DeFi translates into English as “Decentralized Finance” or in French as decentralized finance. Cryptocurrencies, blockchain technologies, digital banking services: before embarking on decentralized finance, it is advisable to be well informed about its operation, its advantages, its disadvantages and its potential future.
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Decentralized Finance: Definition
Decentralized finance or DeFi for “Decentralized Finance” refers to a set of decentralized applications (DAPPS) that are based on blockchain technologies. DeFi offers traditional banking services while being faster, without papers to fill out or intermediaries.
This digital financial infrastructure makes it possible to transmit values and create finance accessible to all. In particular, DeFi allows:
- to obtain loans;
- to send money anywhere in the world at any time;
- to make your money work by benefiting from very attractive interest rates;
- to sustainably transform the financial sector by eliminating financial intermediaries.
The DeFi universe was born on December 18, 2017 with the Maker DAO application, a decentralized organization. Many other financial services applications were subsequently deployed.
How does decentralized finance work?
To use DeFi, Internet users go through decentralized applications called DAPPS which facilitate commercial transactions in peer to peeror from person to person.
DeFi uses cryptocurrencies (such as Ethereum, one of the most popular) and smart contracts to offer financial services that eliminate intermediaries, including guarantors. The user can lend their cryptocurrency and collect interest and rewards in real time. He can also obtain a loan instantly without filing a file, including for very short-term loans, which is impossible in traditional banks. DeFi does not work like a traditional bank account, because the user will not have to provide supporting documents or open an account. It can peer-to-peer (P2P) trade in crypto assets or place cryptocurrency in savings accounts and enjoy lower interest rates than in the traditional banking system. Finally, it is possible for the DeFi user to buy derivatives like the crypto versions of stock options or futures.
DeFi is made up of open source applications. Its protocols and applications are thus open and users can inspect them at any time. A developer can therefore also create his own DAPPS by mixing and combining the different protocols to which he has access.
Many of these DAPPS run on the Ethereum blockchain. Among the many DeFi services and applications, you will find: coins (Ether, Polkadot, Solana), stablecoins (stable-value cryptocurrencies), decentralized token trading, Coinbase and MetaMask (digital wallets) or lending platforms and loans that use smart contracts.
What are the advantages of decentralized finance?
- Immediacy and speed : Assets can be individually managed 24/7. The user will benefit from the returns paid instantly and daily according to transparent rules.
- Open to all : Access is without discrimination or restriction. DeFi is a tool for reducing financial inequalities, by making financial services accessible that were hitherto reserved for a minority in the traditional banking system. This is particularly the case for access to borrowing.
- Freedom : The user chooses his broker and his fee rate. Market rates are generated in real time by active players. A transaction or a loan will not depend on the decision of a bank. Indeed, decentralized finance is not subject to any censorship or manipulation by banking, institutional or governmental institutions. Loans or credits are accepted or refused instantly and debts are impossible, because a collateral (deposit of a mortgaged amount) is systematic.
- Neutrality and transparency : A decentralized system relies on technology that acts neutrally. DeFi identifies and prevents financial scams or unfair business practices while providing increased visibility on transactions. Control audits can also take place on any contract at any time.
What are the disadvantages of decentralized finance?
Despite these definite advantages, DeFi also has its share of disadvantages.
- Price instability and volatility of crypto assets. Indeed, it is possible to have strong variations in the value of crypto-investments. There is also a fluctuation in transaction fees on some blockchains like Ethereum, as transactions can become costly thus reducing the end profit.
- Risky investments and responsibility. This risk is particularly palpable on new products, because their operation can be unclear and the user does not have access to the performance history. No turning back is possible in decentralized finance, the user must therefore keep well informed and carry out concrete research before investing. DeFi does not deal with errors made by users.
- Hacking and security issue. Potential bugs can occur within the code of the DAPPS or the Smart Contract, not to mention a possible failure of the blockchain. The user may also face hacking, an increasingly common problem in the DeFi sector.
- Mortgage and liquidity. Credits are made with deposited cryptocurrency collateral and there may be insufficient liquidity at the time of withdrawal.
What is the future of decentralized finance?
What does the future hold for DeFi?
Decentralized finance, often perceived as a threat by players in traditional financial markets, nevertheless augurs a more inclusive future, especially for the millions of people excluded from the traditional banking system. Still in perpetual development, more and more investors and individuals are feeding DeFi platforms, considering that the advantages are greater than the risks.
Platforms like Nexus Mutual even suggest the development of a decentralized insurance system, where policyholders would share the risks by pooling their funds.
Instability, liability, liquidity management: there are still many points that will have to be studied, supervised and regulated by market players and by the legislator.
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