Decentralized finance is a concept wherein financial products are made available to the consumer without the previously necessary middleman of a bank or brokerage associated with centralized finance. DeFi services run on a public, decentralized blockchain network which allows several entities to hold a copy of the transactions that occur. There is no one governing body controlling the network. Centralized systems can limit speed and sophistication of financial transactions and users have less control over their money. DeFi attempts to address these issues and expands the use of blockchain technology from basic value transfer to more complex financial use cases.
DeFi systems connect buyers and sellers as well as lenders and borrowers with strictly coded software acting as the intermediary between each party. Terms, conditions, rules and governance is controlled in a predetermined manner by technology. Participating members rely on these unchanging rules rather than a potentially flippant person, group of people or organisation.
When using a credit card for example (centralized finance), a financial institution sits between you and the payment recipient. This governing body retains the authority to pause, record or stop any particular transaction. With DeFi, these institutions are cut out of the process.
In the current financial ecosystem, direct transactions are far from the only service controlled and operated by large institutions. Loans, crowdfunding, insurance, betting and derivatives are just some of the others on the extensive list of applications. Defi cuts out middlemen in all of the above, making these services tangible for anybody. Unlike traditional banking, DeFi does not require personal details of its users (e.g. ID, proof of address, SSN). This opens up such services to everybody, regardless of ethnicity, age, cultural identity or location. Independent access to these services becomes especially salient when regions experience conflict or when conditions in a certain area cause disruption/downturn in economic activity. DeFi ensures anyone with an internet connection can avail of the aforementioned services, providing autonomy and opportunity to those who seek it.
Most DeFi applications operate on top of the Ethereum network as developers can utilise complex smart contracts. Smart contracts are transactions that are only approved by the network once certain predetermined conditions are met. Ethereum allows developers to create almost any such conditions and code it into the software of DeFi services and applications. Ethereum programming languages, such as Solidity, are specifically designed for creating and deploying such smart contracts. This has led to huge innovation in the space as limits to the technology are restricted by little more than the creativity of the coders. Furthermore, Ethereum 2.0, a coming upgrade to Ethereum’s underlying network aims to address Ethereum’s scalability issues which will likely lead to more progress and adoption of DeFi services and applications.
Decentralized exchanges: Online exchanges where users are connected so that they can buy or sell cryptocurrencies without trusting an intermediary with their money. Users can make purchases with crypto or fiat.
Stablecoins: A cryptocurrency that is tied to a real world asset (dollar or euro, for example) to stabilize the price. This protects the coin from sharp price fluctuations that can be associated with crypto.
Lending Platforms: Platform that connects borrowers to lenders of cryptocurrencies. Smart contracts replace intermediaries such as banks in these instances. Users can earn interest from lending out their money. Interest rates can change depending how high of a demand is associated with a particular coin. The lenders funds are protected by collateral, usually in the form of Ethereum. That means users don’t give out their identity or credit score to secure a loan.
“Wrapped” Bitcoins (WBTC): Method of sending bitcoin to the Ethereum network so the bitcoin can be used within Ethereum’s DeFi system. Lenders can earn interest on the funds they lend out via decentralized lending platforms (mentioned above).
Prediction markets: Users can bet on future events with the aim to make money. Same functionality as standard prediction markets without the middlemen/intermediaries. This is one of the oldest existing DeFi applications hosted on Ethereum.
As more projects emerge and further users flood to the space it is difficult to predict where DeFi will go next. Scalability and security are the main issues facing DeFi currently.
Eth 2.0, along with a number of other protocols that are in development, offer a chance to address the scalability issues associated with the Ethereum network. This could lead to even more functional, complex and useful applications which could bring DeFi into the mainstream. Unfortunately DeFi bugs are common and smart contracts can’t be altered once added to the code. This means any bugs in a protocol are there to stay and can be exploited. It is important to note with DeFi (and the crypto landscape in general) that although a plethora of good projects exist, so too do bad projects so - beware what you use or invest in!
Where do you see DeFi going next? What current projects or potential future ones do you see gathering popularity and success?
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