What Exactly Is DeFi?
6 min read · · Korean original
Contents 7
DeFi, or Decentralized Finance, is a new peer-to-peer (P2P) financial technology infrastructure that runs on blockchain technology.
Traditional centralized financial products are provided by financial institutions that follow the regulations of countries and governments. DeFi, however, follows its own rules in the form of smart contracts and aims to build a decentralized financial ecosystem by giving each individual participant on a platform control over their own funds.
DeFi charges hardly any of the various fees that banks and other financial companies charge for using their services. That doesn't mean DeFi is completely free, but its fees are far cheaper and more reasonable than those in traditional finance.
One of DeFi's biggest advantages is that anyone with an internet connection can make financial transactions efficiently through a digital wallet and a DeFi platform.
- The goal of DeFi is to remove the centralized financial institutions and third parties involved in financial transactions, and to give everyone free and open access to finance.
- The core components of DeFi are smart contracts, digital wallets, liquidity pools, and native tokens.
Centralized Finance vs. Decentralized Finance
Decentralized finance is different from traditional centralized financial institutions and banks, and there are several clear differences between them.
1. Centralized Finance
In centralized finance, transferring money between parties always has to go through a bank. The bank holds users' funds and charges extra fees for transfer services (especially for international transfers).
With credit card payments, the buyer doesn't pay the seller directly. Instead, the money passes through entities such as banks and credit card companies before it finally reaches the seller. The bank receives the user's transaction information and passes it on to the card company, which then verifies on its own whether the transaction is genuine and settles the payment with the seller. Each company along the way charges a fee for its service.
In this way, every financial transaction in traditional finance, from money transfers to payments and loans, takes place under the supervision of centralized financial institutions.
2. Decentralized Finance (DeFi)
Decentralized finance lets consumers, merchants, businesses, and others carry out financial transactions using new technology. It doesn't require the many intermediaries that centralized finance does. DeFi securely connects financial participants through a P2P blockchain network.
DeFi users can access a distributed financial database from anywhere with an internet connection to send, lend, trade, and borrow. The distributed database collects and aggregates data from all users and verifies its integrity using a consensus mechanism.
DeFi is an innovation on the traditional centralized financial model. By storing and managing assets directly in your own wallet, you gain full control over them.
However, decentralized finance does not provide complete anonymity. Transactions don't include personal names or identity information, but authorities with access, including governments, may be able to trace them in various ways.
How Does DeFi Work?
DeFi is based on blockchain, the core technology behind digital assets. A blockchain is a decentralized database, or ledger. To process transactions on top of these blockchains, decentralized applications called dApps are used.
On a blockchain, transactions are recorded in a block and then verified by other users. Once the validators agree on the transactions, the block is closed and encrypted, and another block containing information about the previous block is created next in line.
Blocks are linked to one another in a chain through block hashes, which is why it's called a blockchain. Because information in a previous block can't be changed without affecting the next block, altering a blockchain is extremely difficult.
DeFi dApps give users an interface for financial services. Users connect a digital wallet such as MetaMask and can then transfer assets, take out loans, and more.
All of these processes run in a decentralized way according to smart contracts. Participants on a DeFi platform trade with each other peer-to-peer (P2P) without a central administrator. This includes not only simple trades but also complex traditional financial transactions such as lending, borrowing, and creating collateralized assets. P2P (person-to-person) financial transactions are one of the core features of decentralized finance.
Advantages of DeFi
Using DeFi comes with the following advantages.
- Accessibility: Anyone connected to the internet can access DeFi platforms and trade without geographical restrictions.
- Low fees and high interest rates: With DeFi, two parties can negotiate an interest rate directly and lend crypto or money through a DeFi network.
- Security and transparency: Blockchains are hard to tamper with, and anyone can review published smart contracts and records of completed transactions.
- Autonomy: Decentralized finance platforms don't depend on centralized financial institutions and are run freely by protocol developers and participants.
However, DeFi also has the following disadvantages.
- Smart contract risk: Although DeFi is built on blockchain technology, smart contracts may contain flaws or security vulnerabilities, and hackers can attack them.
- Regulatory and legal issues: DeFi may face regulatory and legal challenges, and since regulatory frameworks currently differ by country and region, there can be uncertainty.
- High volatility: The prices of DeFi tokens and assets can be extremely volatile, which can expose investors to financial risk.
- Technical complexity: Some users may find DeFi platforms technically complex to use, and there can be a learning curve for newcomers.
| DeFi Advantages | DeFi Disadvantages |
|---|---|
| Send money anywhere in the world through dApps | Technical complexity and processes that aren't easy |
| Various opportunities to earn income | Regulatory issues and potential for fraud |
| High security and transparency of blockchain technology | High coin price volatility |
The Future of DeFi
Decentralized finance is constantly evolving. DeFi is a technology with great potential to transform traditional finance. However, there are a few things to consider.
- Regulation and enforcement: Most DeFi projects currently operate without regulation. However, regulators are paying close attention to DeFi's growth, and regulation looks likely to arrive soon. We need to think about how regulation should be applied and enforced within the DeFi ecosystem.
- Security and stability: Because DeFi manages funds through smart contracts, flaws or security vulnerabilities can become a problem. The blockchain itself is secure, but regular audits of smart contracts are needed to strengthen the security of the system.
- Financial crime and investigation: Responsible discussion is needed about financial crimes that occur in the DeFi environment. Regulating and investigating criminal proceeds that move across borders is no easy task.
- User education: People who use DeFi need financial education. DeFi is technically complex, and users need to understand a range of basics to keep their funds safe.
- Balancing decentralization and centralization: DeFi operates without centralized institutions, but some degree of centralization is sometimes necessary. Maintaining this balance is important, as is the interaction between protocol developers and users.
Final Thoughts
Decentralized finance (DeFi) is a new financial technology that challenges today's centralized banking system. DeFi removes the unnecessary fees that banks and other financial companies charge for their services and promotes P2P (person-to-person) transactions.
However, DeFi still faces issues such as regulation, security, financial fraud, and money laundering. The future of DeFi is full of both uncertainty and possibility, and we need to carefully understand and respond to the many factors involved.
Are Bitcoin and Ethereum Decentralized Finance?
No. Bitcoin and Ethereum are digital assets. Decentralized finance uses digital assets within its ecosystem, but the digital assets themselves are not decentralized finance. Simply put, Bitcoin and Ethereum are just transferable assets, like the dollar ($).
What Is Total Value Locked in Decentralized Finance?
Total Value Locked (TVL) refers to the total sum of all assets in decentralized finance that are deposited for staking, lending, or in pools, or that are being used in other financial activities.
