What is Decentralized Finance (DeFi)?
Decentralized Finance
(or simply DeFi) refers to an ecosystem of financial applications that are
built on top of blockchain networks.
More specifically, the
term Decentralized Finance may refer to a movement that aims to create an
open-source, permissionless, and transparent financial service ecosystem that
is available to everyone and operates without any central authority. The users
would maintain full control over their assets and interact with this ecosystem
through peer-to-peer (P2P), decentralized applications (dapps).
The core benefit of
DeFi is easy access to financial services, especially for those who are
isolated from the current financial system. Another potential advantage of DeFi
is the modular framework it is built upon - interoperable DeFi
applications on public blockchains will potentially create entirely new
financial markets, products, and services.
This article will
provide an introductory dive into DeFi, its potential applications, promises,
limitations, and more.
What are the main advantages of DeFi?
Traditional finance
relies on institutions such as banks to act as intermediaries, and courts to
provide arbitration.
DeFi applications do
not need any intermediaries or arbitrators. The code specifies the resolution
of every possible dispute, and the users maintain control over their funds at
all times. This reduces the costs associated with providing and using these
products and allows for a more frictionless financial system.
As these new financial
services are deployed on top of blockchains, single points of failure are
eliminated. The data is recorded on the blockchain and spread across thousands
of nodes, making censorship or the potential shutdown
of a service a complicated undertaking.
Since the frameworks
for DeFi applications can be built in advance, deploying one becomes much less
complicated and much more secure.
Another significant
advantage of such an open ecosystem is the ease of access for individuals who
otherwise wouldn’t have access to any financial services. Since the traditional
financial system relies on the intermediaries making a profit, their services
are typically absent from locations with low-income communities. However, with
DeFi, the costs are significantly reduced, and low-income individuals can also
benefit from a broader range of financial services.
What are the potential use cases for DeFi?
Borrowing & Lending
Open lending protocols
are one of the most popular types of applications that are part of the DeFi
ecosystem. Open, decentralized borrowing and lending have many advantages over
the traditional credit system. These include instant transaction settlement,
the ability to collateralize digital assets, no credit checks, and potential
standardization in the future.
Since these lending
services are built on public blockchains, they minimize the amount of trust
required and have the assurance of cryptographic verification methods. Lending
marketplaces on the blockchain reduce counterparty risk, make borrowing and
lending cheaper, faster, and available to more people.
Monetary banking services
As DeFi applications
are, by definition, financial applications, monetary banking services are an
obvious use case for them. These can include the issuance of stablecoins, mortgages, and insurance.
As the blockchain
industry is maturing, there is an increased focus on the creation of
stablecoins. They are a type of cryptoasset that is usually pegged to a
real-world asset but can be transferred digitally with relative ease. As
cryptocurrency prices can fluctuate rapidly at times, decentralized stablecoins
could be adopted for everyday use as digital cash that is not issued and
monitored by a central authority.
Largely because of the
number of intermediaries needing to be involved, the process of getting a mortgage
is expensive and time-consuming. With the use of smart contracts, underwriting
and legal fees may be reduced significantly.
Insurance on the
blockchain could eliminate the need for intermediaries and allow the
distribution of risk between many participants. This could result in lower
premiums with the same quality of service.
If you’d like to read
more on the subject of blockchain and banking, we recommend reading our
article How Blockchain Technology Will
Impact the Banking Industry.
Decentralized Marketplaces
This category of
applications can be challenging to assess, as it is the segment of DeFi that
gives the most room for financial innovation.
Arguably, some of the
most crucial DeFi applications are decentralized exchanges (DEXes). These platforms allow users to trade digital assets without
the need for a trusted intermediary (the exchange) to hold their funds.
The trades are made directly between user wallets with the help of smart
contracts.
Since they require
much less maintenance work, decentralized exchanges typically have lower trading
fees than centralized exchanges.
Blockchain technology
may also be used to issue and allow ownership of a wide range of conventional
financial instruments. These applications would work in a decentralized way
that cuts out custodians and eliminates single points of failure.
Security token
issuance platforms, for example, may provide the tools and resources for
issuers to launch tokenized securities on the blockchain with customizable
parameters.
Other projects may
allow the creation of derivatives, synthetic assets, decentralized prediction
markets, and many more.
What role do smart contracts have in DeFi?
Most of the existing
and potential applications of Decentralized Finance involve the creation and
execution of smart contracts. While a usual contract uses legal
terminology to specify the terms of the relationship between the entities
entering the contract, a smart contract uses computer code.
Since their terms are
written in computer code, smart contracts have the unique ability also to
enforce those terms through computer code. This enables the reliable execution
and automation of a large number of business processes that currently require
manual supervision.
Using smart contracts
is faster, easier, and reduces risk for both parties. On the other hand, smart
contracts also introduce new types of risks. As computer code is prone to have
bugs and vulnerabilities, the value and confidential information locked in
smart contracts are at risk.
What challenges does DeFi face?
·
Poor
performance: Blockchains are inherently slower than
their centralized counterparts, and this translates to the applications built
on top of them. The developers of DeFi applications need to take these
limitations into account and optimize their products accordingly.
·
High
risk of user error: DeFi
applications transfer the responsibility from the intermediaries to the user.
This can be a negative aspect for many. Designing products that minimize the
risk of user error is a particularly difficult challenge when the products are
deployed on top of immutable blockchains.
·
Bad
user experience: Currently, using
DeFi applications requires extra effort on the user’s part. For DeFi
applications to be a core element of the global financial system, they must
provide a tangible benefit that incentivizes users to switch over from the
traditional system.
·
Cluttered
ecosystem: It can be a daunting
task to find the application that is the most suitable for a specific use case,
and users must have the ability to find the best choices. The challenge is not
only building the applications but also thinking about how they fit into the
broader DeFi ecosystem.
What is the difference between DeFi and open banking?
Open banking refers to
a banking system where third-party financial service providers are given secure
access to financial data through APIs. This enables the
networking of accounts and data between banks and non-bank financial
institutions. Essentially, it allows new types of products and services within
the traditional financial system.
DeFi, however,
proposes an entirely new financial system that is independent of the current
infrastructure. DeFi is sometimes also referred to as open finance.
For example, open
banking could allow the management of all traditional financial instruments in
one application by drawing data from several banks and institutions securely.
Decentralized Finance,
on the other hand, could allow the management of entirely new financial
instruments and new ways of interacting with them.