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Understanding Decentralized Finance

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Today, almost all aspects of banking, lending, and commerce are managed by centralized systems run by boards and gatekeepers. Ordinary consumers have to deal with a range of financial intermediaries to access everything from auto loans and mortgages to trading in stocks and bonds.

The current financial landscape

The financial landscape today is highly centralized. Consumers have few direct access points to capital and financial services. You cannot avoid middlemen such as banks, stock exchanges, and lenders who profit from every financial and banking transaction. To play, we must all pay.

The new way: decentralized finance

The DeFi (decentralized finance) scene is currently one of the most exciting movements in the blockchain world. It aims to dismantle the existing financial architecture and fight its way out of the niche. DeFi challenges this centralized financial system by disempowering middlemen and gatekeepers and encouraging people to engage in peer-to-peer exchanges.

Traditional finance is unbundled in decentralized finance. It puts key elements of the work done by banks, exchanges, and insurers today — such as lending, borrowing, and trading — in the hands of ordinary people. Today, you could deposit your savings into an online savings account and earn 0.50% interest on your money. The bank then lends the money to a different customer at 3% interest, keeping the 2.5% profit. DeFi allows people to lend their savings directly to others, thereby eliminating the 2.5% profit loss and earning the full 3% interest rate.

You may be thinking, “Hey, that’s what I do when I send money to my friends with PayPal,” but you don’t. You still need a debit card or bank account linked to these apps to send money. Such peer-to-peer payments are still dependent on central financial intermediaries.

DeFi runs on the blockchain

The core technologies that enable decentralized finance are blockchain and cryptocurrencies. When you use your traditional checking account, the transaction is recorded in a private ledger. The cash book, which is owned and managed by a large financial institution, is a record of your banking transactions. Blockchain is a public, decentralized ledger that records financial transactions in computer code.

The term “distributed blockchain” refers to the fact that all parties using a DeFi application have an identical copy of the public ledger. Every transaction is recorded in encrypted code in this. This secures the system by providing users with anonymity, payment verification, and a record of asset ownership.  Thus, it is almost impossible to perform a fraudulent activity. When we say blockchain is decentralized, it means there is no middleman or gatekeeper managing the system. Transactions are verified and recorded by parties sharing the same blockchain by solving complex math problems and adding new transaction blocks to the chain. The decentralized blockchain makes financial transactions more secure and transparent than the private systems used in centralized finance.

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