What is Decentralised Finance (DeFi)?

As the world of crypto expands and financial systems evolve, the importance of decentralised finance – or DeFi for short – continues to grow.

DeFi is an emerging financial technology based on secure distributed ledgers – also known as blockchains. Essentially, the structure of a blockchain allows financial interactions to occur without the need of an intermediary, like a bank. This allows investors to, as a very simple example, send money internationally without requiring the need for a third-party payments provider.

DeFi removes the control that banks and other financial intuitions hold on money, financial products, and financial services. Not only does this allow investors more control over their own money, it improves efficiency and reduces overhead costs.

To gain a complete understanding of DeFi, we need to take a closer look at the difference between centralised and decentralised finance.

Centralised Finance vs Decentralised Finance

Centralised Finance

In centralised finance, money is mostly custodied and managed by banks, whose overarching goal is to make more money. Centralised finance involves intermediaries who facilitate the movement of money between parties, with each attaching their own fees for the use of their service.

For example, think about the process of buying a cup of coffee with your credit card. When you purchase your coffee, the charge goes from the merchant (barista/cafe) to a bank, who then forwards the card details to the credit card network/payment provider (e.g., Square).

The network clears the charge and then requests payment from your bank. Thereafter, your bank approves the charge and sends approval to the network, through the acquiring bank, back to the merchant. Each entity in this chain receives payment for its services because merchants must pay for your ability to use credit or debit cards.

Although it seems to only take the time it takes to tap your card on a PoS device and hear the ‘beep’, the transaction actually travels through about six different steps before it finally settles.

Decentralised Finance

Decentralised finance eliminates the need for third-party involvement in financial transactions by allowing people, merchants and businesses to conduct financial transactions using blockchain technology.

Basically, the introduction of smart contracts in 2015 allows programs to execute on a blockchain based on a preset trigger. In short, this means once certain conditions are met, these contracts can automatically execute agreements – like sending cryptocurrency from one person to another.

Because everything is settled on the blockchain, there’s no need for a third party to validate, approve or process transactions, vastly improving efficiency and financial autonomy.

Any person with an internet connection can participate in decentralised finance. As the industry has evolved in popularity, DeFi has blossomed into a fully-fledged ecosystem brimming with financial services such as lending, contributing to liquidity, borrowing and trading a range of assets.

Through this technology, DeFi can challenge centralised finance models by allowing anybody to use financial services anywhere, regardless of the location and who they are. When you consider that 1/3 of the world remains ubanked, it becomes apparent just how powerful the financial freedom offered by DeFi could be.

Peer-to-Peer Lending Lies at the Core of DeFi

Peer-to-peer (P2P) financial transactions are one of the key aspects behind DeFi. To fully understand this, we will use the example of obtaining a loan in centralised finance. In this case, you would need to apply at the bank or another lender for one. Should you be approved, you would pay interest and fees for the privilege of using the lender’s services.

In the case of DeFi, you would make use of decentralised finance applications (dApps) to enter your loan needs, and an algorithm would match you with peers that meet your needs.

The transaction in this instance is then recorded on the blockchain, and you would receive your loan after the consensus mechanism verifies it. Then, the lender can start collecting payments from you at agreed-upon intervals. When payment is made through your dApp, it follows the same process in the blockchain. Only then are the funds transferred to the lender.

Because the transaction doesn’t require a third-party controlling the flow of value, it is often much cheaper and faster for both participants. Additionally, the lack of a physical requirement (for example, it would be difficult for Aussie citizens to get loans from US-based companies) unlocks a broader range of options for borrowers and lenders.

Some Key Attractions of DeFi for Consumers:

• The elimination of fees that banks and other financial companies charge for the use of their services.
• Consumers will be able to hold their money in a secure digital wallet instead of a bank.
• Control over personal finances rather than using a third-party to manage services.
• 24/7 settlement on assets.
• Access to more competitive rates on savings accounts, as well as unique earning opportunities such as liquidity mining and staking.
• Any person with an internet connection can make use of DeFi without needing approval, thereby increasing access to financial services.
• Funds can be transferred within minutes or seconds, so transaction times are reduced.