What's Decentralized Finance (Defi) And How Does it Work?

Finance is one of the most significant and core industries out there and it is adapting to the ever-changing technical advancement, including blockchain. In the previous article, we learned all about smart contracts that you can read it here, in case you missed it. Today, I'm back with another vital concept of a blockchain that is making lots of fuzz nowadays which is Decentralized Finance or in short Defi. It's not just a mere concept but a completely new way of doing finance-related tasks. It implies decentralization, censorship resistance, immutability, interoperability, transparency, programmability, and more. We'll get to know all about it, right now, right here. So let's get started!

What is Decentralized Finance (Defi)?

Decentralized Finance or Defi is an emerging financial technology that focuses on implementing secure distributed ledgers, similar to cryptocurrencies, and removes any central ruling authority with decentralized infrastructure. We can also understand it as an umbrella term that depicts a wide variety of financial applications that works through a peer-to-peer network. It is entirely different from the old centralized finance by canceling out any central ruling authority by carrying out a working model where every participant holds a copy of the transaction and uses a consensus mechanism to verify the same. Blockchain, being a revolutionary technology advancement, has provided brilliant fintech applications in the field of finance. According to a recent report, the total value locked (TVL) in Defi protocols is evaluated to be around $58.4 billion as of September 2022. Defi is aimed at giving individuals an open-source, transparent, and permissionless financial ecosystem to operate without third-party intervention. At this point, you might be puzzled by a common question that is how does Defi work? Let's find out.

How Does Defi Lending Work?

Before the advent of blockchain technology and financial experts being aware of Defi, such concepts were known to be open finance. Defi implements the core architecture of blockchain to facilitate all crucial tasks ranging from simple asset/cash transfers to the more complex financial implications. Before hopping on to the working of Defi, it is important for you to know its main features. To understand the core working of Defi, let's take a quick example of Defi Lending and how it works. Defi, as we know uses the benefits of blockchain benefits and hence facilitates lenders as well as borrowers to operate under a transparent ecosystem. Smart contracts make up the foundation of Defi and hence supervise the entire transaction chain without the need for a central authority. 

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In the image given above, you can see how Defi Lending works exactly. In the world of Decentralized Finance, anyone can be the lender of crypto assets and fetch loan interests on the same. Lenders can pool their possessed assets and distribute them across borrowers through smart contracts. As in traditional processes, collaterals are required to be associated with the loan, in Defi, the borrower offers something more valuable than the loan amount. Smart contracts regulate all the intermediary transaction processes in a quick and hassle-free manner.

Use Cases of Defi

The major use cases of Defi are as follows:

• Asset management
• Borrowing & Lending
• Identity Management
• Synthetic Assets
• Stablecoins
• Tokenization
• Decentralized Autonomous Organizations or DAOs, and more.

Advantages of Defi

The main advantages of Defi are:

• It provides larger consistency to lending decisions.
• Defi provides a higher level of security & transparency. 
• It ensures tamper-proof data security and increased auditability. 
• The P2P network stack ensures higher interoperability. 
• It facilitates market participants with stronger custody of their assets through Web3 wallets.

Popular Defi Applications

The popular Defi applications that strengthen the decentralized financial architecture include:

1. Synthetix
2. Badger
3. Bancor
4. Uniswap
5. Aave, and more alike.

The Future of Defi in Fintech

Although it might be too early to predict the future scope of Defi in Fintech as per recent statistics, its static growth is quite evident. It replaces the conventional financial methodology with a smarter, innovative, and decentralized open-door model. Many financial and crypto market evangelists have predicted that in the near future several banking institutions will shift themselves, partially or wholly to Defi platforms. The detailed research work report on the "Institutional Defi- The Next generation of Finance" by JP Morgan clearly explains all the expected futuristic changes in the financial services industry.  

The Bottom Line

Decentralized Finance (Defi) is an emerging financial technology, working on the model of blockchain infrastructure that holds widespread potential in the coming future. We learned what Defi means exactly and its working, along with the significant applications and respective advantages.