure for DeFi needs to be a blockchain network that supports smart contracts. Through a platform like Ethereum or Polkadot, you can write decentralized programs where traders can create contracts to manage their finances and transactions.
- DeFi Currency: The DeFi currency needs to be compatible with the infrastructure and smart contracts system. For instance, Bitcoin isn’t compatible with an Ethereum infrastructure. However, not all cryptocurrencies can be used in DeFi, to begin with. To ensure stability instead of investment growth, DeFi uses Stablecoins, which are cryptocurrencies that are pegged to a fiat currency or a traded commodity such as Tether, Paxos Standard, Dai, and Binance USD.
The Current and Future Applications of DeFi
At the start of 2022, DeFi as a technology is still in its infancy. It’s safe to say it’s yet to reach its full potential. In many ways, DeFi could be the first step in a completely decentralized internet. There are countless projects that combine the decentralization power of DeFi with various, powerful blockchains technologies such as Solana, Terra Luna, and Avalanche.
Still, one of the most promising outcomes for DeFi is the cross-over with Artificial Intelligence (AI) and Machine Learning (ML). While most previous blockchain and DeFi projects and systems were developed by humans, AI and ML have the potential to revolutionize DeFi protocols by monitoring previous transactions and optimizing future ones for efficiency and security.
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