What Is Decentralized Finance (DeFi)?

DeFi, defined as Decentralized Finance, rebuilds financial transactions by removing intermediaries. It is a financial system based on blockchain technology, usually buying cryptocurrency while doing so. Available to everyone, the concept of DeFi operates without a central authority. This permissionless system aims to create an open source and transparent financial services ecosystem. In this system, users have full control of their assets. Enabling easy access to financial services, DeFi enables the user to create new financial products, markets and services thanks to the modular infrastructure on which it is built.

Decentralized Finance eliminates intermediaries by allowing users and businesses to conduct financial transactions through emerging technology. This is achieved through peer-to-peer (P2P) financial networks and Decentralized Applications (DApps) using security protocols, connectivity, software and hardware enhancements.

You can lend, trade and borrow money from anywhere with an Internet connection using software that records and verifies financial actions contained in the financial database. A distributed database can be accessed at various locations. It collects data from all users and uses a consensus mechanism to verify it. Allowing users to get financial services at any time and place they want, Decentralized Finance uses this technology to eliminate centralized financial models,  DeFi applications help users gain more control over their assets by providing personal wallets and trading services.

How Does DeFi Work?

how does defi work?

DeFi uses smart contracts to replicate and renew financial services in a more transparent and workable way. Eliminating the need for central financial institutions and intermediaries, DeFi achieves this with a censorship-resistant and permissionless protocol supported by smart contracts. 

Blockchains and dApps are generally used for the exchange of crypto assets. DeFi uses a multi-layered structure. Developers rearrange or create their own layers, because each layer is built on top of each other,  

The Ethereum blockchain, located in the Settlement Layer, ensures the security and scalability of the system. This layer also includes distributed ledgers and a public blockchain. In product requirement determination, value exchange protocols located in the asset layer are developed. Above this layer, the protocol layer is embedded for operations such as derivatives, lending, borrowing. The application layer provides consumer-specific applications. Basic protocols at this layer allow for consumer-oriented services. The aggregation layer is the last layer. This layer consists of aggregators that connect applications from previous layers to provide services to investors.

DeFi Usage Areas

DeFi, defined as decentralized finance, includes a large number of products and services. However, this sector has an interconnected and integrable way of working. Therefore, it is important to obtain comprehensive information about the areas of use before.

Borrowing and Lending

DeFi protocols try to facilitate borrowing and lending without intermediaries. However, since interest rates are largely dependent on supply and demand, they may change over time. In most cases, the lender requires the borrowers to provide more collateral than they received in order to be paid in market fluctuations. 

For example, the user needs $1,000, albeit for a short term. In the absence of DeFi, the user has to sell his Ether or Bitcoin savings. However, the user deposits $1,500 worth of BTC to get a $1,000 loan using the debt services at DeFi. Thus, he can meet his needs without losing his Bitcoin savings and can pay off his loan.

Asset Management

In asset management at DEFI, users can track and manage their deposits using a single interface. In this protocol, lenders who invest funds receive tokens representing interest-earning positions. These tokens are called compound tokens and liquidity provider tokens. However, these tokens must be exchanged for the invested capital or the invested amount in the first place. 

For example, when a user adds 200 DAI to the system, 200 DAI’s worth of cDAI are sent to their account. When the user adds 200 DAI and 200 ETH to the liquidity pool, he also sends LP-ETHDAI to his account. In short, asset management platforms make it easy to manage multiple positions and implement complex strategies in DeFi protocols. 

Futures Transactions

The primary economic functions of financial futures trading are risk transfer (hedging) and price discovery, as well as improving transaction efficiency and liquidity. Chain and off-chain sellers can balance the volatility of open cryptocurrency platforms using DeFi futures. DeFi allows futures contracts to be traded in a simple and user-friendly way.

DeFi futures have versatile benefits compared to traditional futures transactions. Faster settlement, wider access, lower costs and ease of use are these benefits. The extent of innovation is much higher, especially in terms of creating integrated systems. However, the emergence of robust futures platforms and products based on these immediate consequences indicate DeFi’s maturity.

Insurance Transactions

In general, insurance is a risk management in which the user receives financial protection or reimbursement from the insurance company in the case of a loss that he will suffer. In this management strategy, home, life, and health insurances are widely purchased. Cryptocurrencies that are locked in smart contracts are extremely vulnerable to the exploits found in this contract. Although the codes of projects are checked most of the time, users never know if smart contracts are reliable or not. Therefore, if there is a large amount of funds in the DeFi protocols, it is extremely important to provide decentralized insurance against possible risks.

DeFi Coins and Projects

Defi Coins and Projeckts

AVAX (Avalanche) Coin

Avalanche is a blockchain system acts as a securing function in releasing financial assets, commerce and other services, especially DeFi applications to the market. AVAX aims to be global in the sense of aiming to enable users to trade all kinds of assets, control smart contracts, and next-generation technologies.

UNI (Uniswap) Coin

Uniswap is a decentralized trading protocol known for its effect in facilitating automated trading of DeFi tokens. Uniswap multiplies the profits generated by token trading. In addition, it aims to make transactions progress in an automatic system and to be a platform available to everyone who owns tokens.

Chainlink, aiming to combine smart contracts with real data, can be defined as Decentralized oracle network. LINK is the cryptocurrency of Chainlink. LINK is also the payment source for nodes.

Advantages of DeFi

  • All transactions performed at DEFI are anonymous.
  • There are no errors caused by third parties in the process.
  • Each stage of functioning is performed by software running on the blockchain.
  • The system keeps all records on the blockchain.
  • With DeFi, you can get a loan quickly, even at midnight. As long as you have an internet connection, you can access the market from anywhere and anytime.
  • KYC (Know Your Customer) will not be needed to perform the transaction.

Disadvantages of DeFi

  • All of the errors made in the system are caused by the user and only the user is responsible for these problems.
  • Any losses incurred in the system are not compensated.

Felixo is a crypto trading platform offering advanced services and offers a support that makes a difference for liquidity providers and expert investors around the world. You can download Felixo Exchange to learn more about the subject.

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Written by Buket Başol
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I earned a bachelor's degree in computer programming from Gazi University and a master's degree in brand communication from Anadolu University. In several educational institutions, I offered individual and corporate training in topics such as design-oriented thinking, user experience, marketing, marketing strategy, and communication. I worked as a marketing consultant for multinational corporations. Since 2010, I've been working with organizations that provide technology, software, and financial services. Since 2021, I've been the Marketing Director of Felixo Exchange. At the same time, I write my research and analysis on topics such as Blockchain, Cryptocurrency, NFT, and Metaverse on the Felixo Blog.