Decentralized Finance is one of the emerging peer-to-peer financial systems that is soon set to revolutionize the financial system by eliminating intermediaries. It is based on blockchain technology and allows people, businesses, and other entities to directly make payment transactions with each other without the overseeing of a 3rd party like the government or banks. The DeFi system is still in its early stages and therefore has several risks associated with it. In this article, we will look into the DeFi system, how it works, and the various advantages and disadvantages of the famous financial system.
How Does DeFi Work?
Building a financial system that no longer needs go-betweens is the first step to getting rid of taxes and other unwanted charges associated with making payments, especially across cross-countries. The DeFi system uses various security protocols and other software-hardware advancements to facilitate P2P transactions. In essence, they make perfect use of blockchain technology to create an ecosystem where it is highly unlikely that any type of tampering may take place.
Blockchains are digital ledgers shared by all the nodes in a network, which store the record of all transactions that take place in a network. Every transaction that takes place is then verified by these so as to make sure that no misconduct takes place. If any external entity tries to alter data, then an alert will be issued to all the nodes of the network.
If you compare this to the financial system of today, you will find that even high-security banks can’t provide these kinds of safety and protection. On another note, there is an added benefit to DeFi as it allows us to transact other types of assets like NFTs, which can’t be traded using the existing financial system.
Key Components of DeFi
The DeFi system consists of several components. It is by utilizing all these components that the DeFi works. Some of them are as follows.
- Stablecoins
Stablecoins are digital assets that maintain a stable price throughout their lifetime. This is often done by linking their value to a fiat currency like the USD. One special thing about them is that they are always backed by collaterals
- Decentralized exchanges
Decentralized exchanges are a cryptocurrency marketplace where different users can trade their crypto assets directly with each other. There are no intermediaries present, so the associated transaction is considerably very less compared to CEXs (Centralized Exchanges).
- Smart Contracts
A smart contract is an executable file that automatically runs when an agreement between two parties is met. They are tamper-proof and are stored on the blockchain.
- Blockchain Technology
Blockchain technology is a digital ledger that stores data in blocks, which are linked to each other using a chain. It is also known as Distributed Ledger Technology(DLT).
- DeFi protocols
DeFi protocols are essentially smart contracts that are deployed on a blockchain network to provide financial services without the need for an intermediary.
Pros & Cons of DeFi
The DeFi system is still in its infancy, so there are many benefits and drawbacks associated with it. Here, we are going to look into a few of them.
Pros
- Decentralization: The DeFi ecosystem facilitates P2P trading that allows users to conduct financial transactions without depending on 3rd parties.
- High-speed transactions: By eliminating third parties, the transaction became completely fast.
- Cost Reduction: The users no longer need to pay broker fees or other major taxes associated with centralized financial transactions.
- Full-day services: It provides 24/7 services throughout the year without any problem, unlike banks and other financial institutions.
- Security: By utilizing blockchain technology, the security of the DeFi environment has become absolute. It is nearly impossible to tamper with it.
Cons
- Smart contract issues: All the operations in the DeFi system are conducted with the help of smart contracts. However, there is a slight chance that the code can be manipulated by an external entity.
- Liquidity: Liquidity is one of the key factors that determine the success of a DeFi environment. In some cases, there is a probability that the system was not able to meet up with the liquidity requirements.
- Regulations: As there are no regulations in DeFi, it could lead to anomalies. For instance, in case of a wrong fund transfer, it will be impossible to refund your amount.
- Market volatility: The crypto market is a highly volatile place, which can pose significant risks to DeFi in terms of liquidity.
Final Remarks
Even though the DeFi is in its early stages, it has a promising future ahead of it. It could lead to a huge revolution in the financial sector. As technology progresses rapidly with each day, the prospect of a free, decentralized financial system is intriguing. There is also a chance that it will be integrated into many existing sectors or industries.
However, with these many advantages, there are also a number of disadvantages associated with it. There is also the possibility of numerous scams. As the DeFi age is set to start soon, there is an added need for users to carefully tread their way through it so as to mitigate the risks associated with it.