How the DeFi system works

Decentralized Finance, or DeFi, represents a revolution in the financial world, offering an innovative alternative to the traditional financial system. DeFi allows people to access, lend, invest, and even earn interest in cryptocurrencies without the need for traditional intermediaries such as banks. In this article, we will explore how the DeFi system works, its main components, and how people are benefiting from this new form of finance.

What Is DeFi?

DeFi is a term that refers to a set of financial applications and services based on blockchain and cryptocurrencies. These services seek to eliminate traditional intermediaries, such as banks, and offer a more accessible, inclusive, and efficient financial experience. DeFi is primarily built on the Ethereum network, but also on other blockchains.

Key Components of the DeFi System

To understand how the DeFi system works, it is important to know its main components in a simplified way:

Smart Contracts: Smart contracts are self-executing computer programs that define the rules and terms of a financial agreement. They are the backbone of DeFi, allowing transactions to occur automatically when pre-determined conditions are met.

DeFi Protocols: DeFi protocols are a series of interconnected smart contracts that offer financial services such as lending, collateral lending, decentralized exchanges, staking, and even derivatives. Some popular examples include Aave (lending and collateral lending) and Uniswap (decentralized exchanges).

Digital Assets and Stablecoins: To participate in DeFi, users need digital assets such as Ethereum (ETH), Bitcoin (BTC), and stablecoins such as USDC or USDT, which are pegged to fiat currencies such as the US dollar. These assets are used to provide guarantees, and loans, and make trades and investments.

Cryptocurrency Wallets: Cryptocurrency wallets are necessary to store, send and receive digital assets. Wallets can be online (web), desktop, mobile or hardware, and are used to interact with DeFi applications.

How the DeFi System Works

Now, let’s explore how the DeFi system works in practice:

Loans and Collateral Loans: Users can lend their digital assets or obtain loans in DeFi. To obtain a loan, a user must deposit an amount as collateral (collateral) in a DeFi protocol. The amount that can be borrowed depends on the value of the collateral and the interest rates of the protocol. If the conditions are met, the user can receive the loan automatically through a smart contract.

Decentralized Exchanges (DEX): DEXs such as Uniswap and SushiSwap allow users to exchange cryptocurrencies directly with each other without the need for intermediaries. Smart contracts on a DEX act as escrow, ensuring that transactions only occur when all parties have met the terms.

Staking and Yield Farming: Users can lock their assets in DeFi protocols to earn rewards such as interest, tokens, or even more cryptocurrencies. This is known as staking. Yield farming involves actively participating in various DeFi protocols to optimize return on investment.

Derivatives: Some DeFi platforms offer trading in crypto derivatives such as futures and options. These derivatives allow traders to speculate on cryptocurrency price movements.

Advantages of DeFi

Accessibility: DeFi is available globally, without geographic or bureaucratic barriers.

Transparency: The public nature of blockchains makes all DeFi transactions and contracts transparent and verifiable.

Interoperability: DeFi protocols are often interconnected, allowing users to move assets and data between them.

Financial Inclusion: DeFi offers financial services to people who do not have access to the traditional financial system.

Personal Custody: Users have full control over their assets, meaning they don’t need to trust intermediaries.

Challenges and Risks

Security: Smart contracts may contain vulnerabilities, and users must be aware of the risks.

Regulation: DeFi regulation is under development and varies by country.

Volatility: The volatility of digital assets can affect the stability of DeFi.

The DeFi system is transforming the way people access and interact with financial services. Based on blockchains and smart contracts, DeFi offers opportunities for lending, trading, staking, and more, without the need for traditional intermediaries.

However, users should be aware of the risks and challenges associated with DeFi and adopt safety measures when participating in this rapidly growing ecosystem. DeFi promises to continue evolving and play a fundamental role in the finance of the future.

Photo by Ivan Babydov