Decentralised finance: definition, benefits and use cases

What is DeFi?

DeFi refers to a decentralised financial ecosystem built on blockchain networks. Unlike traditional financial systems that rely on intermediaries like banks and other financial institutions, DeFi operates in a peer-to-peer manner, allowing users to transact directly with one another. It aims to eliminate the need for intermediaries, making financial services more accessible, transparent and efficient.

How is decentralised finance different from centralised finance?

Decentralised finance is different from traditional financial institutions primarily by how money and records of transactions are stored. Centralised finance is characterised by banks and other third-party institutions that store money and charge transaction fees. These institutions issue credit and debit cards which issue fees at every point of transfer.

A key component of decentralised finance is to provide relief from these fees and third-party handlers. DeFi is built upon blockchain technology, which eradicates the need for third-party financial institutions. Instead, individuals and merchants can conduct transactions directly on peer-to-peer networks made secure through advanced security protocols and heightened transparency.

Because decentralised finance does not involve traditional banking tools like savings accounts, credit cards and debit cards, money in DeFi is held in a digital wallet. This wallet is encrypted with a private key known only to the wallet holder and operates like a bank account for your crypto assets. It also comes with a public key used for any financial transactions on the blockchain. Interest rates and other traditional financial mechanisms do not apply to digital wallets.

How does DeFi work?

DeFi works by implementing blockchain technologies that allow for transparent and independent peer-to-peer transactions on a blockchain ledger. There are three main elements that facilitate decentralised finance: blockchains, DeFi applications and smart contracts.

1. Blockchain networks: DeFi operates on public blockchain networks like Ethereum, Binance Smart Chain and others. These networks operate as public, immutable ledgers in which every new transaction is verified by multiple nodes and added to the entire history of the blockchain ledger. Blockchains operate on a consensus mechanism, meaning multiple nodes or computers are needed to verify each transaction, allowing for anonymous, automated transactions while still preventing fraud

    

2. Decentralised applications: Decentralised applications, also known as DApps, are applications built on decentralised networks. These applications enable users to interact with financial services such as lending, borrowing, trading and asset management. New DApps are created all the time and have created a robust ecosystem that provides numerous ways to use DeFi beyond just sending and receiving money

1. Smart contracts: At the core of DeFi are smart contracts, which are self-executing contracts with predefined conditions. These contracts are powered by blockchain technology and are integrated into DApps to enable automated and trustless transactions. Smart contracts play a pivotal role in DeFi by enforcing rules, managing assets, and ensuring transparency

Benefits of DeFi

1. Accessibility: DeFi empowers individuals who are underserved by traditional financial systems, particularly in developing countries. Anyone with an internet connection can access DeFi applications, allowing them to participate in financial activities without relying on banks or intermediaries
2. Transparency: DeFi operates on a transparent and auditable blockchain network. All transactions and smart contract interactions are recorded on the blockchain, enabling users to verify and audit financial activities. This transparency reduces the potential for fraud and increases trust among participants
3. Security: DeFi employs robust security mechanisms powered by blockchain technology. As transactions are recorded on a distributed ledger, the risk of hacking or tampering is significantly reduced. Additionally, the use of smart contracts ensures that transactions are executed only when predefined conditions are met, eliminating the need for trust in intermediaries

Common uses for DeFi

While DeFi was first created to allow for faster, less-costly ways to transfer money from one person to another, new uses for DeFi are constantly being developed. Here are a few of the most common ones today.

1. Decentralised lending and borrowing: DeFi platforms enable users to lend their cryptocurrencies and earn interest or borrow assets by providing collateral. These lending and borrowing protocols eliminate the need for banks as intermediaries and allow users to interact directly with each other
2. Decentralised exchanges (DEX): Decentralised exchanges facilitate peer-to-peer trading of cryptocurrencies, removing the reliance on centralised exchanges. Users can trade tokens directly from their wallets, maintaining control over their funds while benefiting from increased liquidity and reduced fees
3. Stablecoins: Unlike other cryptocurrencies, stablecoins are designed to maintain a stable value by pegging them to a fiat currency or an underlying asset. Many DeFi networks use stablecoins to provide a reliable medium of exchange and hedge against market volatility, providing users with the benefits of DeFi without the volatility of crypto
4. Speculative assets: Cryptocurrencies have quickly become a popular new speculative asset for traders. New DApps mean new tokens are always being created, or old ones are gaining more value. As various blockchain networks grow in popularity, so does the value of their cryptocurrency. These factors along with pure sentiment provide tons of volatility in currencies like bitcoin, ether and others

Risks of DeFi

While DeFi presents immense potential, it also comes with its share of challenges and risks. Some possible downsides of decentralised finance include an undetermined future of regulations, a steep knowledge curve and high volatility.

1. Smart contract risks: Bugs or vulnerabilities in smart contracts can lead to financial losses or exploitation by malicious actors. Auditing and ensuring the security of smart contracts is crucial to mitigate these risks
2. Regulatory uncertainty: As DeFi operates in a decentralised and global manner, regulatory frameworks around the world are still catching up. Uncertainty regarding legal and regulatory compliance poses challenges for the widespread adoption of DeFi
3. Vulnerable to hacking: While security protocols prevent entire blockchains from being taken down, scammers and hackers may still target individual users. Without proper education and awareness, a user may fall victim to a hacker stealing crypto or another DeFi asset

How to trade DeFi

You can take part in the DeFi ecosystem by trading popular cryptocurrencies with City Index:

1. Log-in or open a City Index account to get started
2. Search for the crypto you want to trade on our award-winning platform
3. Choose your position and size, and your stop and limit levels
4. Place your trade

Alternatively, you can practice trading cryptocurrencies with a City Index demo account while learning more about DeFi and trading in our Trading Academy.