Decentralized Finance (DeFi), as the name suggests, is a financial system operating without a centralized governing body that runs on digital applications writing smart contracts on different blockchains. To understand the decentralized finance (DeFi) system more clearly, you need to know the idea of the centralized financial system upon which our banking system is based.
In this article, we will talk a little about the mainstream centralized financial systems to provide you with a basic understanding of the centralized financial system. You shall also be given some information about the decentralized applications referred to as dApps, smart contracts, and blockchain technology. All these things combine to form a secure and strong financial system that is called a Decentralized Finance system. It does not involve any third party and does not have a centralized governing body.
So, let’s start exploring the world of secure crypto financial systems starting with the Centralized Financial system.
Centralized Financial System
A centralized financial system is the conventional finance system that runs on centralized platforms and is controlled by central governmental authorities. Almost all of our financial activities such as trading and lending are being controlled by the central government financial institutions. These financial institutions in the shape of banks act as third parties and intermediaries that have the power and authority to approve or deny transactions or withdrawals.
They can freeze your bank accounts, money transactions, or cash withdrawals until they are not satisfied with the transparency of the financial deals. Government financial regulatory bodies have set some guidelines and rules for the financial dealings of citizens of their countries. These rules and regulations of the centralized finance system have their advantages and disadvantages for regular users. Working under these centralized financial authorities has its own limitations that reduce the ease of accessing capital finance and financial services on public forums.
After getting this basic understanding of the centralized financial system, it would be easy for us to understand with a relatively comparative approach to learn about Decentralized Finance. It does not involve any third parties or intermediaries to control or govern our transactions or financial withdrawals.
Decentralized Finance (Defi)
Decentralized Finance is a financial system operating on codes known as smart contracts created by the decentralized applications (dApps) that shape the infrastructure of the DeFi system being powered by blockchain technology. This gives a limitless possibility to the developers to come up with secure and customized financial protocols to produce new investment platforms for the public.
It is a financial ecosystem of decentralized apps that has given a big challenge and competition to the regular centrally governing financial system working mainly through banks. DeFi has the ability to create a transparent and open-source financial protocol that gives freedom of trading without any third-party involvement.
It is built upon blockchain technology like Ethereum blockchain offering the users to create their own cryptocurrencies and use their infrastructure to create unique smart contracts running different Decentralized apps. Before talking about it further, we should have some basic understanding of the Decentralized Finance infrastructure i.e smart contracts, Decentralize Apps (dApps), and blockchain technology.
Smart contracts are computer programs or a protocol on which the transactions are made and are stored on blockchains. Smart contracts run automatically when certain conditions are met. They are automated protocols that are written as codes as terms of the agreement between two users, being buyer and seller. A user selling their online crypto assets and the other one buying them are bound in a contract written in codes that are irreversible. These contracts are the agreements written by the decentralized apps (dApps) and work on public blockchains. These codes are written into the blockchain which is virtually indestructible and there is no intermediary or third party is involved in this agreement.
Smart contracts automatically execute transactions and agreements between, pseudo-anonymous parties. There is no legal system needed or any third party to enforce the process. All the transactions or tradings are traceable and transparent that cannot be reversed. The verification of the transactions made through smart contracts is made through the blockchain network.
Decentralized Applications (dApps)
Decentralized applications (dApps) create the infrastructure of a decentralized financial system. These apps are not like any regular application on your mobile phone that is operated and maintained by a single company or service provider. These apps write codes of the agreement referred to as smart contracts into different public blockchains system. These are open-source decentralized applications that run peer-to-peer (P2P) on blockchain networks and are accessible from any part of the world using the internet.
Generally speaking, these are in the shape of cryptocurrencies that run on different blockchains and are traded on various online cryptocurrency exchanges. Nobody can alter its software, not even the developer who developed it because it is simply not possible to do it making it secure, transparent, and decentralized.
There is a wide range of applications under the umbrella term decentralized apps (dApps). To be designated as a decentralized application, it should meet certain criteria.
It should be an open-source application whose development should not be under one party rather it should be community-driven.
Data, reports, and codes should be stored on a public blockchain making it decentralized.
The data stored on the blockchain should be cryptographically encrypted.
There should be a process through which the user may generate cryptographically encrypted tokens that should result in receiving rewards for the miners.
The generation of these tokens should be according to a cryptographic scheme that is based on a clearly defined consensus mechanism.
Blockchain is also referred to as Distributed Ledger Technology (DLT), records and creates the history of a cryptocurrency that is unchangeable and unalterable. It records all the information created by the decentralized apps. The information recorded in the blockchain is called smart contracts. These codes on the blockchain form the infrastructure of any crypto asset that is virtually unbreakable
To understand it more clearly we can take the analogy of a shared document on any online platform. The document is writable and is shared with a group of people. This document is shared among the group rather than being copied or sent to each other. It is available on an online platform where a group of people can have access to it at the same time. It is being used and worked upon by different people at the same time. The working on it becomes transparent and decentralized by being in access of so many users at the same time. You don’t have to wait for someone to finish their work on it and then it may come to you for work on it. This ensures transparency in making changes on it and everybody knows what is being written on it.
It is a simple analogy to make an average user grasp the idea of how the blockchain works. By saying that it is a simple analogy, it is being stressed that the blockchain is a very complicated system of storing information in form of codes generated by the dApps.
Read More About: What is Decentralized Finance (DeFi)?
After all the above explanation about how does Decentralized Finance works and what is its main difference with the mainstream centralized financial system, we have a clear understanding that DeFi is secure and independent of any third-party intermediary. The crypto assets create on blockchains are without any third-party involvement and have no governing body looking at you to control your transactions or withdrawals.
Decentralized Finance is being considered to be adopted by some mainstream banking companies for its secure and automated style of working. DeFi has made its way through and is here to make a strong impact on our financial mechanism and working process. It gives more independence and transparency than the regular centralized finance system.