What’s Decentralized Finance (DeFi)?
Decentralized Finance (or simply DeFi) refers to a financial application ecosystem that is built on top of blockchain networks.
More specifically, the term Decentralized Finance may refer to a movement aimed at creating an open-source, unauthorized and transparent financial service ecosystem that is accessible to all and operates without any central authority. Users would maintain full control over their assets and interact with the ecosystem through peer-to — peer (P2P), decentralized applications (dapps).
The key 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 on which it is built-interoperable DeFi applications on public block chains will potentially create entirely new financial markets, products and services.
This article will provide an introductory dive into DeFi, its potential applications, its promises, its limitations and more.
Benefits of DeFi
Traditional finance relies on institutions such as banks to act as intermediaries and courts of arbitration.
No intermediary or arbitrator is required for DeFi applications. The code specifies the resolution of any possible dispute, and users keep control of their funds at all times. This reduces the costs associated with the supply and use of these products and allows for a more frictionless financial system.
As these new financial services are deployed on blockchains, the single points of failure are eliminated. The data is recorded on the blockchain and spread across thousands of nodes, making censorship or a possible shutdown of the service a complicated undertaking.
Since the frameworks for DeFi applications can be built in advance, deploying one will become much less complicated and much more secure.
Another significant advantage of such an open ecosystem is the ease of access for individuals who would otherwise not have access to any financial services. Since the traditional financial system relies on profit-making intermediaries, their services are typically absent from low-income communities. However, with DeFi, costs are significantly reduced and low-income individuals can also benefit from a wider range of financial services.
Potential Use of DeFi
Borrowing & Loan
Open loan protocols are one of the most popular types of applications that are part of the DeFi ecosystem. Open, decentralized borrowing and lending has many advantages over the traditional credit system. These include instant transaction settlement, the ability to secure 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 provide assurance on the methods of cryptographic verification. Loan marketplaces on the blockchain reduce counterparty risk, make borrowing and lending cheaper, faster and more accessible to more people.
Currency banking services
As DeFi applications are, by definition, financial applications, monetary banking services are a clear use of the case for them. These may include the issuance of stablecoins, mortgages, and insurance.
As the blockchain industry matures, there is an increased focus on creating stablecoins. They are a type of crypto asset that is usually attached to a real-world asset but can be transferred digitally with relative ease. As cryptocurrency prices may fluctuate rapidly at times, decentralized stablecoins could be used on a daily basis as digital cash that is not issued and monitored by the central authority.
The process of obtaining a mortgage is costly and time-consuming, largely because of the number of intermediaries that need to be involved. With the use of smart contracts, underwriting and legal fees may be significantly reduced.
Blockchain insurance could eliminate the need for intermediaries and allow risk to be distributed among many participants. This could result in lower premiums of the same quality of service.
This category of applications can be difficult to evaluate, as it is the DeFi segment that gives the most room for financial innovation.
Some of the most important DeFi applications are probably decentralized exchanges (DEXes). These platforms allow users to trade digital assets without the need for a trusted intermediary (exchange) to hold their funds. Trades are made directly between user wallets by means of smart contracts.
As much less maintenance work is required, decentralized exchanges typically have lower trading fees than centralized exchanges.
Blockchain technology may also be used to issue and permit ownership of a wide range of conventional financial instruments. These applications would work in a decentralized manner, which would reduce custodians and eliminate single failure points.
Security token issuing platforms, for example, may provide tools and resources for issuers to launch tokenized securities on the blockchain with customizable parameters.
Other projects may allow for the creation of derivatives, synthetic assets, decentralized forecasting markets, and many more.
What is the role of smart contracts in DeFi?
Most of the existing and potential applications of Decentralized Finance involve the creation and implementation of smart contracts. While the usual contract uses legal terminology to specify the terms of the relationship between the contracting parties, the smart contract uses a computer code.
Since their terms are written in a computer code, smart contracts also have the unique ability to enforce those terms through a computer code. This allows 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 both parties’ risk. On the other hand, smart contracts also introduce new types of risk. As computer code is prone to bugs and vulnerabilities, value and confidential information locked in smart contracts are at risk.
What are the challenges DeFi faces?
Poor performance: Blockchains are inherently slower than their centralized counterparts, which translates into applications built on top of them. DeFi application developers need to take these limitations into account and optimize their products accordingly.
High risk of user error: DeFi applications transfer responsibility from intermediaries to users. For many, this can be a negative aspect. Designing products that minimize the risk of user error is a particularly difficult challenge when products are deployed at the top of immutable blockchains.
Bad user experience: the use of DeFi applications currently requires extra effort on the part of the user. In order for DeFi applications to be a key component of the global financial system, they must provide a tangible benefit that encourages users to switch from the traditional system.
Cluttered ecosystem: it can be a daunting task to find the application that is best suited to a specific use case, and users must be able to make the best choices. The challenge is not only to build applications, but also to think about how they fit into the wider DeFi ecosystem.
What’s the difference between DeFi and open banking?
Open banking refers to a banking system where third-party financial service providers are provided with secure access to financial data through APIs. This allows for the networking of accounts and data between banks and non-bank financial institutions. Essentially , it allows for new types of products and services within the traditional financial system.
However, DeFi is proposing a completely new financial system that is independent of the current infrastructure. Sometimes DeFi is also referred to as open finance.
For example , open banking could allow all traditional financial instruments to be managed in a single application by securely collecting data from a number of banks and institutions.
Decentralized finance, on the other hand, could make it possible to manage entirely new financial instruments and new ways of interacting with them.
Decentralized finance focuses on the development of financial services that are separate from the traditional financial and political system. This would allow for a more open financial system , potentially preventing precedents of censorship and discrimination around the world.