Blockchain technology provides the foundation for cryptocurrency and decentralized applications. Together, these tools have created a fast-growing DeFi sector. DeFi, short for decentralized finance, replicates or improves on centralized financial activities like lending and investing while operating outside of traditional financial systems.
As the DeFi industry grows, it could open up new avenues for businesses to save and invest. However, like any new technology, the various DeFi projects which will be met with different degrees of success. For business leaders to choose which of these projects will add the most value to their business, they first need to understand how DeFi was developed and how it relates to the blockchain.
What is a blockchain and how does it work?
Currently, most data records are centralized, meaning that they are maintained, verified, and accessed by a particular person or company. There are several risks involved in this type of data management. The risks can include: the risk of human error in data input, the risk that the central authority will manipulate data, and the risk of data loss when centralized servers are used or compromised. Blockchain technology offers an attractive alternative which minimizes or virtually eliminates these risks.
Blockchain Data is Stored in ‘Blocks’
With blockchain, data is organized into blocks which hold a limited amount of information. Typically, this data contains ownership and transaction records. Before data can be added to the blockchain, it must be verified by a majority of computers on the blockchain’s peer-to-peer network. This greatly reduces the prevalence of human error.
Once a block of data is verified, it is encrypted and distributed across the network. Because blockchain data is stored on a peer-to-peer network, rather than physical servers, it cannot be easily damaged or destroyed.
Verified Blocks Cannot Be Altered
After blocks of data are verified and added to the blockchain, they cannot be readily altered. This makes it extremely difficult for anyone to falsify or change records. For proponents of blockchain, the fact that data cannot be manipulated by a central authority makes data on a blockchain more trustworthy.
By automating data input, verification, and storage, blockchain technology can reduce the cost of traditional financial products. This innovative technology enables lower overhead costs, and reduced labor costs, and lower user fees.
Currently, the global blockchain economy is estimated to be worth $1.8 trillion. This includes hundreds of platforms which support thousands of cryptocurrencies and tens of thousands of decentralized applications. With that in mind, it is likely that DeFi and the blockchain economy has not reached its peak yet. Some experts predict that the DeFi sector could grow as much as tenfold in the next year.
How Does Blockchain Technology Enable DeFi?
DeFi would not be possible without decentralized currency, better known as cryptocurrency. In 2009, the first major cryptocurrency, Bitcoin, was developed. Bitcoin uses blockchain technology to power the currency’s immutable ledger – resulting in a currency that isn’t controlled by any single entity. With Bitcoin, ownership records are stored on the blockchain and are immutable. Despite the popularity of Bitcoin, its functions are somewhat limited.
In 2015, another major cryptocurrency and platform, Ethereum, was launched. Ethereum’s language, Solidity, allows for more varied product uses than Bitcoin. Soon after its creation, developers flocked to Ethereum to create smart contracts and Decentralized Applications [dApps], which facilitate DeFi transactions. Since that time, other platforms have emerged which allow greater flexibility in code to facilitate even more DeFi options.
What are dApps and Smart Contracts?
As a whole, applications are pieces of code that allow a user to take some form of action. Centralized apps, like the ones most utilized today, allow users to interact with the company that created the app. On the other hand, dApps, interact with the blockchain rather than a single institution. These dApps allow users to engage in many types of functions, like buying, selling, lending, and borrowing, with their cryptocurrency.
The actions facilitated by dApps are made possible by smart contract technology. Essentially, smart contracts are “if, then” code. If the conditions of the code are met, then the designated action takes place – like distributing currency. The conditions built into the code can be as simple as facilitating a trade when a price hits a certain benchmark or can include many steps and conditions.
Benefits of dApps
The benefits that blockchain technology add to data management are expanded with dApps. Once dApps are created, their code cannot be changed. Additionally, the code behind decentralized applications is open for all users to view. This is a deviation from traditional, centralized apps, whose code is private to the company who created the app.
The open nature of dApp code and transaction history has allowed these applications to grow at an unprecedented rate. Coders have been able to write code and employ it on the blockchain quickly and easily.
The dApps that facilitate DeFi transactions are quickly evolving. To learn more about how DeFi is being used, and how it is impacting the banking industry, read our article What is DeFi and How Are Banks Responding?
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