What does decentralized finance (DeFi) mean?
Decentralized finance (DeFi) is a blockchain-based financial system. Instead of relying on centralized intermediaries like banks, exchanges, or brokers, DeFi financial services use smart contracts to record transactions and transfer funds.
DeFi systems remove the middleman (financial services companies) that can cause bottlenecks and roadblocks when financial transactions are centralized. While traditional transaction authentication methods require proof of identity, such as a government-issued ID or social security number, anyone can participate in a DeFi system. By making transactions public and peer-to-peer, DeFi is able to circumvent many logistical issues that can negatively affect international transactions, for example.
In order to ensure that all transactions are valid, DeFi uses smart contracts, which are public records that anyone can inspect and verify for authenticity. Records track which crypto accounts in the blockchain have funds, how much, and where they come from. Each time the accounts exchange funds, the balance changes are logged on file, preventing any person or party from tampering with it or sending funds they don’t have.
The importance of DeFi lies in its decentralization. Instead of leaving all financial power in the hands of a few institutions, DeFi enables community oversight and gives users full control over their finances, including how they trade them and where they store them.
Techopedia Explains Decentralized Finance (DeFi)
The concept of decentralized financial system is relatively new. MakerDAO is considered the first DeFi platform to receive sufficient usage and credibility. While the platform itself was founded in 2014 as a concept, it allowed users to buy, trade and borrow a cryptocurrency known as Dai, which was only released only in late 2017. Unlike other cryptocurrencies, Dai is pegged to the US dollar, making it one of the most stable coins to trade with via the Ethereum blockchain.
The components of a DeFi system
Many layers and elements can be implemented to make a DeFi platform more efficient and user-friendly. However, every DeFi platform requires two main elements: an infrastructure to operate on and a currency to operate with.
- DeFi infrastructure: An infrastructure for DeFi must be a blockchain network that supports smart contracts. Through a platform like Ethereum or Polkadot, you can write decentralized programs where traders can create contracts to manage their finances and transactions.
- DeFi Currency: The DeFi currency must be compatible with the infrastructure and the smart contract system. For example, Bitcoin is not compatible with an Ethereum infrastructure. However, not all cryptocurrencies can be used in DeFi, to begin with. To provide stability instead of investment growth, DeFi uses Stablecoins, which are cryptocurrencies pegged to fiat currency or traded commodity such as Tether, Paxos Standard, Dai, and Binance USD.
Current and future applications of DeFi
At the start of 2022, DeFi as a technology is still in its infancy. It’s safe to say that it has yet to reach its full potential. In many ways, DeFi could be the first step to a completely decentralized internet. There are countless projects that combine the decentralizing power of DeFi with various powerful blockchain technologies such as Solana, Terra Luna, and Avalanche.
Yet one of the most promising outcomes for DeFi is the crossover with artificial intelligence (AI) and machine learning (ML). While most previous blockchain and DeFi projects and systems have been developed by humans, AI and ML have the potential to revolutionize DeFi protocols by monitoring previous transactions and optimizing future ones for greater efficiency and security.