Breaking Down DeFi: The Simplest Guide to Understanding Decentralized Finance.

Whether you are a beginner, intermediate, or expert in the Web3 ecosystem, nearly everyone is talking about decentralized finance— a pool of financial services provided using the blockchain ecosystem as the underlying infrastructure. Recently, many individuals, particularly beginners, have confused the entirety of decentralized finance with the term "cryptocurrency."

Cryptocurrency has been in existence and has gained popularity since the inception of Bitcoin in 2009, while decentralized finance came into existence after the creation of the Ethereum blockchain in 2013. However, because of Bitcoin's widespread acceptance and popularity, many people misunderstand the concept of decentralized finance for cryptocurrency.

This article will guide you to understand the concept of decentralized finance by breaking it down and relating it to a traditional finance system. Without wasting too much time, let’s get into it!

Decentralized Finance: What exactly is it?

You've heard about decentralized finance since you joined the Web3 space, but they say it's not "crypto," so what exactly is decentralized Finance if it's not crypto? Don't worry; it will be clear soon.

Decentralized finance refers to a collection of financial products and services that uses blockchain technology as the underlying infrastructure. Banking, Insurance, and Lending are examples of such financial services.

In contrast to the traditional finance system, where financial services are provided by financial institutions / Intermediaries (banks), which serve as the central authority, decentralized finance has no central point of authority, and services are provided by various blockchain networks (the blockchain is already decentralized). Financial transactions are carried out using the blockchain, which is the technology that confirms all transactions that occur while making various financial decisions.

Using financial products and services on the blockchain is possible in decentralized finance, thanks to cryptocurrency - a digital currency. Similarly to how traditional finance systems require physical currency to conduct transactions such as depositing, withdrawing, investing, and so on, decentralized finance requires a currency that allows its users to purchase products and services from the various blockchain networks that provide these financial services.

In a nutshell, decentralized finance is a collection of products and services provided by various blockchain networks, whereas cryptocurrency is the currency that allows you to make transactions and effectively use these services.

Brief History of Decentralized Finance

Bitcoin was the first digital currency created in 2009 on the Bitcoin blockchain network. This blockchain network only facilitates the creation of its currency (bitcoin). However, for a decentralized system to work in the Web3 ecosystem, a physically functional platform where financial transactions and services can take place is required. This led to the creation of the Ethereum Blockchain network.

Ethereum blockchain was founded in 2013 by Vitalik Buterin. It was designed to support Smart Contracts, which are programs that run on the blockchain-based on predefined conditions. This smart contract allows you to create decentralized applications that provide and serve as financial services platforms. Dapps stands for decentralized application. The Smart Contract represents the backend, while the Dapps created have a frontend interface that can make calls to the smart contract and execute instructions based on predefined conditions.

To summarize, decentralized finance emerged in 2013 through the Ethereum blockchain, allowing for the creation of decentralized applications and new alternative cryptocurrencies asides from bitcoin. Solana, AAVE, and OpenSea are examples of Dapps, while ether and sol are some alternative currencies. Some Dapps specialize in particular financial services; an example is AAVE, a lending and borrowing Dapp that allows users to borrow and lend digital currencies. OpenSea is another Dapp which is a marketplace for buying and selling NFTs.

Use Cases of Decentralized Finance

Now that you know what decentralized finance is and how and when it started, let’s talk about its use cases while relating it to traditional finance. There are several use cases for decentralized finance, but you will learn 5 in this article.

Assets management: Defi assists you in managing all cryptocurrency assets you have accumulated over time. Individuals can manage their assets in decentralized finance without involving a third party, compared to traditional finance, where assets are managed by financial institutions such as banks.

With Defi, you can be your bank and start making financial decisions through decentralized applications. These decisions are made by you without interference or fear of third-party policies, exceeding limits or having your assets frozen. Some Dapps that can help you manage your assets include Metamask, Binance, and Gnosis.
Decentralized Exchanges: In decentralized finance, decentralized exchanges help you carry out your daily transactions, from sending and receiving to buying and selling your cryptocurrency. Individuals carrying out these transactions determine all fees associated with making transactions, the time the transactions are sent, and how long it takes to deliver.

Decentralized exchanges can be compared to your traditional exchanges, where banks determine the time your transactions are sent, the fees associated with them, and when they deliver (which sometimes does not happen on time, and you have to wait extra days for banks to correct this issue).
Lending: Lending works the same way in decentralized finance as it does in traditional finance, except that individuals can lend their cryptocurrency to others directly from their end by joining a pool of lenders in a lending Dapp, allowing them to earn interest directly. Unlike traditional finance, where your bank lends you money, and you do not directly own the interest.
Borrowing: Individuals can use decentralized finance to borrow cryptocurrency without having to go through the traditional "know your customer" stress. This allows for increased speed and efficiency. Individuals can borrow from any DeFi platform that provides lending services without a long history of the association.
Insurance: Decentralized finance can provide a decentralized insurance system in which individuals are paid when certain conditions are met. Payments can be made quickly without the need for claims or traditional documentation presented because smart contracts are already in place and ready to execute once insurance conditions are met.

Advantages of Decentralized Finance

You cannot ignore the many advantages decentralized finance has given people and businesses thriving in the Web 3 ecosystem. It is currently the rage. Among the advantages are:

It gives individuals financial control because they have control over their assets in the Defi ecosystem.
The efficiency and speed of transactions in the Defi ecosystem are unprecedented when compared to traditional finance systems.
Smart contracts can be audited when used to build or develop Defi applications and projects. This is due to the transparency provided by blockchain technology.
Users of the Defi ecosystem do not require third-party policy or approval before conducting transactions.

Disadvantages of Decentralized Finance

Even with its growing benefits, you can't deny that decentralized finance has drawbacks. Some disadvantages include:

One disadvantage of the Defi ecosystem is the lack of trust. This is due to the lack of a physical establishment or third party to turn to if a Defi project goes wrong.
Another issue is the issue of irreversibility. Due to the immutability of the blockchain, if an individual makes a mistake or does not verify before making a transaction, it cannot be recognized or revered
Smart Contracts are written by humans, who are prone to making mistakes that could result in individuals losing their assets.

Conclusion

In this article, I explain decentralized finance by comparing it to the traditional financial system you are used to. Decentralized finance has many advantages over disadvantages, but the trust and irreversibility issues that come with it prevent some individuals from exploring it as they should. Nonetheless, decentralized finance is being adopted by various industries to address specific issues, and as Web3 grows and evolves, so will the Defi ecosystem.

Resources

You can check the resources below for further reading.

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