For the longest period of time, financial transactions and systems were controlled by centralized entities such as banks and governments. These entities still control most of the world’s financial systems. This is called a centralized financial system. Such a system has both its pros and cons. To deal with the cons of centralized finance, a new concept, called decentralized finance, was introduced.
Decentralized finance (DeFi) is the exact opposite of centralized finance. While in a centralized system, a central entity like a bank, a company or a government has complete control over financial products & transactions, a decentralized system gives this control to the users.
For example, our bank has complete control over our funds. They can accept or deny a transaction. Each payment is verified and approved by them. Moreover, they have access to the crucial user information that they can use as they find appropriate as well as share it with others. DeFi, or Decentralized Finance, works completely differently. It provides financial products & services on a public network such that they can be used by anyone without having to reveal their identity or personal information and without seeking the approval of any intermediaries like a bank. Users can use the DeFi network to send/receive money, make payments and transfer digital information with anyone in the world.
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Blockchain is one of the most popular and well-known examples of DeFi. It’s the technology that allows peer-to-peer trading of financial services over a public, decentralized network that is managed by its users. Smart Contracts in blockchain are used to automatically execute trades between buyers and sellers based on the underlying terms of an agreement.
Why Decentralized Finance Is Important
- One of the major goals of DeFi is to remove intermediaries in financial transactions and to provide a way to perform peer to peer financial trades between users.
- DeFi makes it possible to perform global financial transactions at a really low cost and without middlemen.
- It can be used for building applications (DApps) for transactions ranging from investments, trading, exchange, savings, security, identity verification, and more.
- As an open-source technology, it is publicly accessible and can be used by anyone to create futuristic digital applications.
- It is secure, transparent and low cost.
While local transactions are flexible and near-instant, thanks to the integration of technology in financial services, the real problem comes in making global payments and other financial transactions, which are still very expensive and take considerable time to process. Then, there is the whole legal process you have to go through to validate your transaction with a bank or the government. DeFi removes the complication from financial transactions by providing a peer-to-peer, transparent and very secure means for financial services.
Let’s understand this with the example of the Libra Ecosystem, which is a blockchain-based ecosystem for e-commerce.
Besides providing e-commerce operators and vendors with a way to enable highly secure and low-cost cross-border payments using the native cryptocurrency Libra Coin, the ecosystem offers a range of other products and solutions for complete e-commerce and investment management. Also, it will allow developers and third parties to build their own e-commerce decentralized applications on Libra’s public blockchain. As a fully-fledged cryptocurrency, the Libra Coin can be used for digital payments and a range of other financial transactions. Also, the Libra-based payment system can be readily integrated into any existing e-commerce system to accept secure & low-fee cross-border payments.
In a centralized financial system, the use of technology is often limited to facilitating financial services with convenience. Such systems lack transparency and are prone to errors, hacking and crashes, which can cause loss of valuable financial/personal data. Decentralized Financial systems are not only more secure, but also by removing the notion of centralized financial management, they help mitigate the risk of financial or data losses due to unforeseen circumstances.
Many financial institutions and banks are already experimenting with the inclusion of DeFi into their systems to make them more productive, secure and cost-effective for end-users. There is a good probability that DeFi could replace the current centralized financial model in the years to come.