The future is here, and while the flying cars that were promised havenât arrived yet, the finance world is speeding full-force into the future with everything from wireless payment apps on our phones to entirely decentralized finance systems.
Decentralized finance, known as DeFi for short, is a fundamentally new financial system that moves monetary control away from centralized banks and towards public blockchains.
Put more simply, DeFi has the potential to change the underlying mechanics of financing and banking, as well as how people access financial services, by using the internet and smart devices instead of going through a centralized bank.
What Is Centralized Finance?
In order to understand DeFi, it is helpful to understand how the traditional financial system works. In general, the current US financial system is largely controlled by central authorities.
For example, some aspects of the financial system are controlled by the Federal Reserve (sometimes referred to as âThe Fedâ). The Federal Reserve, which serves as the nationâs central bank, was created in 1913 after several financial panics caused people to withdraw their money from decentralized banks. Mass withdrawals of money caused banks to fail and incited more financial crises.
cash management accounts, financial management apps, and ATM access, each of those things actually requires turning over that money to an institution and trusting that intermediary to manage it. The underlying goal of DeFi is to give actual control by using blockchain technology and open source coding to do the same types of transactions that currently take place largely through financial institutions.
Blockchain technology is a term commonly used in relation to cryptocurrency. At its most basic, blockchain can be thought of as a secure logbook that records transactions but is not controlled by a centralized institution. Rather, accountability in the blockchain is ensured because the âchainâ is not editable and is stored in many places instead of in one centralized institution.
If this sounds familiar, it may be because blockchain serves as the âbuilding blocksâ of cryptocurrency like bitcoin. To understand DeFi, however, it is only important to understand that blockchain is secure, automatically generated, and able to be examined and tracked, just like a physical ledger. And unlike banks, blockchain is stored on usersâ computers, which means that itâs not controlled by a central authority like the Fed.
In order for cryptocurrency like bitcoin to exist, it needs a secure ledger to track itâthatâs blockchain. So is DeFi just a synonym for bitcoin and other cryptocurrencies? Not exactly. While cryptocurrencies are decentralized when it comes to issuance, transfer, and storage, they are still centralized when it comes to access and management.
Specifically, you still need to access cryptocurrencies through centralized exchanges, and many cryptocurrency projects are managed through companies which functionally act as that intermediary that DeFi seeks to eliminate. Some cryptocurrencies even tie their worth to physical currencies like the US dollar to attempt to provide stability.
DeFi takes crypto to the next level by attempting to give the benefits of cryptocurrency without the need to tie access and management through centralized access points or companies, which can obscure the open nature of these transfers and potentially lead to abuse of the system.
DeFi is a network of open-source apps based on blockchain that allow users to engage in financial acts in an entirely peer-created, peer-reviewed, open-source world, which is all based on the security of blockchain.
Because everything within the DeFi crypto universe is open source, users theoretically have the control to engage in a wide variety of financial transactions with the assurance provided by the underlying blockchain technology.
How Can Decentralized Finance Be Used?
There are many ways that DeFi crypto is and could be used. One popular way that it is being used currently is with open lending protocols. While the name sounds complicated, open lending protocols essentially seek to eliminate the centralized middleman between lenders and borrowers.
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