Decentralized finance, known as DeFi for short, has gotten a lot of attention in recent years as a wide variety of people, from investment pros to ordinary suburbanites, have become dissatisfied with traditional financial institutions. However, many casual observers have questions and concerns about the nature of DeFi. Is it a secure financial system? Is it just a passing fad? How can you get started in the strange new world of decentralized finance? These are all reasonable queries.Decentralized finance is a relatively new monetary ecosystem that essentially cuts out the traditional middlemen involved in financial transactions. DeFi participants can buy, sell, trade, and lend by utilizing automated tools created for this purpose. It does not involve the participation of banks or other financial institutions—i.e., it is a decentralized ecosystem. There’s much more to learn about decentralized finance, so this guide will help you by giving you a more in-depth look at how DeFi technology works and how you can use it.

A Brief Overview of DeFi

Decentralized finance uses distributed-ledger technology to enable peer-to-peer transactions in publicly accessible blockchains. It does not rely on a single centralized authority (e.g., a bank) that holds these funds or actively facilitates transactions; nonetheless, DeFi enables users to engage in many of the financial activities associated with traditional banks: lending, borrowing, and trading assets; purchasing insurance; earning interest; and more. The term "decentralized finance" was coined in 2018. Prior to that, this field was commonly known as "open finance." There is no single entity or person who can be credited with developing this technology. DeFi is set up to be an essentially self-regulating system. Transactions are conducted by individuals who access the blockchain via decentralized applications (dApps).There are various models that can be used to conceptualize DeFi, but perhaps the simplest is to conceive it as a four-layer system: Settlement, Protocol, Application, & Aggregation.

• Settlement (first layer): This is the blockchain that forms the basis of all DeFi transactions. It includes the native token of the blockchain. In the case of Avalanche, this native token is AVAX.
• Protocol (second layer): This consists of the various rules and standards that govern transactions on the blockchain.
• Application (third layer): This consists of the decentralized applications (dApps) that users deploy to interact with the blockchain and carry out various transactions.
• Aggregation (fourth layer): This refers to the third-party platforms that coordinate various applications to provide a better user experience.

DeFi transactions use smart contracts stored on the blockchain to execute the terms agreed upon in advance. A smart contract is designed to manage and transmit funds in accordance with certain predetermined rules. In essence, smart contracts ensure that both parties in the transaction are fulfilling their obligations properly. Often these contracts employ some kind of “if-then” function that releases funds once a specific condition is met.

In every DeFi transaction, the details of the deal are recorded in a block and made subject to a verification process known as a consensus mechanism. Once the transaction has been properly verified, it is added to the blockchain. Consensus mechanisms are confusing to a lot of people, so the topic is worth exploring in more detail, as you’ll be hearing about it frequently as you make your way through the world of DeFi.

Consensus Mechanisms

A consensus mechanism is essentially a way to validate transactions in the absence of the kind of centralized authority that has traditionally been associated with this function. Its purpose is to prevent fraudulent blocks from being added to the blockchain. For instance, without a consensus mechanism, someone could be able to spend the same coin twice, which would compromise the integrity of the cryptocurrency.This is an extremely important function, as blockchains are intended to be immutable—once information has been included in the blockchain, it becomes a permanent part of the data record. If you download a copy of a blockchain, it should be identical to every other copy in existence. Any attempt to alter a block will alter the hash of all preceding blocks, thereby making fraud extraordinarily difficult.There are literally dozens of consensus mechanisms, but the two most common—and the ones you’ll be hearing the most about—are proof-of-work (PoW) and proof-of-stake (PoS).

• Proof-of-work (PoW) - When the PoW consensus mechanism is in place, users compete with one another to solve a complicated math problem with the goal of winning the right to process a specific block. The winning user receives a reward in the form of cryptocurrency. This process relies on the computational power of each user, and it is a very energy-intensive procedure—which is one of the criticisms often levied against it.
• Proof-of-stake (PoS) - With the PoS consensus mechanism, the validator is chosen via computer algorithm. Users with larger "stakes" (cryptocurrency holdings) are more likely to be selected. PoS is increasingly popular due to its relatively small energy demands compared with PoW. Avalanche uses the proof-of-stake consensus mechanism.

Both consensus mechanisms are designed to defend against so-called "51% attacks," where a threat actor can hack the system by accumulating more than half of the computing power of the cryptocurrency (proof-of-work) or more than half of the cryptocurrency itself (proof-of-stake). These attacks are extremely difficult to pull off due to the need to command an enormous amount of resources. For that reason, it's the smaller cryptocurrencies, whose resources can more easily be monopolized, that are most vulnerable to 51% attacks.

Common DeFi Transactions

So what kinds of transactions can be carried out with decentralized applications? Plenty, as it turns out. DeFi transactions include but are not limited to the following:

• Lending crypto - It's possible to lend your cryptocurrency on highly favorable terms.
• Tickets to live events - Blockchain technology holds enormous potential to remake the tangled process of buying and selling tickets to music concerts, theatrical performances, and other live events. NFT tickets are already widely available—but some observers believe that NFT technology may even be able to curtail scalping. With smart contracts, it’s possible to place limits on the resale value of a ticket, effectively placing limits on the greed of scalpers as well.
• Borrowing funds - With DeFi, you can borrow money from a single lender on a peer-to-peer basis or from a pool of lenders.

• Raising funds - If you have an idea for a project, DeFi can be used for crowdfunding. The transparent nature of decentralized finance—everyone can see how much money has been raised—helps promote confidence in the platform.
• Saving funds - You can even use DeFi as a type of savings account, often with rates significantly higher than you would qualify for at a bank.
• Trading crypto - Peer-to-peer trading makes it easy to exchange assets, without the need for a middleman.
• Purchasing derivatives - It’s also possible to make long and short bets on various assets, much as you would in the traditional stock market.
• Buying insurance - DeFi can make the process of obtaining insurance, and getting payouts when needed, much quicker. It’s also cheaper due to automation eliminating certain tasks that normally require human intervention.

Decentralized finance is still a fairly new field, whose full potential has yet to be realized. It’s likely that the near future will bring further innovations and developments in DeFi.

Decentralized Finance and Traditional Finance: A Comparison

It’s reasonable to ask why one should bother getting involved with DeFi in the first place, given that traditional financial institutions continue to provide a variety of time-tested services to millions of customers. But DeFi isn’t just another way of doing business; it provides benefits that old-fashioned financial institutions cannot match.

When you keep your money in a bank, you're enabling a specific third-party institution to take over the responsibilities involved with monitoring and validating transactions. Many of these functions are carried out according to a schedule set by the bank. For instance, anyone who routinely cashes checks at an ATM is familiar with those notices posted on the machine reminding users that their deposits must be made by 6 or 8 p.m. to be counted as a transaction for that day. 

There is also a dizzying variety of transaction fees associated with using traditional banking services: overdraft fees, account maintenance fees, excessive activity fees, minimum balance fees, out-of-network fees, and more. Most bank customers have had the experience of incurring one or more of these fees purely by accident.

Furthermore, certain bank services are restricted to customers who can comply with specific criteria. If you have a poor credit history, it’s unlikely that you will be able to obtain a loan. Even if you can, you may be forced to accept huge interest rates. 

Another drawback is data privacy, or the potential lack of it. Financial institutions, and the various applications used to support them, are frequently targeted by cybercriminals. This can result not only in the loss of your funds but the exposure of your private information (e.g., Social Security number, etc.).

When you use decentralized finance, however, most or all of the above-mentioned issues don’t really come into play. DeFi, like cyberspace in general, operates on a 24/7 basis. There are no daily deadlines to perform certain routine transactions. There are no geographic restrictions. Nor is there a middleman that needs to take a “service fee” of one type or another; smart contracts make these third parties unnecessary. 

DeFi also doesn’t require any kind of application process—you simply access a decentralized application of your preference and then dive right in. Even loans can be obtained anonymously. This provides ample opportunities for individuals who, due to bad credit or other factors impacting their financial stability, may be stonewalled by conventional institutions. 

The speed and flexibility of DeFi is proving to be increasingly difficult to ignore, especially among individuals who would prefer to bypass the roadblocks associated with the old-school financial sector.

Avalanche users include a variety of top companies, such as Polyient Games, Spore Finance, Topps, Gameswap, and Crypto Seals.

Pros and Cons of DeFi

Although DeFi holds enormous potential to revolutionize the financial world, it needs to be understood that this field is still in its infancy. There are risks and shortcomings that must be contended with. Before you jump feet-first into the DeFi ecosystem, you should be aware of what this technology can, and can’t, do for you.

Pros:

• No entry barrier - There’s no formal application process with DeFi—it’s open to anyone with an internet connection. People who might be shut out of the traditional banking world or find themselves unable to access certain services will face no such restrictions in the world of decentralized finance.
• Accessibility - In the DeFi world, transactions occur around the clock and on every day of the year. You’ll never have to put a transaction on hold due to a bank holiday.
• Anonymity - You don’t need to reveal your real name or any other personally identifiable information.
• Immutability - The inability to alter past blocks in a chain gives the system an extremely high degree of credibility.
• Flexibility - It’s easy to withdraw your funds when you need them—any time of the day or night. There is no approval process.
• Speed - Smart contracts allow blockchain transactions to reach fulfillment very quickly.
• Lack of middleman fees - With DeFi, you don’t need to worry about the wide array of fees and expenses linked to conventional banking. (There may be fees associated with certain DeFi transactions, however.)
• Better interest rates - In many cases, DeFi loans have more favorable interest rates than those offered by brick-and-mortar financial institutions. Interest rewards tend to accumulate quicker than with conventional loans.
• Easier access to loans - Many people who could not qualify for a standard bank loan can get one in the DeFi world.
• Transparency - Blockchain transactions are public record, which helps to foster trust in the system and pinpoint areas in need of improvement. By contrast, the workings of the banking system are largely hidden from public view.

Cons:

• Possibility of bugs - Smart contacts may contain errors that could result in the irretrievable loss of user funds. This is why proper auditing of smart contracts is so important.
• Investment risks - "Rug pulls"—where owners of a DeFi or cryptocurrency project simply run away with investors' money—continue to be a serious problem.
• Volatility - Blockchain coins can experience wild swings in value. Sometimes, a blockchain collapses altogether, taking all its accumulated wealth with it.
• Lack of centralized authority - Although this is a plus for many users, it also means that there is no regulatory body that can ameliorate fraud.
• Responsibility for account - If you lose your private keys, you’ll also lose access to your cryptocurrency, as there’s no way to prove your identity—one of the drawbacks of anonymous access. Similarly, failing to secure your crypto wallet leaves you vulnerable to hackers.

Getting Started with DeFi

In order to collect and trade cryptocurrency such as AVAX, you need a DeFi wallet. Like a real-world wallet, this is a place where you store your currency. One of the more popular DeFi wallets is MetaMask. You can also use the Avalanche Wallet. 

A wallet will enable you to interact with Avalanche's C-Chain (Contract Chain), which is essentially a blockchain dedicated to smart contracts. From there you can acquire AVAX and begin trading. 

There’s quite a bit that you can do with your AVAX, more than could be covered in a brief article such as this. The Avalanche community holds a wealth of knowledge that can help you on your journey. 

The world of decentralized finance continues to evolve rapidly—and Avalanche is at the forefront of this ongoing revolution. Avalanche provides the fastest smart contracts platform currently available in the blockchain industry. Supported by a thriving development community, it's also the ideal environment for a wide array of expertly designed decentralized applications. Feel free to explore our website for more information on decentralized finance trends and innovations.