The Core Concepts of DeFi Explained
Blockchain and cryptocurrency are the core technologies that enable decentralized finance. Blockchains make little sense for applications other than the trustless exchange of digital assets with value, as their primary use case is to resolve financial sovereignty and eliminate counterparty risks such as bankruptcy, unavailability, fraud, and hacking. Nonetheless, cryptocurrency exchanges have long veered away from decentralization by forcing users to trust their centralized custodial services.
Custodial Exchange Services
Custodial trading on a centralized exchange exposes the user to significant counterparty risk — if the exchange is breached, or if it simply refuses to return coins to the user’s wallet. This risk has been realized at a large number of centralized exchanges, beginning with the well-known 2014 Mt. Gox hack and a number of other well known hacks, including on BitFloor, Poloniex, Bitstamp, and, more recently, coincheck and BitGrail.
Non-custodial Exchange Services
Non-custodial trading, without a doubt, removes counterparty risk. By using non-custodial trading, users are no longer expected to deposit their coins at a centralized exchange. Instead of being entrusted to the exchange’s wallet, users remain in full control over their wallets and coins. As a result, if the exchange is compromised and coins are stolen from the exchange’s wallet, the user’s coins are not jeopardized.
Enter DeFi
What exactly is Defi? And, how does it work?
Decentralized finance
DeFi is a movement that uses open source software and decentralized networks to convert conventional financial products into trustless and transparent protocols that function without the need for intermediaries. DeFi projects operate in a diverse decentralized ecosystem composed of a multitude of non-custodial financial products. What distinguishes these protocols as DeFi is their decentralized and non-custodial nature.
Smart Contracts
The distributed nature of DeFi platforms and protocols makes them available across the world and allows the development of modular applications enabling a single network to have various features. Unlike most other cryptocurrencies, DeFi tokens are exchanged on the premise of smart contract technology. Smart contracts are blockchain-based programs that will execute automatically when certain conditions are met.
Governance
DeFi transactions are governed strictly by smart contract rules. Since traditional banking services rely on intermediaries who charge exorbitant fees, DeFi applications not only make financial services accessible but also affordable. In addition, most DeFi smart contracts are written in open-source code, which makes them verifiably auditable, without the need to trust the accountability of a third-party auditor. By eliminating intermediaries, DeFi users maintain full control over their virtual wealth, while transacting and working together through complex networks of decentralized financial services.
Dapps
If smart-contracts are the heart of the DeFi ecosystem, then DApps are the brain. DeFi Developers create smart contracts with much more complex features than simply sending and receiving cryptocurrency. These applications are known as Decentralized Applications (dapps).
Ethereum
Virtually all defi applications are based on the ethereum blockchain, which is the most common programmable blockchain in the cryptocurrency space. DeFi leverage key principles of the Ethereum blockchain to increase financial security and transparency, unlock liquidity and growth opportunities, and support an integrated and standardized economic system.
Tokenization
Ethereum and its smart contract-based token standards make all things possible in the DeFi space. Through tokenization, DeFi addresses the pain points of current decentralization and the points for investors participating in traditional finance. Investing is cheaper, faster, more secure and available every hour of the day. This opens up real-world assets and the world of cryptocurrencies to people who previously may not have been able to invest due to geographic or financial restrictions and offers an alternative to traditional and largely outdated investment methods.
