Decentralized finance (or simply DeFi) refers to an ecosystem of financial applications that are based on blockchain networks. The term ‘decentralized finance’ can refer to a movement that aims to create an open, free and transparent ecosystem of financial services that is accessible to everyone and operates without interference from any government. Users will retain full control over their assets and interact with this ecosystem through peer-to-peer (P2P) and decentralized applications (dapps).
The main advantage of DeFi is the easy access to financial services, especially for those who for some reason are isolated from the current financial system. Another potential advantage is the modular framework and interoperability of public blockchain-based applications, which may lead to the emergence of completely new types of financial markets, products and services.
How do centralized finance systems work?
Everyone is familiar with the mechanism of centralized finance. It is simple: a person takes his or her money to a bank or other financial intermediary and expects to receive a certain income in accordance with the rate. The longer money is managed by institution, the higher income person earns.
Financial companies have professional managers on their side, who manage the money skillfully. Their task is to maximize profits — thus, the owner of the bank account also benefits.
Sounds cool, but there are three problems in total:
- You don’t control your money — strangers from financial institutions are responsible for this;
- Bankers are not immune to failure. Remember the world crisis of 2008, the approach of which they did not feel;
- The more money banks control, the higher the concentration of finances in one place. Accordingly, in theory, the risks of undermining the entire financial system increase with each invested banknote.
There is no way to analyze the bank’s operations with your funds. Most likely, you will just get a few green digits in your transactions with the signature “payment on deposit”.
Despite the shortcomings of the financial system, many people simply do not have access to banking services. That is, they do not even have the opportunity to open a deposit — no matter how unreliable this instrument may seem. According to the World Bank, in 2017, 1.7 billion people out of a total population of 7.53 billion had no bank account.
Satoshi Nakamoto tried to change the situation
Satoshi Nakamoto presented the Bitcoin Whitepaper, a document describing the project, on 31 October 2008. His cryptocurrency became the first real means for transactions between residents of any part of the world without intermediaries. After the launch of the network on January 3, 2009, computer owners no longer need to visit a bank to send money to relatives in another country. Just like answering embarrassing questions about the origin of the funds and paying monstrous transfer fees.
But Bitcoin only borrowed money from central banks to issue, store and send. The financial system is still under their control. The example — cryptocurrency exchanges. They are centralized, that is, certain people are responsible for their work, which may also affect the actions of users. In addition, such platforms are influenced by the Securities and Exchange Commission and other regulatory bodies. So we have a freedom tool, but there is still no environment for its implementation. This is where decentralized finance comes into play.
DeFi: pros and cons
The traditional financial system relies on institutions that act as intermediaries and courts to ensure that disputes are resolving. DeFi applications do not need intermediaries or courts. The code defines the resolution of every possible dispute, and users in turn keep all their funds under control. This reduces the cost of providing and using products, and allows for a more seamless financial system.
Since the software for a new type of financial service is deployed on top of blockchain networks, there is no single point of failure for the system. Data is recorded in a blockchain and distributed to thousands of nodes, which virtually eliminates the presence of censorship or shutdown possibility. Due to the fact that the framework allows you to create DeFi applications in advance, their development and deployment becomes less complex and more secure.
Another significant advantage of such an open ecosystem is the ease of access to financial services for people who, for some reason, do not have such an opportunity. Since the traditional financial system is based on the intermediation of profits, they usually do not provide their services, in low-income areas. However, thanks to DeFi, transaction costs are significantly reduced and similar communities can also benefit from the necessary financial services.
What kind of problems does DeFi face? Let’s review some of them:
- Poor performance. Blockchains are inherently slower than their centralized counterparts, resulting in additional applications. Developers of DeFi applications need to be aware of these limitations and optimize their products accordingly;
- There is a high risk of user error. DeFi applications transfer responsibility from intermediaries to the user. This can be a negative aspect for many. Developing products that minimize the risk of user error is particularly challenging when products are deployed over immutable block networks;
- Bad user experience. Currently, the use of DeFi applications requires additional efforts from the user. For these applications to be a key element of the global financial system, they must provide tangible benefits that will affect users’ desire to abandon the traditional system;
- The randomness of the ecosystem. Finding the most appropriate application can be challenging, but users must also have some skill in order to find the best one. It is also a challenge not only to create applications but also to think about how ideal they can fit into a large ecosystem of decentralized finance.
Potential use cases
Open credit protocols are one of the most popular applications in the DeFi ecosystem. Open decentralised loans and credits have many advantages over traditional credit systems. These include: instant transaction settlement, the ability to secure digital assets, lack of credit checks and potential future standardization.
Due to the fact that in this case credit services are based on public blockchains, they minimize the necessary trust to them and guarantee the operation of crypto verification methods. Blockchain credit marketplaces reduce counterparty risk, make loans and credits cheaper, faster and more accessible to more people.
Money and banking services
Since DeFi applications are by definition financial, it is obvious for them that they have monetary banking services. They may include the issuance of stablecoins, mortgages and insurance.
As the blockchain industry develops, more and more attention is paid to the creation of stablecoins. This is a type of cryptocurrency that is tied to a real asset and can be transmitted relatively easily in digital form. Because cryptocurrencies are highly volatile, decentralized stablecoins can be accepted for everyday use as digital money that is not issued or controlled by central authorities.
Due to the number of intermediaries to be involved, the process of obtaining a mortgage is quite expensive and time-consuming. With smart contracts, underwriting and legal fees can become much cheaper. Blockchain insurance can eliminate the need for intermediaries and allow risks to be shared between multiple participants. This can lead to lower insurance premiums without affecting the quality of service.
This category of applications can be difficult to evaluate because the DeFi segment itself provides a large number of opportunities for various financial innovations.
Perhaps some of the most important DeFi applications are Decentralized Exchanges (DEX). These platforms allow users to trade digital assets without a trusted intermediary (exchange) to hold your funds. Transactions are made directly between user wallets using smart contracts.
As these trading platforms require far less maintenance, decentralized exchanges charge a lower trading fee than their centralized counterparts. Blockchain technology can also be used to issue and authorize a wide range of traditional financial instruments. Such applications will operate in a decentralized manner, eliminating a single point of failure and custodian.
Smart contracts and DeFi
Most existing and potential applications in the area of decentralized finance include the creation and execution of smart contracts. While the usual contract uses legal terminology to define the terms and conditions between the entities entering into the contract, the smart contract uses computer code.
Since all conditions are described in computer code, smart contracts have a unique ability to use them. This ensures the reliable execution and automation of a large number of business processes, which currently require manual control.
Smart contracts are much easier and faster to use, which has the effect of reducing the possibility of adverse events for both parties. But despite this, they provide space for the emergence of new types of risk. Because computer code is prone to errors and various vulnerabilities, your confidential information locked into smart contracts is at risk.
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The concept of decentralized finance aims to build financial services separate from traditional financial and political systems. This will allow for a more open financial system and possibly eliminate censorship and discrimination around the world. The idea seems tempting, but not all cases of decentralization can be useful. Finding the most appropriate use for the characteristics of blockchains is crucial to creating a useful stack of open financial products.
If successful, DeFi will take power from large centralized organizations and hand it over to the free software community. However, at this point it is not known exactly how effective this financial system will be, and even more so when decentralized finance becomes mainstream and is accepted by the public.