What is Decentralized Finance (DeFi)?
If you've been around crypto, you've probably heard the term DeFi. But, what is DeFi and why is it important? DeFi (decentralized finance) is a financial technology that cuts the middleman out of the equation. Generally, a financial transaction requires a bank or other financial institution to approve and process a transaction. Whether you are looking for a mortgage for a new home or making a purchase with your credit card at your corner store, a financial institution stands between both parties (and charges a fee for the transaction).
With DeFi, you are in complete control of your finances. You don’t need to work on banking hours or wait for approval for a loan or any other type of financial transaction. If you and another party agree to the terms, you can go ahead with your transaction immediately, saving you time and money.
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What is the point of DeFi?
The goal of DeFi is to remove the expense and inconvenience of a middleman and allow peer-to-peer transactions without the need for a third party to get involved. DeFi works with cryptocurrencies like Bitcoin and Ethereum. Using DeFi, a user stores their cryptocurrencies in their virtual wallet and can then spend their currency the same as they would with a Canadian dollar.
Decentralized Finance vs Centralized Financ
Centralized finance is the traditional form of finance that we have all grown up with. The system relies on users keeping their money in banks or other financial institutions and earns fees based on the type of services they use. This can be anything from monthly fees for managing your chequing account to a flat fee each time you use a credit card or make changes to your investment portfolio. Essentially, with centralized finance, your funds are held by a third party, and you are subject to the rules and restrictions of that organization.
With decentralized finance, you hold onto your funds yourself. Any crypto you own is stored in a secure digital wallet. As long as you have an internet connection, you can buy, sell, invest, or loan funds without waiting for approval from a third party.
Decentralized finance uses the blockchain technology that cryptocurrencies operate on to validate all transactions. In essence, this is a digital ledger system that allows users to verify transactions for the safety and security of everyone involved.
The concept of DeFi can be confusing for new users at first. With that in mind, here are the basic components of how DeFi works:
With DeFi, you connect peer-to-peer for your financial transactions instead of dealing with a third party (like a bank or any other financial institution). If you want to purchase something or pay for a service, you can send funds directly to someone without either of you paying a fee or having the transaction overseen by a financial institution. The process is quicker and cheaper than using centralized finance.
You can loan and/or borrow money using DeFi. While securing a loan with a bank can be a long (and pricey) process, with DeFi you can quickly lend or borrow money if another party or service agrees to the terms. Via peer-to-peer lending (P2P), users employ decentralized applications (DApps) to lend or borrow crypto. You can earn interest by loaning crypto funds to other users (the way a bank traditionally would) or you can take out a loan and have the funds in minutes (instead of days or weeks with traditional financing). Some popular DeFi lending platforms include Aave, Maker, and Compound. All lending platforms have different types of crypto and their own interest fees, so shop around and see which lending platform works best for your needs.
Stablecoins and DeFi
Given the unpredictable market swings of cryptocurrencies, Stablecoins are dollar-digital currencies tied to a more stable traditional currency, including the U.S. dollar or the Euro. If you are using stablecoins in combination with DeFi, you can lend or borrow crypto with the security that the currency should remain relatively stable throughout the transaction (something very helpful when dealing with longer-term loans).
Pros & Cons of DeFi
Pros: The Good Stuff
More freedom and less expense: DeFi offers users complete freedom over their financial transactions. With DeFi, you no longer have to wait for your funds for days or weeks as the bank processes your application; if another user or platform is willing to agree to the terms, you can receive your funds almost immediately. Since the third party is removed from the equation, you can also save money on banking fees, which can quickly add up depending on the volume of your transactions. As long as you have an internet connection, you can buy, sell, trade, or borrow using DeFi 24 hours a day.
Safety: DeFi transactions are recorded and monitored on the blockchain, which provides greater visibility and security than many centralized financing transactions.
Cons: The Not So Good Stuff
An emerging technology: While DeFi may be the financial tool of the future, it is still a new technology and there is always the risk that a glitch could affect users. These potential issues may be ironed out over time, but there is always an inherent risk to being an early adopter of any new financial technology.
Risk of hacking: Just like with centralized financing, there is a risk of hackers attacking the systems DeFi uses for transactions. The technology is still new enough that there isn’t much data on the risks of DeFi hacking, but it is something all potential users should be aware of.
Is DeFi the future of financial transactions? While the technology is still new, DeFi opens new possibilities to many users frustrated with the gatekeeping of the major banks and high fee structures. By allowing users to connect without a middleman, DeFi is sure to grow in popularity as more potential users become aware of its benefits.
Frequently Asked Questions
Yes, you can make money by lending cryptocurrency to potential users and charging interest.
Bitcoin is a component of DeFi; users can pay each other with Bitcoin, along with any other cryptocurrencies by using DeFi technology.
Ethereum is also a component of DeFi.It allows for trusted, peer-to-peer transactions to take place.
The largest part of this rule, the 50%, should be allocated to your monthly fixed expenses, such as rent or mortgage payments and bills. The 30% — and this is the fun part — should be your personal money, where you can spend it on what you wish. The remaining 20% should go towards your financial goals.