Decentralized Finance (DeFi) Best Practices
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What is Decentralized Finance?
Decentralized finance, or DeFi as it is often called, uses cryptocurrency and blockchain technology to run financial transactions.
Currently, the vast majority of financial services are managed by centralized systems which are governed by legacy and strict regulation. DeFi defies our current centralized financial system by removing the power of the middlemen and governing bodies and instead empowering regular people via peer-to-peer exchanges.
Decentralized finance is, at its core, blockchain and cryptocurrency technologies. Blockchain is a decentralized, distributed public ledger in which financial transactions are documented in computer code, rather than in a private ledger owned by financial institutions as it is in conventional checking accounts. Blockchain’s encrypted code recording method means that the users remain anonymous. Users are also provided with a payment verification and a documentation of asset ownership that is impossible to change by fraudulent activity.
Therefore, advocates of DeFi claim that its nature, being a decentralized blockchain, makes the financial transactions more secure and transparent than those in the private systems used in centralized finance.
How does DeFi work and Where is it Employed?
Decentralizing Finance essentially means cutting out the middleman or body in financial services. For example, if you put your savings in an online savings account with your local bank you will earn a 0.5% interest rate on your money. The bank lends the money in your savings account to another customer at 3% interest and keeps the 2.5% profit. Decentralized finance, however, cuts out the 2.5% profit lost because regular people are lending their savings directly to others. If your savings were in a DeFi account, you would earn the full 3% return on your savings.
DeFi is currently being used in a variety of both simple and complex financial transactions. It is powered by decentralized apps called ‘dapps’ or ‘protocols’. Both of these apps complete transactions in the two main cryptocurrencies, Bitcoin and Ethereum.
What are the Risks Associated with DeFi?
As with any new emerging phenomenon, DeFi brings many risks. These include:
• No consumer protections: DeFi was created and continues to exist without rules and regulations. For example, whilst in centralized finance the FDIC will reimburse deposit accounts holders up to $250,000 per account, per institution if a bank fails, no similar protections exist in DeFi.
• Threat of hackers: Whilst blockchains are near impossible to alter, other aspects of DeFi are at risk of being hacked, resulting in your funds being stolen or lost.
• Collateralization: Most DeFi lending transactions require collateral (the asset of value used to secure a loan) equal to at least 100% of the value of the loan. This, therefore, greatly restricts who is eligible for most types of DeFi loans.
• Private key requirements: If you own a DeFi or crypto account, you must secure your wallet with a private key consisting of a long, unique code which only you know. If you lose this key, you will lose access to your funds and there is no way get it back.
For More on Decentralized Finance:
Investopedia Decentralized Finance Definition
For a Beginner’s Guide to Decentralized Finance
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