What is Decentralized Finance:
The term decentralized finance, or abbreviated as DeFi, describes a financial system that operates without the need for traditional, centralized intermediaries. We're used to everything going through a bank and other financial institutions like a global exchange, but DeFi creates a system that can function on its own. It allows us to handle several financial applications – like investing, insurances, exchanging, borrowing, and lending more efficiently and transparently.
How It Works:
Rather than a bank facilitating transactions and services between parties, DeFi uses technology. Several open-source protocols are being developed alongside public blockchains, forming a framework for decentralized finance to operate on.
Two core components allow a finance system to work; it needs an infrastructure to operate on, and a currency to operate with. Banks and financial institutions act as that infrastructure in a centralized system, while fiat money, like the US dollar, acts as currency. Decentralized finance must replace these components to offer a full range of financial services.
Risks and Downsides:
DeFi is an emerging phenomenon that comes with many risks.
For example, there is no consumer protection. DeFi has thrived in the absence of rules and regulations. But this also means users may have little recourse should a transaction go foul.
Another downside is that hackers can be a threat. While a blockchain may be nearly impossible to alter, other aspects of DeFi are at large risk of being hacked, which can lead to theft or loss of funds. All of the decentralized finance’s potential use cases rely on software systems that are vulnerable to hackers.
Collateralization may also prove to be a problem for some people. Nearly all DeFi lending transactions require collateral equal to at least 100% of the value of the loan, if not more. These requirements vastly restrict who is eligible for many types of DeFi loans.
Also, with DeFi and cryptocurrency, you must secure the wallets used to store your cryptocurrency assets. Wallets are secured with private keys, which are long, unique codes known only to the owner of the wallet. If you lose a private key, you lose access to your funds—there is no way to recover a lost private key.
It is important to understand that investing in DeFi is highly risky. The reason the reward is high is that the risk is just as high.
Written by Ishmita Vaish