What is Decentralized Finance and How Does it Work?

Picture : Pluang

Techspace - Cryptocurrency promises someone to make money and payments that are universally accessible to anyone and anywhere. Decentralized Finance (DeFi) is an ecosystem of financial applications that use a blockchain base and can operate without any central authority, such as banks or other financial institutions. A smart contract is a program that runs on the blockchain that can be executed automatically when certain conditions are met. These smart contracts allow developers to build much more advanced functionality than just sending and receiving cryptocurrencies. These programs we now call decentralized applications or dApps.

You can think of dApps as applications built on technology with a decentralized system rather than centrally being created and controlled by a single entity or company. At the same time, some of these concepts may sound futuristic, such as auto loans that can be negotiated directly between two strangers in different parts of the world without a bank as a mediator. This proves that many dApps have been used to this day. 

Then, what is Decentralized Finance?

Decentralized finance (DeFi) is a term for financial products and services accessible to anyone who can use Ethereum. With DeFi, the market is always open, and no centralized authority can block payments or deny you access to anything because the system works on a peer-to-peer network. The previously slow and risky service with DeFi will be more secure because it is handled by code that anyone can check and scrutinize. In addition, DeFi also ensures that all logs can be stored and shared across various nodes across the network.

What is the background for the formation Decentralized Finance?

The need for DeFi stems from financial services not being available to everyone worldwide. Nearly 1.7 billion people worldwide lack the means and access to financial services. Financial institutions can also not provide the necessary infrastructure to allow more people to access these services. The existing infrastructure is enormous but lacking in reaching everyone out there.

There is an over-reliance on centralized authority for the current financial infrastructure to function. Without governance, rules, regulations, and outreach, it is impossible to implement in some areas, especially where the creation and distribution of finance are severely lacking or inadequate. In addition, a centralized authority holds power to delete accounts or block them if deemed inappropriate. Sensors may be necessary in some instances, but in most cases, they will be limiting and difficult for the user.

Picture : financialku

As discussed earlier, another critical element of DeFi is decentralized applications (dApps). DApps allow a financial institution to create functional applications on a public blockchain and ensure that anyone can interact with it at a per-interaction fee.

How does Decentralized Finance work?

The DeFi blockchain ensures the process is secured using a “key.” In this technology, when you use a set of encrypted keys, you will get a unique identification that no one can access. Typically, this essential pair includes the public and private keys.

The process of using key pairs to encrypt this information is called “asymmetric cryptography,” and it is trendy in the blockchain space. Although, some decentralized finance apps work differently where you can perform actions with the KYC protocol. Since cryptocurrency is involved, your public key will most likely serve as a digital wallet. So, using the private key, you can buy, sell or even send cryptocurrencies. This is why you have to keep it safe.

So, to send a transaction, you have to authorize it with your private key. Once you do that, the system will create a block representing the transaction and notify the system for others to verify. After that, when someone else confirms that it is a valid request, your transaction request will be executed, and the block added to the ledger. Furthermore, all blocks get a unique id and time frame which prevents any malicious activity. In DeFi, you will get a pseudo-anonymous address. So, no one can see your name, but they can see your address, which will contain random numbers and letters.

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