While traditional financial transactions are mediated through the help of a central authority such as the banking institution, DeFi is changing the way in which financial transactions are done. With DeFi, financial transactions are quickly facilitated, without the interference of third parties.
For beginners asking the following questions;
- What’s DeFi
- What’s CeFi
- How does DeFi work
- The benefits and drawbacks of DeFi
- Ways to make money with DeFi
This guide will walk you through the right answers. Read on!
Table of Contents
What is DeFi
DeFi is an acronym that stands for Decentralized Financial Services. These services consist of applications that eliminate the use of third-party agents in financial dealings.
Take, for instance, you want to send money to a friend. First, you have to deposit the money to your bank. Next, you request for your bank to transfer the money to your friend’s account.
From your friend’s end, their bank has to receive the sent money and confirm its genuineness before releasing it to them. This illustration shows one thing – The financial institution must interfere with your financial dealings each time you want to make a transaction. And in this case, they act as the middlemen in your transactions.
However, with DeFi, third-party agents are not required – be it your bank or any other kind of governing body including exchange platforms.
So simply put, DeFi is a chain of applications that allow you to carry out financial transactions – trading, saving, earning, and lending – without the need for a middleman.
What is CeFi
Unlike DeFi where your financial dealings are free of third parties or central authority, CeFi is different. To begin with, CeFi is short for Centralized Financial Services. Centralized here means your financial transactions are processed under the control of an authority. This authority could be a banking institution, a broker, an exchange, or even a regulatory body.
So in simple terms, CeFi is a chain of applications under central control or authority.
How Does DeFi Work
Decentralized finance cryptocurrency works by using applications built on blockchain technology to approve transactions between users. These transactions are initiated only when the terms of the agreement are met through Defi Protocols.
Conversely, Defi Protocols responsible for facilitating these transactions are called Smart Contracts. And Smart contracts are open, safe, and free from a governing body which means they run on their own. With smart contracts, users are allowed to write codes for processing transactions such as lending, saving, borrowing, and more.
Terms Associated with DeFi
If you are going to understand DeFi and how it works, you should consider familiarizing yourself with the following DeFi terms
This is short for decentralized applications on which DeFi is built. Essentially, this application is the basis for carrying out transactions such as transfers, lending, borrowing, and more without middlemen. It runs on itself and is vital for creating other DeFi applications.
This is an application that stores information safely and securely. Information stored on the blockchain can’t be changed, hacked, or stolen. They are so tightly secured that even an external system cannot penetrate them. Ethereum is a popular blockchain on which most DeFi developments are built upon.
Cryptography is a messaging system that allows participants to communicate and transact securely without any form of restriction. With cryptography, DeFi can’t be controlled or managed by a central authority.
DAO stands for decentralized autonomous organization. This organization uses open-source code to automate its processes on the blockchain. This code is accessible and open to everyone. Also, DAO does not have a central authority or human control.
These are computer codes that serve as an agreement between participants on the system. Smart contracts cannot be altered or changed and are usually stored on public databases.
Benefits and Drawbacks of DeFi
DeFi like every other investment has its benefits and drawbacks and an understanding of these variables is essential in making an informed decision before investing in them.
Benefits of DeFi
1. Access to control
DeFi allows you full control over your funds and transactions. Whether you want to trade, lend, or borrow, you won’t need the help of a third party. You are in charge and can decide what happens to your finances. Not even a central authority can restrain you from using the Defi protocol.
Anyone from any part of the world can use Defi applications irrespective of their financial capacity. You only need to create a wallet to start moving funds around. Also, unlike the traditional banking system where basic information such as name, mobile address, and other identification details are required, Defi allows you to trade, earn, and lend without any of these.
And more importantly, all transactions and records are made public, meaning you can not trace them directly to anyone. Moreover, accounts are anonymous.
3. Flexible and Compatible
Decentralized Finance allows you to easily assemble, modify, and incorporate external apps into existing DeFi products. This compatibility feature of DeFi with other third-party apps is more known as “Money Legos”.
Drawbacks of DeFi
1. DeFi Codes are corruptible
Decentralized finance is usually built on codes and this means that computer-savvy individuals can take advantage of this and hack into the system. If this happens, people who invested in DeFi can lose money.
2. Lack of protection from Central authority
Central authority does not take care of losses due to mistakes on DeFi. If you lose your investment because of bugs, fraudulent events, or even forget your key – you incur the loss solely without the help of a third party.
3. Little to no data to make informed investment decisions
Unlike other investment solutions where investors can study historical data before making an informed decision, DeFi does not provide users with this information. There are no verifiable data to analyze for risks, loopholes, and possible returns when investing in DeFi.
2 Ways to Make Money with DeFi
1. Yield Farming
You make money through yield farming by lending out loans and charging interests. Yield farming works in a straightforward way. You lock your crypto assets or tokens to Defi protocols, others borrow your assets, you get paid interest and fees.
Staking involves you locking your crypto assets in a DeFi protocol and receiving rewards without having to trade or perform any transactions. Stacking works just the way traditional banks work – you keep your money with your financial institution for some time, you earn some rewards. However, staking rewards are far better than traditional banking rewards. Also, your staking reward is dependent on the percentage of your assets and the timeframe of staking.
The emergency of DeFi is changing how financial transactions are done. More than ever, anyone can access their finances and decide on how to use them without the interference of a governing body. Also, through DeFi applications, anyone can make passive income easily and grow their wealth.
FAQs about DeFi
What is Centralized Finance
Centralized Finance is the process of trading crypto assets under the control of central management.
Examples of CeFi are:
- Blockfi – This platform uses CeFi system for fiat and bitcoin lending and borrowing
- Ledn – Ledn applies CeFi design for lending and borrowing bitcoin to DAI
- Celsius – Celsius utilizes CeFi ideafor bitcoin payment, borrowing, and lending
- Fairlay – Fairlay is a bitcoin platform that uses CeFi speculations for forecasting and exchanging bitcoin
Defi examples are Bitcoin and Ethereum because they are both created through the blockchain technology