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.

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).

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:

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.



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.