DeFi Explained – What is Decentralized Finance?
What is DeFi all about? – Read on as we explain DeFi in an easy to understand way. Here at ARVR Focus we aim to help you understand the world of Decentralized Finance; Virtual reality; the Metaverse; Blockchain; Crypto Currencies, Play-To-Earn, NFTs, and more.
Decentralized Finance, often referred to as DeFi is an internet-based financial technology system that utilizes the Ethereum public blockchain infrastructure to facilitate financial transactions and services.
In a Decentralized Finance system, there is no centralized intermediary, and financial transactions and services are peer-to-peer utilizing Smart Contracts on a Blockchain.
To conduct and manage peer-to-peer business transactions, users utilize Decentralized Apps (dApps,) most of which can be found on the Ethereum network.
In effect, a Decentralized Finance system eliminates the control banks, and other financial institutions have on money, financial transactions, financial products, and financial services.
A decentralized finance system offers a wide range of financial services including, earning interest, borrowing and lending, trading derivatives and assets, and buying insurance.
Why is Decentralized Finance Important?
Decentralized Finance (DeFi) is important because it takes the fundamental premise of digital money or cryptocurrency and enlarges it.
Decentralized Finance provides a digital alternative to centralized exchanges (for example, Wall Street,) and this means it could completely change the financial world as we know it.
Decentralized Finance (DeFi) changes the way a financial system works by minimizing (and even eliminating) associated costs and increasing accessibility to financial markets.
Decentralized Finance is creating a more accessible, gratuitous and equitable financial system.
How does decentralized finance work?
A Decentralized Finance system DeFi works by providing a range of financial services, using Cryptocurrencies and Smart Contracts. DeFi operates online and all the financial services operate on a peer-to-peer basis utilizing the Ethereum platform.
The peer-to-peer process eliminates the need for third party intermediaries (such as brokers or a bank) that are present in the Centralized Finance system and this elimination of intermediaries is at the crux of a decentralized system of finance.
The Blockchain Framework
Decentralized Finance DeFi uses decentralized Apps (dApps) to access the Ethereum blockchain (a distributed or secured database or ledger) and handle transactions. Transactions are then carried out on the blockchain. The blockchain records and verifies transactions of Ethereum compatible cryptocurrency, in blocks. Once the terms of a transaction are agreed upon by parties involved the block is closed and encrypted, then another block that has information about the previous block inside it, is created.
The information contained in each preceding block chains the blocks together thus the name blockchain. The information contained in preceding blocks cannot be changed without affecting the following blocks and the information on each block is locked by a series of security protocols contained in the corresponding Smart Contract.
In order to work a finance system needs two key components — infrastructure and currency.
In the traditional centralized finance system, financial institutions such as banks, finance companies, insurance companies, and brokerage firms provide the infrastructure, and fiat money (for example the US dollar) provides the currency.
In a decentralized financial system, the infrastructure is a decentralized open-source blockchain platform called Ethereum. Ethereum establishes a peer-to-peer network that enables financial transactions and services through application code, called smart contracts.
When operating within a Decentralized Financial system people will typically use Decentralized Apps (dApps) that run on the Ethereum blockchain.
People use Ethereum compatible decentralized apps (dApps) to conduct financial transactions and then use Smart Contracts, also on Ethereum, to establish rules and autonomously manage those transactions.
In a traditional centralized finance system, fiat money (like the US dollar) acts as currency. In a Decentralized Finance system, currency takes the form of cryptocurrency that is compatible with the Ethereum platform and is a “stablecoin” that is backed by an entity or pegged to fiat money.
Decentralized Financial Services
In a Decentralized Finance system, financial services exist on Ethereum and function fairly and securely through Smart Contracts.
A Decentralized Finance system provides all the same financial services as a Centralized Finance system including, exchanges, transactions, borrowing, lending, saving plans, and insurance.
Decentralized Borrowing and Lending
In a traditional Centralized Finance system (DeFI) the borrowing and lending process is primarily between individuals or companies and financial institutions such as banks and credit unions.
In a Decentralized Finance system, borrowing and lending are on a peer-to-peer basis utilizing the Ethereum blockchain. Such services include lending (where users can lend out their cryptocurrency and earn interest in minutes rather than once a month), securing a loan in DeFi is not only faster but also easier because lenders and borrowers from anywhere in the world are automatically matched by an algorithm. Once a lender and borrower (peers) are connected, both parties agree on the terms which are verified by a Smart Contract and the loan then proceeds.
The cryptocurrency lending and borrowing process is best described in a series of steps.
Step 1: Send Ethereum compatible cryptocurrency to your chosen Ethereum wallet. This cryptocurrency in your wallet will act as collateral for the proceeding loan. Currently, there are 4 Ethereum wallets you can choose from Metamask, Ledger, Nano S, and Trezor.
Step 2: Visit the Collateralized Debt Portal (CDP) and connect with the Ethereum wallet you sent the Ethereum compatible cryptocurrency to.
Step 3: Click on the “Open CDP” button to verify the amount of currency you want to post as collateral and the amount of currency you want to loan, or mind.
Step 4: Press the “Collateralize & Generate” button and this will post your collateral funds in lieu of newly generated funds.
Using applicable apps, lenders and borrowers can connect with each other, conduct the lend borrow process, autonomously manage loans using smart contracts, generate interest on their crypto assets through “yield farming” and borrow fiat money against cryptocurrency collateral.
A decentralized exchange (DEX) makes the buying, selling and trading of cryptocurrencies an easier and quicker process. Using the Ethereum platform buyers, sellers and traders can:
- Perform their actions without having to use an exchange operator.
- Perform their actions without requiring sign-ups or ID verification.
- Avoid incurring fees for withdrawing funds.
- Avoid paying an initial deposit
- Engage in autonomous trading with the entire process guided by Smart Contracts.
Through the use of Smart Contracts, it is possible to make peer-to-peer decentralized insurance within the Decentralized Finance system.
For those seeking to insure, their financial assets a Decentralized Finance system offers significantly more options than a Centralized Financial system. A Decentralized Finance system (DeFi) connects those looking to purchase asset insurance and those supplying asset insurance from around the world.
For those looking to supply insurance a Decentralized Finance system (DeFi) makes it possible to insure other people’s assets at a premium.
A Decentralized Finance system makes the insurance process easier because it allows those supplying insurance to do so without ever having to use an insurance company or an insurance agent.
Within a Decentralized system of finance, the entire insurance transaction happens autonomously and Smart Contracts are used to ensure an equitable, safe, and honest process.
Decentralized Saving (Powered Saving)
One important service offered by a Decentralized Finance system (DeFi) is Decentralized or “Powered” Saving. When you save money in a Decentralized Finance system, your savings money earns interest every 15 seconds in line with the real-time variable interest rate.
In effect, this means your savings are gaining compound interest in real-time hence the term “Powered Saving.” The interest rate offered in a Decentralized Finance system is a far better interest rate than those offered by banks in the Centralized Finance system.
When your savings are in a Decentralized Finance system, they are readily accessible, and you can deposit or withdraw savings money on demand. In short, by placing your savings in a Decentralized Financial system (DeFi) you receive high-interest rates without being locked into a long-term commitment.
Another service offered in a Decentralized Finance (DeFi) system is buying derivatives such as stock options and futures contracts.
The Decentralized Finance system is rapidly growing significantly faster than the traditional Centralized Finance. With that growth comes a correspondingly rapid growth in crypto assets, particularly derivatives.
In the traditional Centralized Finance system (CeFi,) the trade-in derivatives are highly regulated and have taken many decades to evolve. In the Decentralized Finance system, crypto derivatives are unregulated and open, meaning anyone can quickly create a derivative in a permissionless way.
In all financial market’s there is an element of risk and speculation, and it is these that have encouraged the rapid growth of trade in derivatives. Derivatives act as a hedge that lessens risk and acts as a form of speculation.
Advantages of a Decentralized Finance System
A decentralized financial system has numerous advantages over the traditional centralized finance system.
For a start DeFi is a more cost-effective system. DeFi operates through peer-to-peer transactions and in so doing eliminates the need for third party intermediaries and their associated costs and fees.
A decentralized finance system through utilizing peer-to-peer transactions eliminates the traditional costs such as overdraft fees, wire transfer fees, banking and brokerage fees, salaries and more.
Operating in a decentralized finance system DeFi is less time consuming and more simplified than operating in a Centralized Finance CeFi system. In a decentralized finance system DeFi you can get more done in a shorter period of time.
For example, in the DeFi system there is no opening an account and gaining access is as simple as opening a crypto wallet. When transacting there is no paperwork (like application forms) involved, there are no ID requirements and there are far fewer regulations and restrictions.
In a Decentralized Finance system DeFi the financial services are completed more quickly and easily. Take for example the process of getting a loan. In a Decentralized financial system, lenders have to go through a complicated and restrictive application process whereas in a decentralized finance system DeFi a loan can be secured in a matter of minutes.
The Decentralized Financial system also allows quicker transfer of funds and in a deregulated environment funds can be anonymously transferred in seconds and minutes.
In short, a Decentralized Finance system is a more cost effective. More efficient and more economically viable financial system.
It can also be argued that because the decentralized finance system (DeFi) eliminates the need for centralized financial institutions it represents a, more open, accessible, trustworthy and secure financial system.
Many financial experts have argued that because the Decentralized Finance system is secured by blockchain technology it will reduce fraud, theft, corruption and general mismanagement of assets.
A Decentralized Financial system (DeFi) offers higher and quicker interest rates. For example, in a Decentralized financial environment users receive high rates of real-time compound interest on their crypto savings and loans assets, in a matter of minutes rather than months.
Because it is basically a de-regularized environment this means there are fewer rules and regulations and there is no government oversight.
Another big advantage of Decentralized finance DeFi is that it is growing rapidly (in Oct 2021 it was estimated to have an asset value of over $100 billion) and is offering a huge range of opportunities.
Increased accessibility is an important advantage of Decentralized Finance DeFi. A Decentralized Finance DeFi environment can be accessed by anyone from anywhere there is an internet connection and there is no identification needed. In other words, the Decentralized Financial environment is more open and easily accessible.
Decentralized Finance DeFi applications through the use of personal Crypto Wallets, Smart Contracts and personalized trading services, give users more control over their Crypto funds.
Another advantage of Decentralized Finance DeFi is its flexibility and ease of fund management. In DeFi users can quickly transfer funds at any time and without asking permission. In effect this equates to more control over funds.
Lastly, the Decentralized Finance system (DeFi) offers more transparency. All parties involved in a transaction can view all details of that transaction at any time. This is considerably more transparency than is offered in the Centralized Finance CeFi system.
Decentralized cryptocurrency exchanges (DEXs) operate without a central authority and instead transactions are done on a peer-to-peer basis. In peer-to-peer transactions the crypto assets are never kept in the DEX itself but in peers, crypto wallets. The result of peer-to-peer transactions is that peers have more control of their funds and the chances of price manipulation hacking or theft are substantially reduced.
The composability of DeFi has created opportunities for product developers to integrate DeFi protocols into a variety of verticals. For example, Decentralized Finance is used to create the built-in economies of Ethereum based games.
Here are a few links of interest: