Blockchain has gained momentum over the past few years, and industries from every sector are keen on implementing blockchain technology to develop protocols, applications and benefit from its decentralized and distributed structure. The financial industry is no different and is looking for technologies that provide security and convenience. Therefore, the use of crypto assets has been increased as an individual from anywhere can access their purchases, make payments and benefit from other advantages as well. Decentralized Finance (DeFi) is the new path used to manage and monitor finances in a decentralized environment with no interference from an intermediary.
With crypto being used in various industries and proving to be a benefit for them, it can be expected that the majority of financial services will look forward to implementing DeFi in their infrastructure. It can bring revolution in the insurance industry due to its applications in lending and borrowing activities.
What Is Decentralized Finance?
Decentralized Finance (DeFi) refers to the financial transactions that eradicate intermediaries between participants. It uses cryptocurrency and blockchain technology to eliminate central authorities and provide peer-to-peer facilities to carry out financial services such as banking, loans, mortgages, and more. The primary purpose of DeFi is to establish an open-source, transparent, and permissionless ecosystem without any central authority owning the power over financial transactions. It allows participants to control their assets, efficiently conduct peer-to-peer exchanges and build decentralized applications (dApps).
Once a transaction is carried out in a traditional banking system, its details are recorded in a private ledger owned and monitored by a financial institution. However, in DeFi, the financial transactions are stored in a computer code on a decentralized public ledger. All participants using DeFi applications and platforms have an identical copy of the general ledger. This ledger holds the information of every transaction in encryption code. Since decentralized blockchain platforms and applications are immutable, the records of ownership cannot be modified or deleted by a third party providing security in verifying transactions and storing their data.
Decentralized Finance (DeFi) works on the traditional financial system and replaces the intermediaries or central authorities with smart contracts. A smart contract is an automated merger, enforces agreements without intermediary involvement, and is easily accessible by anyone with an established internet connection. Most of the DeFi protocols work on the Ethereum blockchain, and the decentralized applications are often created using Ethereum.
Applications of DeFi
Some of the applications of decentralized finance are:
Decentralized Exchanges (DeX)
Decentralized Exchanges (DeX) allow participants to exchange tokens with other assets in their possession without a need of a custodian. It will enable them to transact peer-to-peer and monitor their funds. It reduces the risk of theft as crypto assets are not in the exchange custody itself. Some DeX includes Uniwasp, Curve, SushiSwap, AirSwap, etc.
Lending and Borrowing platforms
The lending and borrowing protocols are some of the widely used applications in the DeFi ecosystem. Decentralized lending platforms offer loans to businesses or individuals without any involvement of an intermediary. DeFi lending protocols also help individuals to earn interest in their supplied cryptocurrencies and stable coins. The lending and borrowing platforms use smart contracts to eliminate intermediaries such as banks, financial institutions, etc., creating an ecosystem where borrowers and lenders can participate in open infrastructure. It assists borrowers by offering them liquidity without selling off their possessed assets and providing lenders the chance to earn interest by loaning crypto assets.
One of the primary applications of DeFi is for making payments and other banking services. DeFi payments will create payments and banking systems to eliminate the third party, and therefore, individuals can directly transfer their cryptocurrency through a secured channel. With DeFi, faster payments and processes can be ensured. It helps large financial institutions streamline market infrastructure and serve wholesale and retail customers in a disciplined manner. It also assists in reaching out to people in a systematic way.
Blockchain-based prediction marketplaces allow users to vote, trade, or bet on the outcomes of future events. DeFi prediction markets combine the knowledge of a particular event through various oracles. These markets have smart contracts that decide how much the individuals will get paid if a specific event occurs. The platforms operate similarly to the traditional prediction markets without an intermediary. Examples of the DeFi prediction market are Augur, Gnosis, and FTX.
Advantages of DeFi
New financial instruments and digital assets can be built rapidly by taking advantage of the highly programmable smart contracts and their automated execution, which helps run everything smoothly.
Blockchain’s decentralized nature offers immutability. It indicates that a record, once stored, cannot be modified or deleted through any form. Therefore, decentralized finance is built on the exact nature and provides increased security and audit precision.
New DeFi applications or products can be built or modified by combining the existing product with another DeFi product. Developers have the flexibility to create new products on top of existing protocols, customize the user interface and integrate third-party applications. Therefore, DeFi products are often referred to as ‘Money Legos.’
Public Ethereum blockchain allows every individual participant to broadcast and verify transactions on the network. It boosts qualitative data analysis and ensures that every user can access the network’s activities. DeFi protocols are built with open-source code, allowing individuals to read, modify and use the code to make other DeFi products.
Every individual is allowed to use DeFi applications and products as well as build them without any restrictions. It also enables users to direct smart contract contracts through their crypto wallets without any minimum amount of resources.
Challenges Faced While Using DeFi
Data feed centralization
Blockchain protocols cannot access off-chain data records or information. Many blockchain technologies use third-party services that allow access to external information. They work as bridges between blockchains and the outside information. The central point of trust in a decentralized infrastructure proves to be the vulnerability for a smart contract. If an external third-party feeds corrupted information, then it would disrupt the DeFi protocols.
Security risks with smart contracts
As smart contracts form the fundamental backbone of any DeFi protocol or application, the security risk related to them can disrupt the entire application or protocol. Smart contracts are open-source, enabling users and programmers to review them before investing in the DeFi protocol. They tend to miss flaws in the smart contracts, which raises the threat of a cyberattack. Therefore, developers must ensure their smart contracts go through various audit levels.
Decentralized Finance (DeFi) can prove to be the next big thing in the technology world since it provides advantages to all the sectors looking for a secured financial infrastructure. With blockchain technology as its backbone, DeFi is has a high probability of getting incorporated by various organizations.
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