020 – Decentralized finance, or DeFi, uses emerging technology to eliminate third parties and centralized institutions from financial transactions. The components of DeFi are stable currencies, software and hardware that enable application development. The infrastructure for DeFi and its regulation are constantly evolving.
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In the U.S., the Federal Reserve and the Securities and Exchange Commission (SEC) define the rules for centralized financial institutions, such as banks and brokerages, that consumers rely on for direct access to capital and financial services. DeFi challenges this centralized financial system by empowering individuals with peer-to-peer digital exchanges.
DeFi eliminates fees charged by banks and other financial companies for using their services. People have money in a secure digital wallet, can transfer funds in minutes, and anyone with an Internet connection can use DeFi.
How does DeFi work?
Decentralized finance uses the blockchain technology used by cryptocurrencies. A blockchain is a secure distributed database or ledger. Applications called dApps are used to manage transactions and run the blockchain.
In blockchain, transactions are recorded in blocks and then verified by other users. If these verifiers agree on a transaction, the block is closed and encrypted; another block is created containing information about the previous block.
The blocks are “chained” through the information in each previous block, giving it the name block chain. The information in the previous blocks cannot be changed without affecting subsequent blocks, so there is no way to alter a blockchain. This concept, along with other security protocols, provides the secure nature of a blockchain.
Peer-to-peer financial transactions are one of the central premises behind DeFi. A DeFi P2P transaction is where two parties agree to exchange cryptocurrencies for goods or services without the involvement of a third party.
In DeFi, P2P can meet an individual’s borrowing needs, and an algorithm would match pairs that agree to the lender’s terms, and a loan is issued. P2P payments are made through a decentralized application, or dApp, and follow the same process on the blockchain.
The use of DeFi allows:
• Accessibility: anyone with an Internet connection can access a DeFi platform and transactions are carried out without any geographical restriction.
• Low rates and high interest rates: DeFi allows two parties to directly negotiate interest rates and lend money over DeFi networks.
• Security and transparency: smart contracts published on a blockchain and records of completed transactions are available for anyone to review, but do not reveal your identity. Blockchains are immutable, meaning they cannot be changed.
• Autonomy: DeFi platforms are not dependent on any centralized financial institution and are not subject to adversity or bankruptcy. The decentralized nature of DeFi protocols mitigates much of this risk.
Advantages and disadvantages of DeFi
-Decentralized applications allow people to transfer capital around the world.
-Investor’s ability to generate income.
-High level of security
-Participation in DeFi is complex and not easily understood.
-High risk of fraud and scams
-High level of volatility