In a nutshell, DeFi connects financial users without an intermediary. DeFi is an abbreviation for decentralized finance, and it is often deemed as an ecosystem of financial tools and applications “roaming” on the internet. It aims to replicate and innovate on services or models using decentralized blockchain technology.
More specifically, DeFi is a movement. Its scope is to build a permissionless, open-source, and transparent marketplaces without being bound to a central authority. By making the ecosystem available to everyone – regardless of location – via P2P (peer-to-peer) dApps (decentralized applications), DeFi aims to disrupt asset control and financial services.
To understand this better, let’s look at some examples:
- DeFi crypto lending and borrowing platforms: Apps built on Ethereum provide loans without intermediaries.
- DEXs: A decentralized exchange (or DEX) is a peer-to-peer marketplace where transactions occur directly between crypto traders.
- DeFi asset management: This includes apps and wallets for managing assets. These can be used as gateways to Web 3.0.
- DeFi yield protocols: Platform that offers solutions for yield farming and staking.
- DeFi insurance: People can now take out insurance policies on smart contracts or digital assets. These protocols are used to protect traders and investors against smart contract failures or exchange hacks.
Everyone should be entitled to access financial services, irrespective of social status, location, or financial background. As a consequence, DeFi paves the way to the creation of an open system; a blockchain-based financial model made up of new services, markets, and products. Often deemed as “open finance”, every action, transaction or information exchange between parties will be verified by blockchains rather than by a third party entity like a legacy institution.
DeFi & blockchain technology
A larger portion of DeFi protocols are developed on the 2nd most widely-known blockchain, Ethereum. The purpose is to cut out third parties and middlemen commonly seen when financial transactions occur. This is done via smart contracts.
In simple terms, smart contracts are computer codes powerful enough to execute all duties of an intermediary. The Ethereum network enables complete financial autonomy because, just like with most public blockchains, nobody owns it.
Ethereum is a type of public blockchain that leverages a proprietary Turing-complete coding language. Basically, it allows users to write smart contracts that are immutable. Apart from being impossible to alter in any way, these automated lines of code handle and execute all transactions embedded into the network.
The majority of DeFi platforms are shaped by dApps, which are smart contracts that automate transactions. This way, in the absence of human biases, transactions become more efficient, faster, and convenient to all parties involved.
The benefits of DeFi for the financial system
Before blockchain, the financial industry was known as a bureaucratic system ruled by slow, insecure legacy systems. The rise of Bitcoin and cryptocurrency has disrupted the way online payments are made and value is stored. While still in its infancy years, the introduction of DeFi makes a strong case for the future of finance.
The promise is that decentralized apps will bring valuable, long-term benefits to both customers and investors. By eliminating middlemen, DeFi aims to make financial markets more open and more accessible. Needless to say, to make it all happen, the following core properties of blockchain technology lie at the core of the DeFi movement.
Permissionless
The unique value proposition of blockchain has always been decentralization. The goal is to switch from relying financial entities to store, trade, and exchange value. By sharing transaction history and storing every transaction made anonymously, blockchain networks are not just democratizing banking and finance, but are also building some of the world’s largest financial ledgers. In the context of Ethereum, which is a permissionless type of blockchain, anyone can build or use dApps and enable different integrations without asking for consent from an intermediary. Anyone can participate in the consensus mechanisms that blockchains use to validate transactions and data.
Transparency
As far as transactions are concerned, decentralization leads the way to improved transparency. Given that DLTs (distributed ledger technologies) like the Ethereum Network contain immutable information of every bit of activity that has happened, the data cannot be altered. On top of that, it remains public on the internet for the world to assess. For added transparency, the cryptographic principles at the heart of blockchain ensure that the information has been recorded only after it has been verified.
Immutability
Both consensus algorithms (e.g. proof-of-work, proof-of-stake) and cryptography ensure the immutability of blockchain technology and any attempts of manipulation of the stored records is impossible.
What are the risks of DeFi?
The extensibility and massive interest rates generated by DeFi dApps and protocols have contributed to an unprecedented growth in the sector, but there is substantial risk and volatility in the ecosystem. As lending products can provide superior revenue to conventional financial products, it is important to acknowledge the technical risks involved. Hardware, software, and protocols are predisposed to system glitches and bugs. In general, user experience can be hindered by poor testing and insufficient smart contract audits that may impact functionality. Extensive due diligence is important to mitigating all of the associated risks. Even the most stable of stablecoins involve substantial investment risk.
An open financial system with services that can be accessed by anyone, from anywhere is the guiding principle of decentralized finance. Although the DeFi ecosystem is still in its early stages, it will likely have a great impact on the financial system we know today.
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