What is DeFi
DeFi are financial instruments in the form of services and applications created on the blockchain. The main task of decentralized finance is to become an alternative to the banking sector and replace the traditional technologies of the current financial system with open source protocols. That is, to open access to decentralized lending and new investment platforms to a large number of people, as well as to allow them to receive passive income from cryptocurrency assets.
What does DeFi consist of
DeFi uses various technologies developed in the field of blockchain. All of them find application outside of decentralized finance, but play an important role in the DeFi ecosystem.
According to a joint study by Wharton Blockchain and Digital Asset and the World Economic Forum, there are several components of what DeFi is.
First of all, DeFi projects are blockchains, distributed registries for recording transactions. Currently, most DeFi services operate on the Ethereum network due to its capabilities and popularity among developers. However, the activity of DeFi is also growing in other blockchains.
Next come digital assets, that is, DeFi tokens, representing value that can be sold or transferred to the blockchain network. "Bitcoin and other cryptocurrencies were the first blockchain-based digital assets. Others have a number of functions that go beyond payments," the study notes.
The next component is wallets: software user interfaces for managing assets stored in the blockchain. With the help of a non-custodial wallet, the user fully controls their funds through private keys. In the case of custodial wallets, the private keys are managed by the service provider.
Another important block of the ecosystem is smart contracts. It is a blockchain-based program code that executes, monitors and documents relevant events and actions in accordance with predefined conditions and rules.
On the basis of smart contracts, decentralized applications (Dapps) are created, which are often integrated with the user interface using traditional web technologies, and decentralized autonomous organizations (DAO): organizations whose rules are defined and regulated using smart contracts.
The next step is stablecoins (digital assets whose value is tied to a fiat currency, a basket of fiat currencies or other assets with a stable price).
Software mechanisms that manage changes in smart contracts or other blockchain protocols are embedded in DeFi management systems. They are often based on tokens that distribute voting rights among stakeholders.
Advantages of DeFi
The advantages of decentralized financial services have been known on the market for quite a long time.
The first is decentralization: DeFi tokens allow you to conclude transactions between users using a variety of computers of other participants.
The second is the absence of the human factor. Decentralized finance (DeFi) works on the basis of smart contracts, which eliminates the human factor.
You can also mention transparency — the DeFi market is based on source code. All information about transactions is always available to any user. Therefore, such applications will easily pass an honest audit.
Experts call inclusivity another significant advantage of the ecosystem, that is, the ability to launch a DeFi product for any project, without the permission of banks and regulators.
Another strong feature of the DeFi system is its cross-border nature. Here you can use financial services without intermediaries. Loans are issued in a few clicks at home, without bureaucratic red tape and draconian interest.
Disadvantages of DeFi
However, this new toolkit certainly has its drawbacks.
These experts include low system performance. Blockchains by their nature work slower than their centralized counterparts, which leads to the creation of additional applications. Developers of DeFi applications should take into account such limitations and optimize their products accordingly.
There is a high risk of user error within the system. DeFi applications transfer responsibility from intermediaries to the user. This can be a negative aspect for many. Developing products that minimize the risk of user error is particularly challenging when products are deployed on top of immutable blockchain networks.
Another factor of instability in the ecosystem is its randomness. Finding the most suitable application can be quite a difficult task, along with this, users must have a certain skill to choose the best option. According to experts, the problem is not only in creating applications, but also in thinking about how perfectly they can fit into a large ecosystem of decentralized finance.