What is DeFi?
DeFi stands for Decentralized finance and its relatively new trend in crypto industry with the rapid growth in the last three years.
Origin of the term is unknown; some tie it to the appearance of the Bitcoin in 2008, another to the group of developers on Telegram trying to find a name for the new mechanism emerging on the blockchain. Either way, DeFi became an indivisible part of crypto and blockchain. What does it actually mean and why is it gaining in popularity? Answer lies in the way we manage our finances or how intermediaries do it for us.
Current financial system is centralized, meaning banks and corporations are holding and managing your money for you. To do that, the whole system revolves around the existence of third parties whose job is to facilitate money transactions. In plain words, this means that for every transaction you do, there is a third party involved doing check ups, making sure everything is according to regulations of the country, and taking commission fees for that.
Centralized finance relies on human factor and the country’s regulatory body to make sure transactions are safe and no law is broken in the process. Mechanism of today’s financial system is built in the way that you need to meet certain criteria to even open a bank account, take out a loan or enter the stock market. Not only the origin of your money, but all your personal data, will undergo thorough investigation to prove your identity. All that is necessary for you to open a bank account, access and use your money or take out a loan/mortgage but the bank, or regulatory body, still has the authority to freeze your assets or deny you access if they find something incriminating during their investigation.
Decentralized finance (DeFi) is the new financial system emerging on the blockchain. Blockchain’s decentralization is enabling DeFi’s democratization of the finance world – removing the need for intermediaries when managing one’s own money.
Traditional financial institutions play the role of guarantors of transactions, because of it they hold immense power and control over the money of their clients. DeFi’s removal of the control traditional institutions have is making people owners of their assets – you act as your own bank.
How does it work?
Technology behind DeFi is still fairly new and removal of traditional financial institutions guaranteeing safety of your money may not be attractive for people. The way DeFi solved that problem lies in the technology it’s based on – blockchain.
Blockchain’s main feature is decentralization and the cryptography behind it (codes and protocols) ensuring safety and transparency of the data shared across it. It can be explained as a secured database or ledger without the need for the human factor.
Security traditional institutions offer is solved with smart contracts – digital protocols that use mathematical algorithms for automatic transaction execution.
Instead of intermediaries, smart contracts will enforce terms set by involving sides through the code, allowing automation and safe and trustworthy transactions. Transactions have to be verified by the users of blockchain and when consensus is reached – data regarding the transaction is stored inside the block and encrypted, containing information from the previous block and chained to the next one without the possibility of changing any of the blocks.
This is, not only eliminating security risks, but also eliminating commission fees you would have to pay for the services of the financial institution and there would be no need for your physical presence for any of this. All you need is an internet connection to start managing your money.
Transparency is one of those words that pops up every time blockchain is mentioned. When it comes to DeFi, transparency is one of its main selling points, that doesn’t mean that your personal data is out in the open for everyone to see. Data and information regarding your transaction is stored across the blockchain and is transparent, but the transaction itself is pseudonymous by default – there is no personal information regarding your name, account and address.
DeFi dApps (applications built on blockchain) are designed to use cryptocurrency and everything you need is one of the many cryptocurrencies (bitcoin, ethereum, terra etc) to start making income, taking out loans or mortgages and even entering the stock market.
Technology behind crypto is still new and developing, making crypto prone to volatility and this is how stablecoins came to existence.
Stablecoins (DAI, USDC, Terra etc.) refers to cryptocurrency designed to preserve stable market price. To achieve this, stablecoins are pegged to the value of another asset, usually US dollar, but it can be anything like commodities (gold, silver) or other cryptocurrency.
Protocols DeFi relies on are advanced autonomous programs ensuring execution and governance of the task they are programmed for.
Some of the most popular DeFi protocols are:
MakerDAO: Landing protocol, where you can get a loan in DAI stablecoins by providing collateral in other cryptocurrencies. Such loans are mainly used by margin traders in order not to borrow funds from centralized crypto exchange. Beside landing, MakerDAO is developing technology to facilitate savings and borrowings.
Aave: lend and borrow protocol that allows users to lend and borrow crypto without (de)centralized intermediaries.
Compound: loan protocol managed by the holders of COMP tokens through decentralized voting. It can be seen as a digital marketplace for digital assets.
Uniswap: the most famous decentralized protocol for crypto exchange.
Curve Finance: decentralized protocol for stablecoins trade.
The vast majority of dApps and protocols behind them are developed on Ethereum blockchain due to its ability to not only trade crypto, but allowing users to experiment and create dApps that can do much more due to its permissionless nature allowing for decentralization.
Pros and cons of DeFi:
Decentralized finance promises a new financial ecosystem accessible for everyone, removing mechanisms of the traditional financial system – intermediaries and centralized authorities controlling and managing finance. In other words, DeFi is promising to give people power and control over their finances without third party involvement.
Blockchain technology is opening many possibilities for DeFi and the way it can reshape the world of finance, especially creation of possibilities for communities being denied access to traditional financial institutions – banks mostly.
- Permissionless and inclusiveness – everyone can access it and start managing their finances without waiting for the approval from the traditional financial system mechanisms.
- Instant transactions – transactions are done in real time, making them not only faster but cheaper.
- Safe and transparent – with the smart contracts and blockchain’s decentralization all transactions are safe and transparent from end to end.
- Banking services – DeFi dApps are offering services of traditional banking – getting loans, insurance. mortgages etc.
- Passive income.
- Borderless transactions – no geographical limitations.
- Poor performance – due to the decentralization of the blockchain speed of data and transaction procession is still low.
- User protection – while a centralized financial system has many flaws it can vouch for the safety of clients’ assets. Lack of regulations in DeFi is still to be solved when it comes to the safety of its users and their assets.
- Hackers – blockchain itself is heavily secured against hacking attacks due to decentralization, but DeFi dApps built on it are vulnerable due to the open source philosophy. This also leaves space for scamming.
- User experience – at the moment, using DeFi dApps requires knowledge and time from users.
DeFi is a fairly new technology that has gained in popularity, especially in the last three years, it brings new possibilities in reshaping the traditional financial ecosystem based on centralization. The invention of blockchain and its concept of decentralization is allowing for the development of DeFi dApps and opportunities it brings for the common people.
In simple words, DeFi is promising and creating a financial system that offers everything the traditional system does (money transactions, loans, mortgages, insurance etc.) but with one important feature – removal of intermediaries and unnecessary fees. This also means that communities that are usually denied access to traditional financial institutions will be able to gain control over the money they own or be able to make income that can lead to stability.
Yes, DeFi is still new and it has a long way to go before all the risks are minimized and integrated in our everyday lives; but the democratization it brings is revolutionary and it’s bound to shape the world we live in.