Cryptocurrencies have gone wildly popular since their creation back in 2009. Every day, more and more people want to learn about Bitcoin, blockchain, and all the terms out there that you need to know about if you want to succeed in this market. One of the concepts that you might face when learning about cryptocurrencies is decentralized finance, which is usually referred to as DeFi. Knowing about this concept is almost crucial to your performance in the crypto industry. So, in this article, we will try to explain this type of finance and its major differences compared to traditional finance to help you in your learning process.
What is DeFi?
In simple words, Decentralized Finance refers to a financial system that requires no central authority and no intermediaries, such as banks and clearinghouses. This system operates solely based on the power of smart contracts. In fact, DeFi works as a merger between blockchain technology the long-established banking services. In this system, financial products become available on a blockchain network that allows everyone to use and buy their desired products without needing to rely on middlemen.
Advantages of using DeFi
- Lower Barriers to Register
You know that in traditional banking, it might take a few days to fully create or close accounts. Also in the brokerage business, it takes several days to fully transfer securities between different platforms. You would probably need to do a lot of paperwork and make a few phone calls. The process of entering Decentralized Finance platforms is almost nothing in comparison. Like we mentioned in the previous section, you just need to create an account and get a smart wallet to enter this market.
- Advanced Analytics
Process improvement and the profitability of a lending process are important to both borrowers and lenders. Within a Decentralized system, the users can monitor the loan applications for a certain duration. Decentralized Finance also gives the users advanced analytics about the demographics, credit tiers, loan sources, etc.
- Complete freedom for Users
Like we said before, one of the main advantages of using Decentralized Finance systems is that you don’t need any middlemen in the process. This system gives you permissionless and open access to its blockchain-based applications. So basically anyone who has a crypto wallet can have access to the applications, without any need to submit your geographical location. There is also no minimum amount for the fund that you want to lend or borrow.
Disadvantages of DeFi
Every rose has its own thorns and DeFi is not excluded from this fact. In this part, we mention the drawbacks and security risks that a user might face while using DeFi.
- The struggles of Smart Contracts
Smart contracts are the main base of the DeFi protocol, but sometimes they are not 100% secure and might be in danger of manipulation. These open-source contracts usually allow users to review them before fully delving into the DeFi system. And most of the Decentralized Finance platforms try to reach maximum security by giving their contracts to security firms. But usually, if there is a flaw in these contracts, it’s not possible for humans to identify them. Obviously, this might cause problems for the users in the future. A great example is DAO or the decentralized autonomous organization that was one of the biggest crowdfunding systems in 2016. In June of that year, hackers detected a flaw in DAO’s smart contracts and managed to steal a third of the organization’s total funds. This unfortunate situation sparked an awakening in the decentralized system. Protocol builders started to take the security of their smart contracts more seriously since then.
- Centralization of Data Feed
To explain this advantage, we first need to talk about oracles. Oracles are third-party services that allow you to have access to external information. These services act like a merger between blockchains and the outside world. Now you might ask why we need to know about Oracles. Blockchain systems usually can’t directly have access to off-chain data. So they rely on oracles to solve this issue. Everything is fine until this part. The main problem that oracles cause is that they create a central point of trust in decentralized setups. You know Decentralized Finance protocols are known for being completely trustless, so oracles do not exactly fit into its narrative and provide a vulnerability in an almost perfect system.
DeFi or Decentralized Finance is a type of finance created in the blockchain space that removes the need to rely on centralized intermediaries.