Decentralized Finance, also known as DeFi or open finance is a common buzzword in the financial industry and cryptocurrency world in recent times. It aims to recreate the traditional finance systems like borrowing, lending, and exchange using automation instead of middlemen. After being automated, the system can be used for more complex challenges and capabilities. Although together the foremost venue for DeFi is Ethereum, these ideas can and will be soon implemented in various smart contract platforms.
In a nutshell, DeFi today is a smart financial system for cryptocurrencies. Bitcoin was the first to put money on the internet and DeFi aspires to keep this money constantly moving, working, and leveraging its meaningful value.
For any currency, being part of a healthy financial system is the key to its prosperity. Similarly, for cryptocurrencies, being a part of DeFi will bring along multiple benefits. Soon, central bank digital currencies, digital gold, real estate assets or even energy and cryptocurrencies will all be digital assets under the DeFi ecosystem.
If you’re an investor in cryptocurrencies or a financial or technology expert who wants to understand the future, DeFi is something you can’t ignore. This guide takes you through the basics of Decentralized Finance and why it’s important — today, and in the future.
What is DeFi?
In simple words, DeFi is an ecosystem of financial applications that are built on blockchain networks. But in complexity, DeFi is much more — it’s a movement to create an open-source, permission-free and transparent financial service which will be easily available to everyone and will operate without any central authority. All the users on the ecosystem will have complete control over their assets, and they will interact using peer-to-peer (P2P), decentralized applications (dApps).
This new movement is pumping hope, oxygen, and energy into the cryptocurrency industry with the notion that crypto entrepreneurs will have the ability to re-create the traditional financial instruments using a decentralized architecture. This will be without the control of companies or the government and it has raised interest in the minds of users because it offers a libertarian streak.
What are the Core Advantages of DeFi?
The greatest advantage of DeFi is that it doesn’t require any permission or paperwork to participate. So, you don’t need KYC or a credit score to be a part of this system. Plus, the same rules apply to anyone, anywhere across the globe and liquidity is borderless, too. All you need is a working internet connection to access the market. Since it is non-custodial, you have full access to your money and you can use it however you want!
For example, Aave uses a pool-based strategy wherein the lenders offer liquidity by depositing Ethereum or ERC-20 tokens into a pool contract. They can then earn interest or use their deposited funds as collateral to borrow assets. Thus, users can access to a short-term credit line for stablecoins without the need to liquidate their assets.
In the case of traditional financial systems, there’s a huge reliance on banks as intermediates and even courts to offer arbitration. But the DeFi applications don’t need any arbitrators or intermediaries as the code itself specifies the resolution for every possible conflict. Not only does this reduce the costs associated with using these products, but it also brings forth a frictionless financial system.
Plus, DeFi apps are deployed on top of blockchains, eliminating a single point of failure. The framework is built in advance, making the process of deployment faster, safer, and simpler.
Another major advantage of DeFi is the easy access to individuals who may not have access to traditional financial services. The regular financial services rely on intermediaries making a profit, and thus, are often absent in low-income community locations. Low-income individuals can actually benefit from the lower cost of DeFi and the broader range of financial services offered.
How Does DeFi Work?
The Decentralized Finance ecosystem is built on two main characteristics of blockchain:
· It is trusted to be tamper-proof and majorly automated
· It is programmed to interact with cryptocurrencies
These characteristics make it possible for dApps to automatically interact with money in various ways without the requirement of a bank or any other authority. When more and more dApps are built on the network, and they keep integrating with each other, the system becomes more effective and efficient.
An example of a Smart Contract is Swap — which allows users to safety trade their assets with strangers online. Although this in itself is a basic app with lack of scalability, it is connected with other apps like Pricing Oracles or Liquidity Pool which makes it faster, convenient and perfect for large-scale use.
As more and more dApps will emerge and connect, the DeFi ecosystem is likely to experience an exponential growth.
While Centralized Finance solves problems like liquidity or matchmaking with the help of a central authority such as a bank, DeFi splits up the responsibilities amongst different dApps.
As a result, the following benefits are easily achieved:
· Better Security — As everything is split up, the system lets go of many of its weak points and becomes more secure
· Higher Competitiveness — Since anyone can build the DeFi dApps and access the system, the market becomes leaner and more competitive, innovative and highly consumer-friendly.
· Greater Value — Since dApps are interdependent on each other, they offer more value to one another and grow rapidly as well.
· Newer Applications — There are many novel things you can do with DeFi that can’t be done with CeFi.
· Lower Cost — Above all, dApps offer services autonomously, making them far more cost-effective than centralized financial systems.
With the aim to build a financial system that’s different from the traditional and political one, DeFi could potentially prevent the precedents of censorship and discrimination on a global level. It is possible that in the coming years, people would move from CeFi to DeFi for multiple reasons and gain countless benefits.
But what are the challenges it might face? What potential use cases for DeFi will make it so tempting? Click here to explore further.