DeFi is a new financial system that is more cost-efficient and secure than the traditional one. In doing so, blockchain technology enables a peer-to-peer based system that is accessible to everyone worldwide and is designed to work without middlemen. Sound like a dream? Let’s take a closer look at DeFi, its use cases and risks, so you too can make smart and informed decisions in the crypto world.
DeFi stands for Decentralized Finance. It means decentralized finance and is a generic term for financial applications based on the blockchain.
DeFi is one of the largest application fields for blockchains and cryptocurrencies. Along with terms like Web3, Metaverse, and blockchain gaming, DeFi is one of the most promising subfields in the crypto world.
Blockchain technology can be used to create a transparent and immutable financial system. This new financial system is said to have many advantages over the old one. Blockchain technology is fundamentally intended to ensure that users worldwide can send money or interact with each other quickly and inexpensively.
Unlike our current financial system, DeFi is accessible from anywhere in the world. Whether you’re off-grid or in a developing country that has limited access to banks. All you need is a smartphone or computer and an internet connection to plug into the new global financial system.
Yet this new financial system is designed to be decentralized. Again, crypto advocates believe that decentralization has many advantages. This is because common financial applications that have a centralized structure also offer centralized vulnerabilities. DeFi aims to eradicate these centralized attack points and replace them with a more robust, decentralized network or protocol.
In most cases, these decentralized protocols are managed by native tokens. Holders of the tokens get voting rights and can vote on important decisions. In this way, one would like to strive for a democratic administration of protocols.
In most cases, these decentralized protocols are managed by the native tokens. Holders of the tokens get voting rights and can vote on important decisions. In this way, one would like to strive for a democratic administration of protocols.
At the same time, most of the middlemen, who cost a lot of resources as labor in the old financial system, are simply eliminated in Defi. Since the new financial applications are mapped as smart contracts on the blockchain, most tasks are now automated merely and executed by computer programs.
All of this leads to a new financial system that should be more cost-efficient, secure, and transparent. The immutability of the blockchain ensures this. Even though Defi technology is still in its infancy, some promising applications for a financial system based on the blockchain are already emerging.
Decentralized exchanges (also called DEXes) are the decentralized counterpart of the usually centralized crypto exchanges like Binance. While on a traditional exchange, you first have to create an account and, if necessary, carry out identification, on a DEX you log in directly via your crypto wallet. This way, you have access to almost all cryptocurrencies that exist. In contrast to common exchanges, price discovery on decentralized exchanges works through an algorithm called an automatic market maker.
Usual exchanges, on the other hand, are based on an order book. These are also mapped in a decentralized manner on the blockchain and are part of the DeFi ecosystem. This allows users to trade crypto derivatives and without a central middleman. In doing so, the user experience of these decentralized trading venues is similar to that of a regular stock exchange. Running limit orders, stopping losses, and selling your coins directly to the market is possible.
Peer-to-peer lending platforms are also called lending protocols. Here, backers provide their cryptos to a protocol, which then lends these coins. This creates a decentralized ecosystem of borrowers and lenders that is open to users on a global scale. Lenders earn passive interest income on their lent assets.
More exotic financial products, such as options trading or NFT derivatives, can also be found in the DeFi world. In doing so, DeFi enables novel use cases that would never be possible without blockchain technology. These include, for example, streaming money or lending platforms that accept your NFTs as collateral.
Thus, DeFi is merging with the other areas of the crypto world, including NFTs, blockchain gaming, and the metaverse. This is giving rise to many novel products such as NFT exchanges that operate via an automated market maker, protocols that enable trading of NFT derivatives, or video games that can showcase their own tokens and thus an economy all their own.
The risks of the decentralized financial system
The world of cryptocurrencies can be like the Wild West. That makes it all the more important that you educate yourself to avoid the risks of crypto. This is because many scammers target ignorant people and try to rob you of your cryptocurrencies. There are phishing attacks, pump-and-dumps and many other scams. It is of utmost importance to never give out your private keys and to keep your cryptos safe.
However, not only scammers but also software bugs can be devastating for you. Since these financial applications handle billions of dollars, so-called “bugs” that lead to errors in the software are especially costly. While this risk can’t be avoided, it can be mitigated. Some questions to ask yourself: Has the software been in use for a long time? Have the developers performed a code audit or have there been bug bounties?
Hackers are just lurking to find bugs in the code that they can exploit. But those aren’t the only risks for Defi users. Since the decentralized financial system is currently subject to few regulations, it is impossible to predict how new government regulations might affect your Defi investments. Even simply holding Defi tokens carries risks and the underlying companies should be well scrutinized.
For newcomers in particular, cryptocurrencies are confusing and confounding, to the point of being downright dangerous. Especially as a beginner, it is therefore important to deal well with the matter. This is the only way to make informed decisions and survive in the world of cryptocurrencies.
That’s why there are numerous platforms that offer an extensive education section for beginners and advanced users. So, if you are interested in crypto education, you can check out Binance’s Academy, for example. There you can find answers to the most important questions about Bitcoin, blockchains, NFTs, Metaverse, gaming and much more.
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