Decentralized finance, also known as DeFi, uses cryptocurrency and blockchain technology to manage financial transactions.
DeFi aims to democratize finance by replacing legacy, centralized institutions with peer-to-peer relationships that can provide a full spectrum of financial services, from everyday banking, loans and mortgages, to complicated contractual relationships and asset trading.
Mudrex is Indian Govt. recognized platform with 100% insured deposits stored in encrypted wallets
Listed On Deloitte Fast 50 index, 2022 Best Global FX Broker – ForexExpo Dubai October 2022 & more
Today, almost every aspect of banking, lending and trading is managed by centralized systems, operated by governing bodies and gatekeepers. Regular consumers need to deal with a raft of financial middlemen to get access to everything from auto loans and mortgages to trading stocks and bonds.
In India, the regulatory body, the Reserve Bank of India (RBI) set the rules for the world of centralized financial institutions and brokerages.
As a result, there are few paths for consumers to access capital and financial services directly. They cannot bypass middlemen like banks, exchanges and lenders, who earn a percentage of every financial and banking transaction as profit. We all have to pay to play.
DeFi challenges this centralized financial system by disempowering middlemen and gatekeepers, and empowering everyday people via peer-to-peer exchanges.
“Decentralized finance is an unbundling of traditional finance,” says Rafael Cosman, CEO and co-founder of TrustToken. “DeFi takes the key elements of the work done by banks, exchanges and insurers today—like lending, borrowing and trading—and puts it in the hands of regular people.”
Here’s how that might play out. Today, you might put your savings in an online savings account and earn a 0.50% interest rate on your money. The bank then turns around and lends that money to another customer at 3% interest and pockets the 2.5% profit. With DeFi, people lend their savings directly to others, cutting out that 2.5% profit loss and earn the full 3% return on their money.
You might think, “Hey, I already do this when I send my friends money with PayPal, Venmo or CashApp.” But you don’t. You still have to have a debit card or bank account linked to those apps to send funds, so these peer-to-peer payments are still reliant on centralized financial middlemen to work.
Blockchain and cryptocurrency are the core technologies that enable decentralized finance.
When you make a transaction in your conventional checking account, it’s recorded in a private ledger—your banking transaction history—which is owned and managed by a large financial institution. Blockchain is a decentralized, distributed public ledger where financial transactions are recorded in computer code.
When we say that blockchain is distributed, that means all parties using a DeFi application have an identical copy of the public ledger, which records each and every transaction in encrypted code. That secures the system by providing users with anonymity, plus verification of payments and a record of asset ownership that’s (nearly) impossible to alter by fraudulent activity.
When we say blockchain is decentralized, that means there is no middleman or gatekeeper managing the system. Transactions are verified and recorded by parties who use the same blockchain, through a process of solving complex math problems and adding new blocks of transactions to the chain.
Advocates of DeFi assert that the decentralized blockchain makes financial transactions secure and more transparent than the private, opaque systems employed in centralized finance.
DeFI is making its way into a wide variety of simple and complex financial transactions. It’s powered by decentralized apps called “dapps,” or other programs called “protocols.” Dapps and protocols handle transactions in the two main cryptocurrencies, Bitcoin (BTC) and Ethereum (ETH).
While Bitcoin is the more popular cryptocurrency, Ethereum is much more adaptable to a wider variety of uses, meaning much of the dapp and protocol landscape uses Ethereum-based code.
The DeFi market gauges adoption by measuring what’s called locked value, which calculates how much money is currently working in different DeFi protocols. At present, the total locked value in DeFi protocols is nearly INR 3 trillion.
Adoption of DeFi is powered by the omnipresent nature of blockchain: The same moment a dapp is encoded on the blockchain, it’s globally available. While most centralized financial instruments and technologies roll out slowly over time, governed by the respective rules and regulations of regional economies, dapps exist outside of these rules, increasing their potential reward—and also increasing their risks.
DeFi is an emerging phenomenon that comes with many risks. As a recent innovation, decentralized finance has not been stress tested by long or widespread use. In addition, national authorities are taking a harder look at the systems it’s putting in place, with an eye toward regulation. Some of the other risks of DeFi include:
If you’d like to learn more about DeFi in a hands-on way, here are a few ways to get started:
“Start by setting up an Ethereum wallet like Metamask, then funding it with Ethereum,” says Cosman. “Self-custody wallets are your ticket to the world of DeFi, but make sure to save your public and private key. Lose these, and you won’t be able to get back into your wallet.”
“I recommend trading a small amount of two assets on a decentralized exchange such as Uniswap,” says Doug Schwenk, chairman of Digital Asset Research. “Trying this exercise will help a crypto enthusiast understand the current landscape, but be prepared to lose everything while you’re learning which assets and platforms are best and how to manage risks.”
“An exciting way to try out DeFi without exposing oneself to the price swings of an underlying asset is to try out TrueFi, which offers competitive returns on stablecoins (AKA dollar-backed tokens, which aren’t subject to price movements),” Cosman says.
The key to any foray into a new financial space is to start slow, stay humble and don’t get ahead of yourself. Keep in mind that digital assets traded in the cryptocurrency and DeFi worlds are fast-moving and there’s significant potential for loss.
Mudrex is Indian Govt. recognized platform with 100% insured deposits stored in encrypted wallets
Listed On Deloitte Fast 50 index, 2022 Best Global FX Broker – ForexExpo Dubai October 2022 & more
From taking out the middleman to turning basketball clips into digital assets with monetary value, DeFi’s future looks bright. That’s why people like Dan Simerman, head of financial relations at IOTA Foundation, a DeFi research and development group, see both the promise and potential of DeFi as far-reaching, even though it’s still in the infancy of its capabilities.
Investors will soon have more independence, which will allow them to “deploy [assets] in creative ways that seem impossible today,” Simerman says. DeFi also carries big implications for the big data sector as it matures to enable new ways to commodify data, Simerman says.
But for all its promise, DeFi has a long road ahead, especially when it comes to uptake by the general public.
“The promise is there,” says Simerman. “It’s up to us to continue educating people about the potential, but we also need to keep working hard to build the tools that will allow people to see it for themselves.”
E. Napoletano is a former registered financial advisor and award-winning author and journalist.
Michael is Deputy Editor, Cryptocurrency at Forbes Advisor. He began his financial writing career in 2005 as a marketing copywriter, which is how he refined his investing knowledge and skills. Over the years, he’s written editorial and marketing pieces for many of the world’s leading financial newsletters and publications. His main investing interests are technology, blockchain and cryptocurrency.