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What Is Decentralized Finance (DeFi)?

Decentralized finance, or DeFi, encompasses a sector of blockchain-based protocols and assets. This is an umbrella term for a number of P2P financial services, from trading to lending and borrowing. DeFi operates through decentralized applications (dApps) that run almost autonomously. This autonomy empowers individuals to conduct various financial services in a completely P2P manner. It operates globally and directly between individuals as well as ensures anonymity, accessibility, and openness to all.Read on to find out what is DeFi and how it changes the sphere of traditional monetary services.

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What Is Decentralized Finance (DeFi)?  %Post Title photo

What Is Decentralized Finance (DeFi)?

Decentralized finance, or DeFi, encompasses a sector of blockchain-based protocols and assets. This is an umbrella term for a number of P2P financial services, from trading to lending and borrowing. DeFi operates through decentralized applications (dApps) that run almost autonomously. This autonomy empowers individuals to conduct various financial services in a completely P2P manner. It operates globally and directly between individuals as well as ensures anonymity, accessibility, and openness to all.Read on to find out what is DeFi and how it changes the sphere of traditional monetary services.

How DeFi Works

DeFi definition covers these three elements: public blockchain, tokens and smart contracts. Let’s move on to its mechanism of work.

Blockchain

First thing first, what is decentralized finance? DeFi relies on blockchain technology that provides a distributed ledger system for dApp data, managed by volunteer participants called “nodes” globally. Nodes store, validate transactions, and adhere to strict protocols. Developers often build dApps on existing networks like Ethereum or Cardano to save time and money, and ensure interoperability. Established blockchains offer security and large user communities for DeFi services compared with newly created networks.

Cryptocurrency

Native crypto tokens incentivize user participation in blockchain networks and are required for dApp activities, with fees paid in the native cryptocurrency. Ethereum users pay fees in Ether (ETH), Cardano users in Ada (ADA), etc. Additionally, some tokens, like governance tokens, can have additional utilities, i.e. holders can vote over protocol management and future direction.

Smart Contracts

Apps achieve autonomy through specific self-executing programs that fulfill contract obligations when specific terms are satisfied. They are called smart contracts. Smart contracts are executed by simulated computer environments referred to as virtual machines. Nodes validate transactions involving smart contracts, ensuring compliance with protocol rules. 

An excellent example of a dApp in practice is the DAI DeFi application. Users lock cryptocurrency in Ethereum smart contracts to generate DAI tokens for lending. These tokens can be traded or used in other DeFi platforms. This project provides liquidity to investors without necessitating direct disposal of their ETH. Next, step – retrieving assets incurs a small interest fee.

DeFi vs. Traditional Finance: A Comparative Analysis

The emergence of DeFi has challenged the conventional structures of traditional finance. What is the DeFi and traditional financial ecosystem difference? Let’s consider the disparities between these systems.

  1. Accessibility.
    Traditional finance often erects barriers to entry and favors those with established wealth or access to centralized institutions. Due to blockchain mechanisms, there is no need for third parties.
  2. Efficiency.
    Traditional systems are plagued by inefficiencies such as bureaucratic processes, lengthy processing times, and geographic limitations. On the contrary, DeFi works worldwide with fast transaction processing speeds. For example, the Tron network processes over 2,000 transactions per second.
  3. Control over Transactions.
    In traditional ecosystems, individuals relinquish control over their money to centralized entities, which exposes themselves to the risks of censorship, fraud, and mismanagement. DeFi provides users with unparalleled control over their funds through non-custodial solutions.

Pros and Cons of DeFi

DeFi services offer several significant advantages over standard third-party applications, including the following:

  • Automatization. Users have 24/7 access to DeFi services without the long permission processes required by traditional financial institutions.
  • Democracy. Users can participate in these services’ governance (for example, by voting on pricing increases). 
  • Permissionless manner. Users cannot be refused access to DeFi services arbitrarily or due to unfair regulations. 
  • Trust. When using dApps, users do not need to trust centralized entities or any single person.

DeFi also comes with certain drawbacks and risks.

  • Security Risks. Transactions are automated due to smart contracts. While they are intended to be secure, they are susceptible to vulnerabilities and faults. 
  • Complexity and Technical Barriers. Users need to have technical expertise and familiarity with blockchain technology prior to using it. 
  • Price and Volatility Risks. Tokens and assets can experience high volatility. Many DeFi projects create their own coins, which can face dramatic price changes due to speculative trading, liquidity imbalances, and market sentiment.

Real-World Applications of DeFi

  • Lending cryptocurrency and earning interest and prizes every day, not just once a month. 
  • Getting a loan quickly and easily, including short-term “flash loans” not available at traditional banks. 
  • Trading crypto assets P2P, similar to buying and selling stocks without a stockbroker. 
  • Investing in crypto savings accounts to get higher interest rates than traditional banks. 
  • Buying derivatives: placing long or short wagers on certain token pairs.

The Future of DeFi

If you ask us to describe the potential of DeFi in three words, our answer would be “convergence, scalability, and innovation”. Here’s an explanation.

Integration with Traditional Finance

Increased collaboration and integration will open the way for hybrid models. For example, established banks and financial institutions will explore partnerships with DeFi projects to offer their clients access to decentralized services.

Scalability Solutions

As of now, scalability remains an issue for DeFi platforms, given the limitations of existing blockchain networks in handling high transaction volumes. To address this challenge, developers are actively working on scalability solutions such as L2 scaling solutions, sharding, and interoperability protocols. This way, DeFi platforms will be able to support a growing user base and a diverse variety of industry-specific activities.

Emergence of New Platforms

The evolution of decentralized finance meaning results in new applications and protocols. We can witness the emergence of specialized platforms that will cater to niche markets or specific financial instruments. Thus, advancements in blockchain, such as quantum-resistant cryptography and zero-knowledge proofs, could speed up the development of even more sophisticated DeFi applications. 

For example, you can check our recent Defiway project case study. Our blockchain developers at HowSimpl have created a logically designed platform for a company specializing in crypto transfers. 

One more example – Adivin. For this Web3 Project, we designed a user-friendly minimalistic platform that is 100% secure for crypto holdings.

Getting Started with DeFi

The best thing about blockchain is that there are plenty of use cases that you can apply at the same time. Once you have an idea of what does DeFi mean, you do not need to rush into this sector to earn quick money. The How Simpl team has prepared a brief guide for beginners on how to safely engage with DeFi.

  • We strongly recommend taking the time to learn the basics of blockchain and decentralized finance definition. 
  • You should thoroughly research the project’s background, team members, development roadmap, security measures, and community feedback. For this purpose, you can use websites like CoinGecko, CoinMarketCap, and DeFi Pulse.
  • Start with a small amount of capital that you can afford to lose. Remember that putting all your funds into a single platform or token can result in significant losses in case of a security breach or market downturn.
  • Use reputable wallets that support dApps. They should provide robust security features such as hardware wallet integration and multi-signature support. 
  • Keep yourself updated on the latest news in the DeFi space. 

Have an Idea for a Cool DeFi project? HowSimpl developers are at your service!

In recent years, a number of macroeconomic and technological variables have added to the exponential growth of DeFi. This new field is rapidly changing and expanding traditional finances, either in the form of DEXes, lending and borrowing of various asset types, or insurance products. This new Fintech type will eventually have an impact on the future of centralized finance companies. DeFi will potentially be viewed as a cheaper, faster, and more relevant option. 

At HowSimpl, we provide customized comprehensive blockchain development solutions for your specific project needs. Tell us your idea and we’ll take care of its implementation. Feel free to contact us for a free initial consultation.

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