Our world has seen the evolution of financial transactions over the centuries. It started from the barter system, then came token currencies. After the formation of large kingdoms, copper, silver and gold coins became the medium of exchange. After many centuries the inception of paper currency revolutionised the payment system. With the advent of the internet and banking system payment systems developed further and today it is possible to pay someone remotely with the help of online transactions. But what is next? Well, the answer is Defi or Decentralised Finance. Today in this article we will understand about a payment system that could become the future of financial transactions. To understand Defi, it is important to know about centralised finance.
What is centralised finance?
If you have surplus money and you want to earn interest on that, you can deposit it in the bank in order to earn interest.
On the other hand, if someone wants to borrow the money can go to the bank and mortgage any asset as security. In lieu of security, a person can take a loan from the bank. In this system, the bank earns money by offering and charging different interest rates. In this system, a bank acts as a centralised party and manage the finances. Here bank takes the risk of loan defaulting while guaranteeing the principal and interest amount to depositors.
Although both parties can deal directly but in that case lender will have to bear the risk of loan default. That is why we need a centralised body here.
Moreover, in a centralised finance system flow of currency can be regulated through a central bank. In a nutshell, in centralised finance transactions are monitored and controlled by a centralised body.
What is DeFi or Decentralised Finance?
DeFi is an umbrella term that covers numerous applications and projects in the public blockchain space. In centralized finance, banks are the trusted party, in decentralized finance, banks are replaced by smart contracts. Smart contracts that disparate banks are 100% transparent and follow simple rules that are coded into the smart contract. This code can be verified by anyone before making an investment, whether the smart contract is valid or not.
How does it work?
To understand the working, let’s take an example, You have crypto assets on which you want to earn interest then you can deposit your crypto assets in smart contacts of DeFi and in return earn interest monthly or annually.
On the other hand, there is person X who needs money, Although that person X has some other crypto assets, X does not want to sell those assets. So here X can take some money on loan in exchange for pledging his assets through DeFi smart contract and get his assets redeemed by paying off the loan when the time comes.
So here’s what happened when the smart contract automatically took a deposit of crypto assets by you and gave that deposit on loan to X. In this, system the role of the bank was played by smart contract.
In simple words, DeFi removes the need for any third party to facilitate financial transactions.
What shortcomings do DeFi plug in existing system?
- If you will use any product or service of Centralize Finance, then KYC is mandatory for that but in DeFi you do not need any KYC.
- Centralize finance is bound by country. That is, if you are in India, then you cannot enter the financial system of any other country. Whereas, DeFi knows no political or economic boundaries, it means you can enter Decentralize Finance from any country without any hassle.
- Centralized finance is prone to regulation and puts a lot of autonomy in a single authority. On the other hand DeFi removes this censorship.
- Centralize finance is not transparent here if you make a deposit once you lose all track of your money. You don’t know where your money is being used. But Decentralized Finance is completely transparent where you can keep a complete track that you have deposited the money, where is that money being transferred and where is it being used.
DeFi has immense potential, it is the future of finance where there will be a trustless economy, where you will be responsible for your own money and you will control your own money.