For many, dealing with the traditional financial landscape is not a walk in the park. Due to limited operating hours, hefty charges, and complex banking procedures, this system often excludes those who need the financial services the most. Imagine being denied a loan or access to basic finances because you have a limited credit history. This can leave you frustrated.

This is where a revolution that can provide individuals access to the best financial services becomes imperative. Interestingly, decentralized finance (or DeFi) emerged recently with the goal of achieving this feat and transitioning power from centralized entities to users. 

However, there are questions regarding this concept of DeFi: how does it work? Is it truly a viable alternative to the already familiar banking system? In this guide, we’ll dive into the world of DeFi, explore how it works, and highlight its benefits. Read on to find out more. 

What is DeFi?

Before we learn the concept behind decentralized finance, it’s important to consider the concept of Centralized Finance (or CeFi). In simple terms, CeFi refers to the central banks and institutions that control access to financial products and services.

They manage our money, process transactions, and connect loans with lenders. Despite their popularity and offerings, these entities have certain limitations. They are often unreliable, human-biased, charge high fees, and their transaction process could take forever. Also, the bureaucratic process of opening a bank account can be tiresome. 

However, decentralized finance is a novel concept driven by blockchain technology that shifts power from centralized institutions to individuals. Blockchains function as secure, transparent, and distributed digital ledgers spread across a vast network of computers. This distributed nature eliminates the need for a central authority, allowing users to operate freely without intermediaries. 

DeFi is a new financial system built on these safe and secure distributed ledgers.  It eliminates the need for banks and financial institutions; individuals are given more control of their money and can easily access financial services. 

How DeFi Works 

Now that you’ve seen the big idea behind DeFi, how does it work? Interestingly, it relies on two key elements: cryptocurrencies and smart contracts. Cryptocurrencies, such as Bitcoin, Ethereum, Solana, Binance coin, and more, are digital assets used for transactions in the DeFi ecosystem.

On the other hand, smart contracts are automated agreements written in code. These agreements are hosted on the blockchain, as they define the terms and conditions of a DeFi transaction. Therefore, users can send crypto to others based on the conditions laid out in the smart contract. This process is effective, safe, and cost-efficient. It also reduces human error and eliminates malicious activities. 

Services Rendered in Decentralized Finance

Understanding how decentralized finance works can help users uncover services they can perform. Remarkably, there are popular services available in DeFi that make it a viable alternative to its traditional counterpart.  Here are a few of them:

Borrowing and Lending

People can engage in borrowing and lending services without needing a bank’s involvement. Lenders deposit funds in the DeFi pool to earn interest, while borrowers provide excess crypto as collateral to secure loans. 

For example, a user, Jane, needs to cover an unexpected bill and holds Bitcoin. She can deposit Bitcoin into a secure DeFi platform and earn substantial interests. Now, another user, John, on the same platform needs to run transactions via Bitcoin but only holds Ethereum. He will place his asset as collateral to receive Bitcoin from the pool Jane deposited hers. 

Smart contracts automate the process efficiently. They receive John’s collateral and release the Bitcoin only after the loan is paid back with interest. Jane enjoys accrued interests and her assets are well-protected even if John defaults in payments. Unlike traditional banks, DeFi offers higher interest rates on both sides, which makes it an attractive alternative. 

Trading

Imagine buying and selling cryptos without a middleman. That is the beauty of DeFi trading. Users can trade with other users via peer-to-peer (P2P) or through decentralized exchanges (or DEX). It gives one more control over their crypto assets when purchasing at a low price and selling at a higher price. 

Also, DeFi offers spot and margin trading. In spot, you get to have complete ownership of your assets once bought, which is great for new users. Experienced players can access margin trading, where they borrow crypto (via leveraging) to amplify their gains (or losses). 

Yield Farming and Staking

This service is the most attractive, as you can earn interest on your crypto assets. DeFi projects create some kind of liquidity pool where users can deposit their holdings. By doing so, they help facilitate trading. As operations go well in the ecosystem, they receive a portion of the transaction fees or tokens specific to the project. 

Staking, however, takes a more passive approach. You essentially “lock” your crypto on a DeFi platform for a set period. Doing so allows you to contribute to the security and validation of a blockchain network. Over time, you earn rewards in the form of new crypto issued by the network.  They usually come with fixed terms but have a more predictable return, albeit lower, compared to yield farming.

Advantages of Decentralized Finance

DeFi goes beyond simply bypassing traditional financial institutions. It encompasses a few perks that make it an attractive option for users seeking better services. Here are the benefits of this novel concept: 

Enhanced Transparency and Security

DeFi makes use of blockchain’s security and transparency. All transactions are permanently recorded on a distributed ledger, which everyone on the network can access. This public record makes tampering with data incredibly difficult, thereby reducing the chances of fraudulent activity. DeFi further reduces the risk of human errors and conducts transactions swiftly.

Accessibility

Decentralized finance eliminates geographic restrictions or the need to have a financial history. With an internet-enabled smartphone and a secure crypto wallet, you have unlimited access to DeFi services. This opens up a world of financial inclusion. 

Lower Transaction Costs

Most of the time, transaction costs within a DeFi ecosystem are less expensive than those of central banks or traditional financial institutions. Since these services operates on a P2P basis, users can interact directly without a third party to charge high fees in between. 

This direct interaction reduces costs as well as increases transaction speed and efficiency. Consequently, users benefit from more funds saved over time when conducting financial activities on DeFi platforms. 

More Control

Allowing people to have greater ownership of their own funds is among the things that DeFi facilitates. People can now save their crypto directly in wallets and keep them under their ownership at any given time. It also allows for increased user control through DAOs or decentralized autonomous organizations. These entities allow users to participate in any decision-making activities related to DeFi protocols and applications

Innovation

DeFi fosters a culture of innovation and creativity thanks to its permissionless nature. Anyone with a good idea can build a new application on their preferred blockchain, which is open to the public. This allows faster development as more innovative dApps (decentalized applications) are popping up to cater to diverse financial needs.

DeFi vs CeFi: What’s Your Pick?

Managing your finances without needing a bank may seem like a foreign idea. Well, from our discussions, we’ve discovered the core idea behind decentralized finance — the elimination of intermediaries while having full control of your assets.  

To discern the key differences between decentralized finance and centralized finance (CeFi), we must examine their core ideas and features. So, to sum things up a bit, when we talk of centralized finance, the following should come to mind:

• Banks: They control your money, handle your transactions, and offer loans and investments.
• Human-run: People and government make decisions and manage financial products and services
• Limited access: Financial services are often unavailable everywhere and anytime.

What about Decentralized Finance (DeFi)?

• Peer-to-Peer: It removes the middlemen (banks). You connect directly with others for financial services via blockchain technology.
• Code-Driven: Smart contracts automate financial transactions based on pre-programmed rules.
• Global Access: Anyone with an internet connection can access DeFi services anywhere.

The table below further reveals the differences between DeFi and traditional finance.

How to Get Started with DeFi 

Journeying into the world of DeFi offers endless financial possibilities. Yet, taking it one step at a time is essential to grasp this new technology fully. Here are steps to consider before delving into decentralized finance: 

Educate yourself properly

Make sure you understand DeFi, cryptocurrencies, and blockchain technology before investing any real money.

Select a reputable DeFi platform

Once you have acquired knowledge regarding DeFi, research various platforms and use cases that align with your interests. It is best to go for platforms with a proven track record.

Start small

Despite the novelty and innovation it offers, the DeFi world can be overwhelming. For instance, when investing in cryptos in this new bullish cycle, endeavor to start small and only put amounts you can afford to lose. This helps you gain the needed experience over time.

Be security conscious

It is beneficial to prioritize security. Put a strong password on your wallets, and never share your private keys with any third party.

Final Thoughts

In a nutshell, DeFi has revolutionized the finance landscape. Going deeper into this sector, we see that there is better transparency, accessibility, and automation compared with its traditional counterpart. No doubt, you now have a better understanding of decentralized finance and cannot wait to give it a shot.

Endeavor to approach it cautiously and be willing to learn new information. The journey has just begun, and its potential to democratize finance is worth anticipating. So educate yourself, prioritize security, and start small. 

What’s your take on DeFi? Do you think it is the way forward in the future of finance? Kindly share your thoughts in the comment section below.