In the first part of this series I explored what DEFI was and why it was important. In this part of the series I will begin to explore (in laymans terms), how DEFI actually works.
Crypto and blockchain technology are very complicated concepts, lets be honest! However, I aim to break down how DEFI works in a simple and easy way to follow. As DEFI is decentralized, it cuts out the middle man (such as banks and exchanges) and thus there is no central governance or corporation charge and making massive profits.
The majority of DEFI projects run through the Ethereum blockchain, and and operate through smart contracts.
Hang on a minute, you lost me - what are smart contracts?
Good question! A smart contract is essentially just a fancy term for a decentralized contract between users on the blockchain. When certain conditions are met, then transactions are approved. As it runs through blockchain technology it is irreversible. As it is an agreement based on pre defined criteria, smart contract can be used for all sorts of things such as insurance, voting, banking and so much more.
Great lets move on!
Right back to DEFI. Ethereum has the capabilities for smart contracts and so many of the DEFI projects are run through the Ethereum blockchain. Probably the most common use of DEFI is that of crypto exchanges and also crypto lending. In the centralized system to lend or borrow money you have to agree to the banks terms (or find a different bank!) and thus there isnt much choice. Using DEFI, you can set your asking rate and terms and then you will be matched up with someone who agrees to your terms - such as fees/interest and repayments. What this means is greater automotive, choice and freedom. It can also lead to much greater gains (but much greater risk!).
Tell me more about the risks!
As DEFI is still relatively new it is unregulated and thus a great place for scammers to hang out. Yes they might offer great returns, but may not pull through with this and can escape with your money fairly easily.
Although it is still early days for DEFI it is a very interesting and important direction that is taking place on the blockchain. Next I will be looking at some of the different DEFI projects, what they do and then finally I will be giving some of these a go and seeing how easy they are to use and sharing my results!