Centralized finance systems function on an existing hierarchy, where a central bank regulates the actions of financial institutions in a country. The central bank oversees the actions of commercial banks and functions as a regulatory body. It enforces consumer protection and prevents terrorism financing, fraudulent activities and misuse of customer funds. A majority of financial institutions exist under this form of banking system.

What is DeFi?

Decentralized finance (DeFi) is a modern deviation from the norm. It is a financial system built on blockchain technology. It is different from centralized banking because it does not need a middleman/intermediary.

It operates by allowing individuals and businesses to conduct financial transactions on the blockchain network, that records them on a distributed network. It needs internet connection and other supplementary software for a transaction to be carried out successfully. Such software include digital wallets for sending and receiving funds like MetaMask, DeFi Pulse, CoinBase Wallet and others. It can also be used to keep track record of investments.

DeFi does not task users for fees, and it does not require physical meet-ups in order for transactions to be carried out. DeFi is a relatively new concept in the financial market, and as such, it has not been widely accepted. Money is a touchy subject, and because its infrastructure and regulations have not completely evolved, it will take some time to gain major acceptance and use in the finance sector and its associates.

What does DeFi Need to Function?

There are two components DeFi needs to function: infrastructure and currency. DeFi infrastructure needs to be situated on the blockchain. It should support smart contract development for the creation and management of financial transactions. Ethereum is a platform that allows the creation of smart contracts.

The currency used in DeFi is required to be compatible with the smart contract in use and its underlying infrastructure. It is advised to use stable coins for stability.

Core components of DeFi

Some of the major components of DeFi include the following discussed below:

Stable coins: These are cryptocurrencies whos values are attached to existing currencies, commodities, fiat money and other related assets. Stable coins exist to provide value in the decentralized exchange market, provide value despite the market’s volatility and facilitate lending and borrowing. Examples of stable coins are Dai (DAI), TrueUSD (TUSD), bitCNY (BITCNY), U. S. Dollar Coin (USDC), and Tether (USDT).
Lending and borrowing: Unlike to the traditional banking system, anybody can be a lender in the DeFi space. Account owners can lend certain amounts of crypto another person and gain interest. Lendins is done in a lending pool that utilizes smart contracts. Borrowers are required to deposit collaterals deemed more important than the loan.
Derivatives: These are financial contracts traded on blockchain-based protocols that derive their value from digital assets. They serve as a contract between the parties involved, and when the associated assets gain an increase in value, the investors can gain profits without actually owning them. Derivatives has various segments, which include swaps, futures and options. Derivatives come with a lot of risks, even as they help with portfolio diversification. Investors are advised to consider these before engaging in trading activities.
Margin trading: Margin trading is using borrowed funds to trade a financial asset. The funds are from a broker, while the financial asset are collateral to the broker. Traders are required to pay a interest fee and other monies to cover the cost of the transaction. Margin trading is risky because if the market experiences unfavourable circumstances, the trader may not be able to recover the borrowed funds.
Decentralized exchanges: Otherwise known as DEX, is a market place for peer-to-per (P2P) cryptocurrency transactions. Here, cryptocurrencies are translated solely for other cryptocurrencies, fiat money excluded. Prices for available cryptocurrencies are published algorithmically, and liquidity pools are used to initiate trades. Anonymity can be initiated on DEX platforms, funds are retained in their owners’ accounts which reduces hack risks, and they are open-source projects. Examples of DEXs include SushiSwap, PancakeSwap, UniSwap, etc.

Benefits of DeFi Adoption

There are endless benefits of investing on decentralized finance platforms. Some of them include:

DeFi is permissionless. It does not require advanced hardware and software tools for participation. Users just need an internet connection, compatible devices, and accounts for trading.
DeFi platforms offer fast, efficient transactions.
Most DeFi platforms are open-source projects, which allows anyone to view and audit it. Developers can access the source code of these projects without having to seek permission.
There is transparency in the DeFi space. Transactions are not hidden, increasing trust amongst transacting parties, and real-time monitoring of funds transfer.
DeFi data is built on blockchain technology, making it easily auditable and tamper-proof.

Conclusion

DeFi, with its endless opportunities across all sectors, is still a new concept in the finance market. As such, finance regulatory bodies are still evaluating its credibility and its sustainability. DeFi is rapidly growing, giving investors a chance to earn profits at a massive rate, while retaining their funds.