A decentralized finance model (DeFi) enables cryptocurrency-based transactions, exchanges, and financial services.The core premise of DeFi is that there is no centralized authority that dictates or controls operations. The model differs from traditional models of finance for fiat currencies or centralized finance (CeFi) within cryptocurrency markets. The flow of transactions can be influenced and controlled by a core foundational authority in centralized models. In many cases, assets are also entrusted to the central authority for custody.
DeFi does not have a central authority. Decentralized authority is distributed instead to give individuals more power and control. Peer-to-peer (P2P) transactions with cryptocurrency are possible without a central authority in the DeFi model.
The custody of an asset is one of the most fundamental components of a financial model. Cryptocurrencies can be held in custody with the DeFi approach because traders control their own cryptographic encryption keys. In the DeFi model, financial transactions are enabled by smart contracts that use Ethereum-based blockchains
Additionally, DeFi encompasses the concept of decentralized exchanges (DEXs), which facilitate cryptocurrency transactions by connecting and enabling individuals. Additionally, decentralized apps (dApps) are often closely associated with DeFi, typically for financial services.
Cryptocurrencies and decentralized finance both use blockchain technology. Blockchains are distributed, secure databases or ledgers. Applications called dApps are used to handle transactions on the blockchain.
Blockchain records transactions in blocks, which are then verified by other users. Upon agreement between these verifiers, the block is closed and encrypted; another block contains information about the previous block.
Blocks are connected through the information in each preceding block, giving blockchain its name. Changing previous blocks without affecting following blocks is impossible, so it is impossible to alter a blockchain. As a result of this concept, as well as other security protocols, a blockchain is secure.
Using an Ethereum-based blockchain, smart contracts facilitate the DeFi model. Blockchains provide distributed ledgers and cryptographic encryption capabilities that make smart contracts possible. An execution of a smart contract is governed by its terms and conditions.
DeFi vs CeFi: A Comparison
Traditional financial services like payments, lending, and borrowing were only available through established financial institutions and banks. As a result of the introduction of blockchain technology, it has undergone a significant transformation. As cryptocurrency began to expand, the debate shifted to decentralized finance (DeFi) and centralized finance (CeFi), two different approaches to monetary policy.
We must first understand CeFi and DeFi in order to compare their pros and cons.
What is Centralized Finance (CeFi)?
DeFi replaced Centralized Finance as the standard for crypto trading before its introduction. The company holds a stronghold over the cryptocurrency industry. All crypto trade orders are handled by a central exchange in centralized finance (CeFi). The funds of the central exchange are managed by specific individuals. As a result, you don’t have access to your wallet because you don’t have a private key.
Additionally, the exchange provides information about the coins it lists for trading or the fees you must pay to trade.If you buy or sell cryptocurrencies through a centralized exchange, you do not own them. A centralized exchange also has rules that you must follow. Furthermore, you must comply with the exchange’s rules.
What is Decentralized Finance? (DeFi)
Decentralized exchanges do not involve exchanges. Automated applications are developed on blockchain platforms to automate the entire process. Furthermore, decentralized finance allows anyone to participate in a fair and transparent financial system. Through blockchain technology, unbanked people can access financial and banking services.
Open-source, permissionless, and transparent financial services are the goals of DeFi. The decentralized financial system allows for borrowing, yield farming, crypto lending, asset storage, and other services.
The advantage of using DeFi over CeFi is that you are in full control of your assets. For users to access DeFi services, they need to use decentralized applications (dApps) built on blockchain platforms.
Also read more on Real Time Applications of Smart Contracts and Blockchain Technology
How is DeFi different from CeFi?
Although DeFi and CeFi have many differences, the question is whether users should trust technology or their peers.The DeFi technology assures users that the service will be delivered as promised. With CeFi, users trust that a business’s people will manage funds and execute its services.
Both DeFi and CeFi provide cryptocurrency-related financial services
The Advantages of DeFi
Cryptocurrency-based transactions and applications can be made more secure by using DeFi, which offers the following advantages:
- Decentralized. Unlike CeFi, which may lose user funds when an exchange fails, DeFi is decentralized and not subject to the inherent risks of CeFi.
- Permissionless. There is no need for a central authority to approve or enable transactions in a decentralized model. Instead, the programmatic logic of smart contracts defines what is possible, making this model permissionless.
- Transparency. With smart contracts, users can understand a transaction’s terms and logic in a transparent manner without having to see the code behind the transaction.
- Anonymity. On the blockchain, smart contracts can be transparent, but users are not required to identify themselves. DeFi does not specifically impose Know Your Client requirements, which are common with centralized and regulated models.
- Custody. Users control assets in DeFi and hold the cryptographic private key for cryptocurrency tokens.
- DApps. In addition to financial services applications, DeFi supports dApps, such as games and social media applications.
- Fees. Due to the lack of a central authority, DeFi offers lower transaction fees than CeFi.