Decoding the Basic Concepts of Decentralized Finance

While the world of cryptocurrencies and blockchain has continued to evolve and grow over time, the latest buzzword in the technology space is DeFi or decentralized finance. Like any other budding piece of technology, DeFi has also been subject to a lot of assumptions and preconceived notions. In this blog post, we will look at the concept of DeFi from a very basic point of view and offer a holistic understanding of how it works.

As the name suggests, decentralized finance is the exact opposite of centralized finance, and it aims to solve the existing loopholes of the legacy banking system by harnessing the power of blockchain, a cutting edge technology. In order to understand DeFi, it is extremely important to have a conceptual knowledge of how traditional banking works.

Traditional banking or traditional finance operates on a centralized model. This essentially means that some centralized organizations like banks are in control of the entire economy as they control the supply of currency along with all other financial activities an individual or entity performs. These include – investments, savings, lending, etc. However, there are a few major drawbacks of this system. For example, with traditional banking, we are basically giving up a considerable amount of control over our personal finances, thus inviting a lot of risks. Moreover, this system of centralized finance does not offer a lot of financial freedom, as anyone from a poor economic background is highly unlike to be able to secure loans and credits from banks.

Decentralized Finance or DeFi address all the above-mentioned drawbacks and loopholes by using the power of blockchain technology and creating a financial environment that is much more transparent and inclusive in nature. In simple words, Decentralized Finance or DeFi involves a wide range of financial instruments that eliminate the need for dependence on intermediaries and third parties for any kind of financial activity.

In order to understand the need for developing DeFisolutions and actively using those, it is crucial to understand why and how centralized/traditional finance is somewhat intruding in nature. This is not to suggest that banks and other centralized financial organizations have no role to play in the economic setup. Let us understand this through a couple of real-life examples.

Let us consider that Mr. Sharma invests $30000 in a financial scheme operated by the bank, with an objective to earn a certain return over the next 5 years. Now, that bank invests this $3000 to other schemes and third-party platforms in the market to grow the initial investment. Along the way, the bank makes a profit on that investment and shares a certain percentage of that with Mr. Shama. It is important to note that throughout the entire process, Mr. Sharma did not have any control over his investment, as the bank used and invested the money as per its discretion. Moreover, while he did not any clue about where his money was further invested, he also had no control over the potential ROI that he could have earned.

In another scenario, Mr. Sharma uses the banking services to save and store his assets against a certain percentage of interest that the bank offers. Now, it is important to understand that banks are eventually centralized organizations and hence storing all financial assets in banks poses a continued risk due to several potential possibilities like centralized server crash, data manipulation by dishonest or fraudulent parties, etc. 

Based on both these scenarios, it is fair to say that while centralized financial systems might have certain advantages, at the same time, these systems compel us to give up financial freedom and depend heavily on centralized third-party organizations. Decentralized Finance or DeFi turns around the scenario by enabling us to control our own data and personal finance without the need for intermediaries.

Let us now look at a few major highlights that set apart the concept of Decentralized Finance and present a very differentiated proposition.

DeFi networks consist of several members and each of them are handed the capability to build and deploy decentralized applications over the network. These decentralized applications can be used for several transactional processes and are governed by smart contacts. This essentially means that all kinds of activities that are performed within these applications are completely independent and transparent without the need for any third-party interventions. In other words, DeFi enables peer to peer transactions of all kinds.

DeFi enables peer to peer lending and borrowing. Unlike traditional or legacy banking systems, anyone and everyone have the opportunity to lend or borrow as long as both parties agree upon their pre-set terms and conditions. Moreover, the interest rates on these loans are based on the mutual agreement between the lender and borrower, as opposed to interest rates being set by centralized organizations like banks.

DeFi is permissionless as anyone within the network can access the smart contracts and pre-set conditions (subject to authorization) to check the integrity of the transactions being processed.

The concept of DeFi is gradually gaining prominence but it is still far from being accepted in the mainstream. Emerging cryptocurrencies like, ModiCoin, is making it even safer for investors. Having said that, several blockchain projects are actively building up their DeFi networks to offer a wide range of advantages to their users. All in all, as the drawback of traditional finance continue to be highlighted, decentralized finance is growing up the ranks.