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A Beginner’s Guide to DeFi and How It Works
Decentralised Finance, otherwise known as DeFi, has seen a hyperbolic growth within the blockchain industry in 2020
Cryptocurrencies are giving us an alternative to using government-backed money. Likewise, DeFi is creating new financial instruments that don’t need centralized institutions. But how does decentralized finance work? Let’s find out right now!
Although compared to the global economy, the whole spectrum of DeFi is still small, yet we are seeing rapid growth in 2020. In January 2019, $278.75M value was locked in the DeFi economy. However, by Jan 2020, that increased to $676.24M. More so, it reached $1B by June 2020 and continued to grow within July, going up to $3.95B. Now, in October, it’s hitting $11.2B, which is a massive amount of value.
This growth is showing how massive DeFi is going to become, and even though it’s still a small sector, many enterprises are highly interested in it. But still, many are not quite familiar with what is DeFi or how decentralized finance works.
How Does DeFi Work?
Before I explain the process of how decentralized finance can work, let’s check out some important features of this technology. In reality, decentralized finance uses public blockchains instead of private or federated ones.
So, more or less, these applications replicate the features or working process of public blockchains.
Basically, in the DeFi blockchain, you will see a ledger system that will keep tabs on all the different types of data exchanges that happen on the network. Actually, these data exchanges are ‘transactions’ in the blockchain network. Once these are verified, they get added to the ledger and called a block.
DeFi applications use a different type of distributed network to make sure that all the transactions within the system are on point and within peers only. Furthermore, once the network verifies a blockchain and adds it up to the ledger, no other peer can change or delete that.
The DeFi Process
DeFi blockchain makes sure that the process is secured by using “keys.” In this technology, when you will use a set of encrypted keys, you will get a unique identification that no one can get access to. Usually, this key pair includes a public and private key.
In reality, this process of using key pairs to encrypt information is called “asymmetric cryptography,” and it’s widely popular in the blockchain space.
Basically, here, other peers can see or use your public key to find you on the system. On the other hand, using your private key, you can authorize your transactions or any type of action. So, you will need a private key to perform certain actions on the DeFi blockchain network.
Although, some decentralized finance applications work differently where you may perform actions with KYC protocols.
As there are cryptocurrencies involved, so your public key will more likely work as your digital wallet. So, using your private key, you can buy, sell, or even send cryptocurrencies. This is why you really need to keep it safe.
So, for sending a transaction, you’ll have to authorize it with your private key. Once you do it, the system will create a block representing the transaction and notify the system for others to verify. After that, when others verify that it’s a valid request, then it will execute your transaction request and add the block to the ledger.
Furthermore, all the block gets a unique id and time frame that prevents any kind of malicious activity.
In DeFi, you will get pseudonymous addresses. So, basically, no one can see your name, but they can see your address, which will contain random numbers and letters.
Are DeFi applications secure enough to use?
Well, DeFi applications aren’t completely secure. In reality, no system can offer you 100% security. However, DeFi ensures that it offers a far more advanced security system compared to traditional monetary systems.
In reality, hacking these applications is highly difficult and quite tricky. As the system is distributed, cyber-criminals have to hack every single device using the application. This takes up a lot of resources and, in the end, not worth the effort.
But there are risks if a DeFi application is rolled out with an underlying bug or loophole. Just for this type of risk, many aren’t sure whether it’s a good idea to use the DeFi instead of CeFi.
Anyhow, just like any technology, DeFi just only started its journey and still has a long road ahead. But if we compare DeFi vs. CeFi, DeFi will surely take the win even with all the flaws.
Five key elements of the DeFi Ecosystem
Basically, at the very core of the specialised decentralised finance ecosystem, you will see five elements:
- Open Ledger Standards
- Smart Contracts
- Marketplaces and Exchanges
- Asset Management and Insurance Platforms
Is DeFi incomplete without Crypto?
It’s quite obvious that without cryptocurrencies decentralized finance ecosystem can’t work. As it’s a new type of monetary system, it needs to have digital assets and cryptocurrencies to fully function. However, even though most decentralized finance examples use some kind of native token or asset, it’s not compulsory for every DeFi app to use it.
In reality, many DeFi applications don’t need cryptos. For example, infrastructure development tools such as Morpheus Labs or Stratis gives you a suite of tools. You can use these tools to develop solutions, but you won’t need cryptos to use the tools, except to pay for its underlying solutions in some cases. The ecosystem is vast, and while the ecosystem is dependent on cryptocurrencies, not all the elements are dependent on them.
More so, the digital asset industry varies greatly based on the type of application it is.
DeFi could serve as a bridge to the real-world
Well, cryptocurrencies have their own issues – they are volatile and unpredictable. So, basing a new monetary system on a volatile asset wouldn’t be a smart call.
Another important thing to note down is the increasing popularity of stablecoins. Stablecoins are also cryptocurrencies, but they are pegged against real-world fiat money. So, they can replace all the volatile nature of the cryptocurrencies.
To make it perfect, another type of financial system is quickly getting into the limelight – Central Bank Digital Currency (CBDC).
Here, the system uses blockchain technology, but it’s not fully decentralized. More so, it also introduces a digital version of the fiat money that we use. So, the control over the digital money will prevail, but it will ensure that the asset will not become volatile.
Therefore, it’s more like a hybrid version of decentralized finance technology. In the future, DeFi can take a turn to become this type of structure if it wants to replace the traditional monetary system. However, if DeFi manages to get rid of its flaws, it may truly retain its decentralized nature.
A game-changer on our existing monetary system
Decentralized finance is truly a unique take on our typical monetary system, and it can surely make a lot of differences. In reality, the ecosystem is vast and still rapidly growing. So, it’s only a matter of time that this technology will become widely accepted around the world over the next decade or so.
Now that you know how decentralized finance can work from this guide, you can now try out these applications yourself. Through our user-friendly interface, we have helped many developers and students from all over the world to learn, develop and deploy their very first decentralised applications right from our Blockchain-Platform-As-A-Service (BPaaS), where numerous enterprises and developers from all over the world has leveraged on the simplicity in the development process found in Morpheus Labs SEED to create useful and relevant DeFi-related applications.
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Meanwhile, stay safe and healthy, we’ll see you in our next chapter!