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What Does Decentralized Finance Mean?
Decentralized Finance (DeFi) is a blockchain-based financial system. Instead of relying on banks or brokers to validate financial transactions, DeFi services use smart contracts.
Smart contracts are self-executing programs that enforce the terms of a financial agreement between two parties. The automated technology not only eliminates the need for intermediaries, it also reduces the costs associated with traditional financial transactions.
In a DeFi ecosystem, users have full control over their funds without having to use a bank that charges fees for financial transactions or a brokerage that might impose restrictions on trading. Instead, users make transactions directly without any third-party involvement.
DeFi applications offer a wide range of financial services including lending, borrowing, trading and insurance. These services are more inclusive and accessible to the unbanked and underbanked segments of a population because they are accessible to anyone with an internet connection and a compatible digital wallet.
Techopedia Explains Decentralized Finance
DeFi’s importance lies in its decentralization and its community monitoring. The concept of a decentralized financial system is relatively new. MakerDAO is credited as the first DeFi platform to receive sufficient use and credibility. The platform was launched in 2014 as a concept. It allowed users to buy, exchange and borrow a cryptocurrency known as Dai, which wasn’t released until late 2017. Dai is a stablecoin that is tied to the US dollar and traded through the Ethereum blockchain.
The Components of a DeFi System
Every DeFi platform requires two core elements: an infrastructure to function on and a currency to function with.
- DeFi Infrastructure: An infrastructure for DeFi needs to be a blockchain network that supports smart contracts. Developers can write decentralized programs on platforms like Ethereum or Polkadot and allow traders to create contracts to manage their finances and transactions. Projects that combine the decentralization power of DeFi with blockchain technologies include Solana, Terra Luna and Avalanche.
- DeFi Currency: The DeFi currency needs to be compatible with the infrastructure and smart contracts system. (For example, Bitcoin isn’t compatible with an Ethereum infrastructure.) To ensure stability, DeFi contrats can use stablecoins, which are cryptocurrencies pegged to a fiat currency or traded commodity such as Tether, Paxos Standard, Dai and Binance USD.
The Current and Future Applications of DeFi
DeFi is still in its infancy and experts agree the technology has yet to reach its full potential.
Artificial intelligence (AI) and machine learning (ML) are expected to play a significant role in the evolution of DeFi. In addition to helping make the technology more efficient, secure and accessible to a wider range of users, AI is expected to help with:
Risk Management: Machine learning can be used to identify patterns that indicate potential risks to a DeFi ecosystem. This knowledge can be used to protect investors and prevent security exploits and fraudulent activities such as money laundering.
Smart Contract Optimization: AI algorithms can be used to analyze and optimize smart contract code, automate testing and optimize the design and structure of smart contracts to reduce complexity and improve functionality.
Predictive Analytics: ML algorithms can be used to analyze current market trends, predict future market movements and help investors make informed decisions when buying or selling digital assets.
Fraud Detection: AI and ML can be used to detect fraudulent activities in the DeFi ecosystem such as fake asset listings, money laundering and pump-and-dump schemes.
