Image Credit: File Photo
Traditional financial services include lending and borrowing money and receiving and sending payments which can be availed with the help of financial institutes and banks. However, in the last few years, with the introduction of blockchain technology, the attention has shifted from centralized finance or CeFi to decentralized finance or DeFi. It is still common to see CeFi as many people still use governing bodies or a centralized system to manage the finance. In CeFi, consumers can gain access to financial services through a centralized system. Banks, exchangers, and lenders often work as middlemen in CeFi and earn profit in all financial transactions. However, with DeFi, things are different.
What Is Decentralized Finance?
DeFi works against the centralized financial system. It works towards eliminating the intermediaries by disempowering them. It is against traditional finance. It takes the power of insurers, banks and exchanges and puts it in regular people. It is like receiving salary to your account without the involvement of any banks or other financial institutions. To understand the working of DeFi, let us focus on its working.
Imagine putting your savings in a savings account with an interest rate of 0.5%. The bank then uses your money to lend it to other people at an interest of 3%. In the entire transaction, putting your money in a savings account makes the banks earn a profit of 2.5%. This is how CeFi works. Now, in DeFi, people get the option of directly lending their money to someone else, and instead of earning just 0.5% or facing the potential 2.5% profit loss, you gain 3% profit on your savings.
Even though such transactions still occur, and one might argue that they do the same when they lend money to their friends through various systems like PayPal, PNR Status or online banking, it is not the case. Because your account is linked to a bank and in such transactions, the centralized financial organization works like a middleman.
The Working Of DeFi
Blockchain technology plays a crucial role in DeFi. It eliminates the trusted intermediaries in the entire financial transaction and is the USP of DeFi. Decentralized Finance eliminates the intermediaries with the help of smart contracts and cryptocurrencies. In a centralized system, all the money passes through financial institutions. In DeFi, the mediators are replaced with a smart contract.
DeFi guarantees accessibility, control, and, most importantly, transparency. In other words, these are the characteristics of DeFi. It works against back-deals, private agreements, and centralizations. DeFi gives its users absolute control of their assets. It ensures that assets cannot be moved or destroyed without the user’s permission. Currently, the popularity of DeFi is increasing in traditional financial transactions, DEXs, e-wallets, stablecoins, NFTs and flash loans. Let us now dive in to understand the advantages of DeFi.
The Advantages Of DeFi
The very first advantage of DeFi is that the user has complete control over the funds. Also, there is an element of transparency in DeFi. The user can audit the codes to verify the different DeFi services. One also has the freedom to check if the transaction was carried out correctly or not. To make a transaction in DeFi, there is no need to fill out a KYC, and one can make any financial transaction anonymously if one wants to. The services of DeFi are available for all.
Is Decentralized Finance Better Than Centralized Finance?
We have now looked at how DeFi works and its advantages. Now the question is, is DeFi better than CeFi? Both DeFi and CeFi have their own sets of pros and cons. However, there are a few cons of DeFi, which puts the system in vulnerable situations. For instance, the absence of rules and regulations in DeFi, which is an advantage, works against it because there is no consumer protection. Amending the mistake is almost impossible if a transaction goes wrong in DeFi. Hackers are also a real threat to DeFi. Even though blockchain is hard to tamper with, the entire DeFi relies on a software system, making it very vulnerable to hackers. To control the asset completely, the DeFi users are provided with a private key. If by any chance, the user loses the private key, they lose accessibility to all the funds, and there is no way to recover the private key. Therefore, even though it looks like DeFi is the future of finance, it still needs to include more elements to make things more secure for its users.