Lending, borrowing, selling, and buying have gone on for centuries. These are important aspects of finance, which are for the most part managed by centralized systems, long-established and governed by authorized banks and financial bodies. Traditionally, if a consumer wanted to take a car loan or mortgage on a new home or buy stocks or invest in funds or avail any kind of financial service, they would need to go through some form of middleman, namely the governing financial bodies like banks, exchanges etc.
In case of lending, banks and exchanges earn some percentage of the profit resulting from these transactions. Typically, to ensure security, they apply gatekeeping measures (KYC checks) for those requiring these financial services. As a result, the process becomes lengthy with many people involved and can create friction points in the formal credit system. Decentralized finance (DeFi), on the other hand, is aiming to cut out the middleman, and making lending and other financial transactions possible and more convenient between peers directly. At present, DeFi services can be enabled for a number of crucial areas of finance from lending to borrowing, funding, trading, derivatives, and insurance.
Decoding DeFi
The central idea behind DeFi is to facilitate the management of money through P2P transactions between individuals, merchants, and businesses without interventions by large financial institutions or corporations. It’s based on open-source technology without a controlling authority to deny access to any financial product/services sought by users. It also facilitates market exchanges round the clock.
DeFi is based on Blockchain technology, which enables financial applications and protocols with programmable functionality. Transactions on the blockchain are carried out automatically by smart contracts. Smart contracts include terms of agreement and the deal struck between concerned parties. These contracts set up a rules-based ecosystem where financial transactions such as lending, and investing can take place without needing third parties like banks and brokerage houses.
The transactions happen automatically when the conditions of the smart contract are met, as opposed to traditional finance where many people and systems can be involved in processing, verification, and logging of transactions. Transaction records are maintained on the immutable ledger and independently verified by thousands of computers around the globe.
From a consumer perspective, with just an internet connection, individuals can conduct financial transactions with peers. They have software to note every financial transaction and get it validated in distributed financial databases, which are accessible in various locations. These databases typically gather data from all users and rely on a consensus mechanism for verification. As a result, more of the work historically handled by banks and other financial institutions can now be performed between peers, directly. Here the concerned parties agree to provide cryptocurrency in exchange for goods/services without needing an intermediary or overseer.
If you would like to read more about decentralized finance and how it is changing the global lending landscape, click here.
