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Understanding DeFi: How It Works And Why It Matters

DeFi, or ‘Decentralized Finance’ is the new age of money. It covers a huge range of cryptocurrencies and blockchain technologies. Learn more.

SageFX - Nov, 10, 21

*Sage FX would like to state that traders should research extensively before following any information given hereby. Any assumptions made in this article are provided solely for entertainment purposes and not for traders to guide or alter their positions. Please read our Terms & Conditions and Risk Disclosure for more information.

Principal Points

  • How Did We Get To DeFi?
  • What Defines DeFi?
  • Examples of DeFi In Practice
  • Problems With DeFi
  • The Future

DeFi, or Decentralized Finance, represents the latest chapter in the history of money and fintech. Since the birth of Bitcoin and the blockchain in 2009, DeFi has revolutionized our financial security and enhanced our digital lives. By shedding some light on Decentralized Finance, we hope this article will help you understand how your personal finances and investments could be transformed in the future.

How Did We Get To DeFi?

The history of modern finance goes hand-in-hand with the history of technology. From rudimentary accounting machines of the 1920s to the birth of banking mainframes in the 1950s, financial systems took a great leap forward with every significant technological breakthrough. Over the years, the emphasis on personalized finance has grown, especially with the introduction of credit cards and ATMs in the 1970s. The 1990s internet explosion continued this trend, allowing individuals to make payments, trade, and invest from anywhere.

Each of these developments made personalized finance more efficient but not all problems were resolved. To this day, issues of transparency, accessibility, and security constrict our financial freedom. This is where DeFi seeks to change the game.

What Defines DeFi?

Decentralized Finance is an umbrella term that covers a range of technologies. Overall, it incorporates particular features that set it apart from traditional monetary systems:

  1. Decentralization – Conventionally, our finance is controlled and processed through intermediary bodies such as banks and clearing-houses. Unfortunately, these institutions are far from impartial; governmental policy or indeed, their own economic interests can influence their operations. DeFi removes these mediators and their monopoly of control, and instead processes transactions through the blockchain network.
  2. Accessibility – Like the internet, DeFi is permissionless and welcomes participants regardless of their background, race, or credit history. This is invaluable for remote or unbanked populations.
  3. Secure and Immutable – The blockchain is an unchangeable database of transactions that guards against risks of tampering or fraud. With every “block” that is added to the “chain”, transactions become more cemented into the digital ledger.
  4. Distribution – The blockchain is a global network, which means it is fully transparent and resistant to censorship.
  5. Efficiency – The removal of intermediary bodies makes transactions more direct, or Peer-to-Peer (P2P). Even international exchanges can be made faster and cheaper.
  6. Open development – DeFi’s open-source structure has allowed it to progress at an incredible rate over the last decade. For the first time ever, the public has direct input into their financial infrastructure through the creation of smart contracts and Decentralized Applications.

Examples Of DeFi In Practice

Probably the most obvious application of blockchain technology is through cryptocurrencies, the digital alternative to fiat money. Cryptos have become hugely popular for speculatory trading as well as storing value outside of fiat systems.

However, DeFi’s technology is already being harnessed for non-financial operations. For example, Defi networks can offer tokens that unlock exclusive functions or privileges for holders. Numerous major sports clubs and independent film companies have adopted fan tokens to enhance their interactions with the public. 2021 also saw the explosion of NFTs (Non-Fungible Tokens). These media articles (such as artworks, songs, or videos) have unique digital tags which grant them collectable status in internet culture.

Yet aside from its utility in entertainment, blockchain technology is solving more and more real-world problems. Like the internet, it has the potential to revolutionize the efficiency of numerous industries, from supply-chain management to retail, healthcare to insurance.

Problems With DeFi

But also like the internet, DeFi’s permissionless and anonymous nature makes it vulnerable to exploitation. Governments and authorities are still wary of the risks of fraud and money laundering attached to a decentralized system, so regulation is likely to be a recurring issue. DeFi still has some way to go before it becomes the de facto alternative to fiat.

Additionally, DeFi’s technology is by no means perfect. Scalability will be a serious problem if demand increases, and developers are racing to build networks that can handle increased transactions without becoming congested. Bitcoin is just over a decade old and its limitations have already become apparent, so flexible and efficient innovation will be key to DeFi’s survival.

The Future

In any case, DeFi developers can be optimistic in light of their achievements so far. The industry is evolving swiftly, and with the crypto market capitalization topping $3 trillion in 2021, it’s evident that public support is spreading. It’s true the technology still has teething issues and that trust remains a significant barrier to wider adoption. Nevertheless, the principles behind DeFi and the ideology of financial freedom are surely here to stay.

Keep an eye on the latest DeFi developments on our news page

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