What Is DeFi and How Does It Work?

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If you’ve been around the crypto space recently, the chances are that you have heard people mention DeFi a couple of times.

DeFi is one of the most popular buzzwords in the crypto community. It’s a term used to describe decentralized finance — or financial services built on blockchain technology. But what is DeFi, and how does it work? What does it hope to achieve, and why should we care?

This article will answer these questions so you can get an overview of this exciting new concept, its potential, and how it works.

What is DeFi in Simple Terms?

Simply put, DeFi is a term used to describe financial services built on top of blockchain technology. It’s similar to decentralization but with a twist. Unlike traditional centralized institutions owned by a single entity, DeFi is distributed among many stakeholders while still being governed by smart contracts.

The goal of DeFi is to make financial products and services more accessible and affordable for everyone. By doing so, it hopes to increase global financial inclusion and reduce the cost of using money.

Understanding Decentralized Finance

In order to understand how DeFi works, let’s first take a look at what’s wrong with the current financial system.

What is Centralized Finance?

Centralized finance refers to any financial product or service provided by a central authority. This includes banks, credit card companies, insurance providers, etc.

When banks hold your money, they’re essentially keeping it safe and secure in their vaults. They also handle all transactions and provide access to loans. In exchange, they charge fees for providing those services.

Banks are not only expensive but also slow. You’ll need to wait days or even weeks before getting approved for a loan. The process is time-consuming and often requires collateral (like real estate).

Banks are also highly regulated. That means you won’t be able to open accounts without meeting certain requirements. For example, you must pass a background check and prove that you have enough income to cover your monthly expenses.

These restrictions mean that some people may find themselves excluded from the mainstream banking system. These include unbanked individuals, immigrants, refugees, and others who don’t meet the criteria set out by existing banks.

How is DeFi Different, And How Does It Work?

Decentralized finance is different because it allows anyone to use financial products and services regardless of where they live or what type of bank account they already have.

With DeFi, no matter if you’re a citizen of a developing country or living in a developed nation, you can easily create a wallet and start making payments. All you need is a smartphone and an internet connection.

Decentralized finance also provides greater transparency and security than centralized systems. Because there are no middlemen involved, you know exactly where your funds are going. There’s no risk of losing them due to fraud or theft.

Moreover, decentralized finance doesn’t require users to trust each other. Instead, it relies on smart contracts to enforce rules and regulations. Smart contracts allow parties to agree upon terms and conditions through automated processes.

Different DeFi Products

DeFi’s primary principle is the use of P2P financial transactions. This type of transaction involves two parties directly interacting with one another instead of relying on an intermediary like a bank.

This model makes it easier to transfer value between parties. Imagine if you want to get a loan in a centralized system. You’ll need to tender an application form at your bank or loan company. You’ll pay back interest and service fees if your request gets approved.

In DeFi, you’d utilize a dApp to register your loan demands, and an algorithm would connect you with peers. You’d then agree to a lender’s conditions and get a loan.

After the consensus process confirms the blockchain transaction, you receive your loan. The lender can then receive payment at defined intervals. When you make a payment using your dApp, the transaction follows the same procedure on the blockchain, and subsequently, the funds are sent to the lender.

You should be aware of the tax implications of cryptocurrency activity and transactions you participate in. DeFi like most other crypto activity triggers IRS and state tax department tax  payer obligations. If you have doubts, questions and/or need help navigating crypto taxes and accounting responsibilities, seek the help of a specialized crypto CPA or cryptocurrency accountant like Results Tax Accountants.

Final Thoughts and Future of DeFi

There are many ways to build a product within this space. Some companies provide lending and borrowing services, while others specialize in investing or insurance.

However, most projects focus on building solutions that help consumers save and make money.

Whether you’re looking to lend someone money, borrow money, or just invest in something, you can do so without going through the traditional banking system.

The future of decentralized finance looks bright. The industry has grown rapidly over the past few years, and we’ll see more use cases as people continue to build.