With the development of blockchain technology, decentralized finance (DeFi) has gradually become one of the major trends in fintech. While many traditional financial institutions are exploring how to leverage this technology to enhance their business efficiency, for most ordinary investors, DeFi remains a relatively unfamiliar concept. This article will provide an in-depth introduction to the fundamentals of DeFi, helping readers understand how DeFi works and its potential applications.

The Fundamentals of DeFi

When we talk about DeFi (Decentralized Finance), the core concept is the removal of the "middlemen" in traditional financial systems. A simple analogy can explain this: if you want to borrow money to buy a house in the traditional financial system, you would go through a bank or a financial institution. These intermediaries would assess your credit, set the loan terms, and charge fees to cover their risk. In the world of DeFi, these middlemen are replaced by smart contracts, which are computer-coded agreements that run automatically on the blockchain. These smart contracts execute without the need for banks or other financial institutions.

The Relationship Between Decentralization and Blockchain

Traditional financial systems are like large marketplaces, where most financial products and services are centralized under a few major companies, such as banks and securities firms. DeFi, on the other hand, is more like a free market, where each stall (i.e., decentralized applications, or DApps) operates independently, and you can trade directly with stall owners without going through market managers. These transactions are recorded on a blockchain, a public, decentralized ledger that anyone can view and verify.

How Smart Contracts Work

Smart contracts function like vending machines. When you insert a coin, the machine automatically dispenses the product you selected. Similarly, a smart contract executes transactions or other financial activities based on pre-set terms. This means that all participants agree to the terms in advance, and the smart contract operates according to those terms without needing third-party intervention.

For example, in traditional finance, an international transfer would require going through a bank, a process that could take several days. In DeFi, transfers can be completed within minutes using smart contracts, with greater transparency and lower costs.

The Advantages of Removing Intermediaries

In traditional finance, intermediaries like banks and payment processors act as "trusted agents" to ensure that both parties in a transaction fulfill their obligations. However, these intermediaries charge fees and can impose restrictions on how you use your funds. In DeFi, these "trusted agents" are replaced by technology—smart contracts become the new "trusted agents." As long as the pre-set conditions are met, the contract automatically executes without third-party interference.

You can think of it as breaking the "monopoly" of banks, where individuals can engage in financial activities directly without relying on large financial institutions. For example, lending or investing can be done directly on DeFi platforms, where you can lend assets to others and earn interest without needing a bank to arrange the process.

DeFi vs. Traditional Finance

Another key difference between DeFi and traditional finance is transparency. In the traditional financial system, it is impossible to know the internal workings of a bank, but in DeFi, all transactions and terms are recorded on the blockchain for public viewing. This transparency significantly increases users' trust, as everything is visible and cannot be arbitrarily changed or hidden.

In summary, DeFi removes the intermediary role from the traditional financial system, making financial transactions more free, autonomous, and transparent. This concept is a major shift for those familiar with traditional finance but new to blockchain. With this new financial model, users can manage their assets more efficiently and participate in various financial activities at a lower cost.

Common Applications of DeFi

• Decentralized Exchanges (DEXs): Unlike traditional exchanges, DEXs allow users to trade peer-to-peer directly on the blockchain, without going through a third party. This makes trading faster and more transparent, reducing the risks of fund misappropriation or hacking on centralized platforms.
• Decentralized Lending: In the DeFi world, users can borrow and lend directly without going through banks. Smart contracts automatically manage assets, and borrowers provide cryptocurrency as collateral to receive loans in stablecoins or other digital assets. Without intermediaries, the process is more efficient, and interest rates are often more attractive than those offered by traditional financial institutions.
• Decentralized Stablecoins: Stablecoins play a crucial role in DeFi by providing price stability in a decentralized financial ecosystem. Common decentralized stablecoins like DAI are issued based on collateral, with their value typically pegged to fiat currencies to avoid the volatility of the cryptocurrency market.

The Advantages and Risks of DeFi

DeFi offers several key advantages:

• Lower fees: With no intermediaries involved, transaction fees are reduced.
• Global financial services: Anyone with internet access can participate, without needing a bank account or credit score.
• Transparency and openness: All transactions are recorded on the blockchain, providing transparency and accessibility for all.

However, DeFi also comes with risks:

• Technical risks: Once deployed, smart contracts on the blockchain cannot be easily modified or fixed. If there are vulnerabilities in the contract, funds could be at risk.
• Market volatility: The cryptocurrency market is highly volatile, and the value of collateral can quickly decrease, leading to the liquidation of borrowers' assets.
• Regulatory uncertainty: Due to its decentralized nature, many countries have not yet established clear regulations for DeFi, which may pose challenges for protecting users' rights.

Conclusion

As one of the core applications of blockchain technology, DeFi not only redefines how financial markets operate but also sparks widespread innovation. It decentralizes the power of traditional finance, allowing more people to participate directly in lending, payments, investments, and other financial activities. For those unfamiliar with this emerging space, it presents a realm of potential, offering a decentralized, transparent, and trustless financial experience.

While DeFi is still in a rapid growth phase, and risks and uncertainties are inevitable, its applications will become more widespread as technology advances and regulatory frameworks are developed. DeFi may well become a crucial pillar of the global financial system, making it a transformative trend worth watching closely.