Decentralized finance is the new hot trend in the cryptocurrency industry today. Building financial applications, services, and products on blockchain networks introduce new opportunities to explore. Accessing these DeFi solutions requires a lengthy introduction, however.
Table of contents
- What Is DeFi Exactly?
- What DeFi Aims To Achieve
- DeFi Isn’t Open Banking
- The Main Advantages of DeFi
- The Current DeFi Use Cases
- The Importance Of Smart Contracts
- The Many Challenges To Overcome
What Is DeFi Exactly?
Most people are accustomed to dealing with financial services, products, and applications through their bank or other institutions. It is a convenient system that works yet also creates a lot of economic inequality. Rather than ensuring everyone worldwide can access these services and products, banks have created a divide between the “banked” and the “unbanked.” It is a very complex ecosystem in its current format and one that may prove prone to disruption.
On the other hand, decentralized finance is designed to create an open-source, permissionless, and more transparent financial ecosystem. It is open to anyone who knows how to access the internet and spans multiple blockchains without intermediaries or central authorities. Users not only maintain control of their portfolio, but they also have a say in the governance of these DeFi ecosystems.
Providing easier access to financial services – especially to those already in the “unbanked” category – is a daunting task. As the first generation of DeFi applications has made its way to the masses, it is painfully apparent there is still a lot of work to be done. That is only normal, as this industry is in its infancy.
What DeFi Aims To Achieve
Removing the intermediaries and gatekeepers currently present in the financial world creates an entirely new dynamic. There are no institutions such as banks or courts, empowering users to take full control of their financial destiny. It instills a lot of responsibility in those who want to experiment with a meddling-free financial industry.
To build or use a DeFi application, one doesn’t need permission or a license. Regardless of one’s current access to financial products and services, decentralized finance welcomes everyone with open arms. Everything is taken care of by blockchains and smart contracts leveraging this technology. In theory, this technology should prove viable to resolve any disputes or issues, reducing the costs associated with these products’ provision and usage.
All data of these financial services and products is recorded in blockchains and their network nodes sharing the same ledger. Censoring or disrupting any service in the decentralized finance industry becomes a nigh-impossible task. It is possible to achieve this goal, but the economic cost associated with exploring this option is very high.
Moreover, the deployment of DeFi products and services does not require deploying new frameworks. Every concept can leverage the existing blockchain technology at the team’s disposal to introduce new ideas. That doesn’t mean all of these projects are secure by default; however, developers need to properly test their code and undergo multiple audits before releasing something to the public.
Bringing the “unbanked” and “underbanked” into the financial services fold is a gamechanger for the broader industry. The role of decentralized finance in all of this remains to be determined. With no intermediaries looking to pocket big profits or preventing access to specific products, developers can turn the entire industry on its head.
DeFi Isn’t Open Banking
On paper, one may think that decentralized finance and open banking are the same. In reality, the situation is very different. Open banking is a system where third-party service providers receive data through APIs, which banks often maintain. It creates a scenario where new types of products and services can thrive.
DeFi, on the other hand, is a different creature. Rather than “expanding” the existing financial system, decentralized finance wants to disrupt it altogether. One can think of decentralized finance as open finance rather than open banking. Whether it will lead to powerful new instruments is impossible to predict.
The Main Advantages of DeFi
The average person on the street may not see an immediate use for decentralized finance. These users already have access to bank accounts, payment cards, and other products in most cases. For the rest of the world’s population, that may not necessarily be the case. They want a system that is accessible and innovative.
A Modular Framework
Compared to traditional financial infrastructure, DeFi provides a more modular approach. Several platforms and services focus on doing one thing right, yet they are interoperable in many different ways. Unfortunately, the current landscape dictates that only projects on the same blockchain will communicate with one another. It may take a while until cross-chain DeFi applications become commonplace.
For instance, the current DeFi landscape is dominated by the Ethereum blockchain. However, services and products exist on blockchains like Bitcoin, Tron, EOS, and many others. Currently, it isn’t possible to access Ethereum DeFi and move to Bitcoin with these assets unless one wants to jump through several hoops and potentially lose money in the process.
Creating New Financial Markets
The main draw of decentralized finance is how there is no real limit to what one can achieve. Blockchain technology has tremendous potential, yet developers have barely scraped the surface of what this technology can do. The world may witness a financial revolution of sorts in the coming years, yet it is too early to conclude.
Without intermediaries and arbitration, decentralized finance offers a unique approach to financial products and services. As long as developers put together working code, they can build simple and complex applications alike. Ultimately, the goal is to create a frictionless financial system, although that may prove somewhat challenging.
Major Cost Reductions
Accessing financial products and services is never free. Those with a stable income will not notice the fees banks and other intermediaries charge them every month or year. Those with a low income, on the other hand, often have to make choices as to which services they want to access. Predatory banking fees are nothing new, but the problem only grows worse over time.
In decentralized finance, such arbitrary checks are not present. Instead, anyone can obtain loans or funds, assuming they can provide some degree of collateral. Additionally, new products are frequently in development, providing a very different outlook on financial services.
The Current DeFi Use Cases
Contrary to what some people may expect, the decentralized finance industry is already gaining momentum. Several use cases are accessible to everyone today, assuming they are willing to take a deeper dive into the cryptocurrency industry.
Borrowing & Lending
The financial industry’s primary bread and butter lets corporations and consumers borrow and lend funds whenever necessary. A similar approach exists in DeFi, where open lending protocols are one of the primary use cases. Contrary to the traditional system, decentralized borrowing and lending offer instant transaction settlement, collateralization of digital assets, and no credit checks. Some may see this latter aspect as a weakness, but it doesn’t necessarily have to be.
Trust is far less of a factor in decentralized finance. These open protocols are built on public blockchains, using code for everyone to review. Additionally, all participants benefit from cryptographic verification procedures to ensure everything is recorded as agreed upon.
Plethora Of Banking Services
It may seem straightforward, but decentralized finance can always use more traditional banking services. Mortgages and insurance are two areas that warrant further exploration. The growing popularity of stablecoins can help accelerate growth in this department. Currently, there are roughly a dozen stablecoins on the market, yet more pop up regularly.
Every stablecoin has a fixed value to the US Dollar, Euro, or other currency. This creates an ecosystem in which insurance and mortgage solutions can become a factor. Additionally, it paves the way for entering and exiting the DeFi space with real-world assets, creating unprecedented potential. Using stablecoins also helps avoid potential price fluctuations affecting all cryptocurrencies.
As blockchain technology and smart contracts remove the need for intermediaries, the time spent on mortgaging can decrease significantly. There’s also the benefit of offering a cheaper and tamper-proof solution by recording everything on the blockchain.
For insurance, the same benefits apply. However, there’s also the option to distribute risk between multiple participants, creating a self-sustaining insurance environment. Clients benefit from lower premiums while obtaining a similar level of service.
A New Breed Of Marketplaces
Selling and buying goods or services online is only possible through centralized service providers. While that approach works, it also leaves much to be desired. Decentralizing marketplaces is a benefit one can unlock through decentralized finance. In the current form, it primarily applies to exchanges and trading platforms, but there are other opportunities out there.
Blockchain technology allows for some innovative concepts that would otherwise not be possible. Decentralized marketplaces can come in many different forms and shapes, assuming the underlying technology can meet expectations. Any development affecting decentralized exchanges can pave the foundation for other marketplace models in the future.
The Importance Of Smart Contracts
At the core, decentralized finance does not work without smart contract functionality. The objective is to make these products and services trustless and permissionless, ensuring users interface with technology rather than intermediaries. Smart contracts are often associated with Ethereum, although many other blockchains – including Bitcoin – support this functionality.
A smart contract allows developers to write terms of a DeFi protocol in computer code, visible on a blockchain, and executable by anyone. It also provides for automating business processes, although that may be a risky venture. The vast majority of smart contract code is never reviewed or audited, creating potential security vulnerabilities that may incur a loss of funds.
The Many Challenges To Overcome
As is always the case with new technologies and concepts, there are plenty of growing pains to overcome. Decentralized finance is no exception, as DeFi is a novel industry with many shortcomings and aspects that need improvements.
The common issues can be summed up as follows:
- Lack of performance: Public blockchains are slow and inefficient, as is any contract or code running on top of these networks.
- High fees: if Ethereum DeFi serves as an example, the network costs associated with transactions are spiraling out of control. Paying over $70 to provide liquidity or withdraw a stake from a protocol is not acceptable. Ethereum 2.0 may solve some of these issues, yet it has no official timeline or release date.
- User Error: There is no real “convenient” UI when interfacing with decentralized finance applications and protocols. It often requires a good understanding of cryptocurrency and the industry’s wallet services. Far too many projects fail to diminish user error risk, an aspect that warrants further improvements.
- Unnecessary Clutter: Despite hundreds of DeFi applications and protocols existing today, most of them seem to focus on the same ideas. Innovation keeps this industry alive, yet it is sometimes difficult to come by. Building the next crucial piece of DeFi infrastructure needs to be the priority, rather than copying what already exists.
No one will deny that blockchain technology and smart contracts can make a genuine impact on the financial sector. Removing the intermediaries from the equation creates an ecosystem to empower users rather than bowing to the will of banks and governments. With this great freedom comes equally great responsibility, an aspect that society may not be ready to embrace just yet.
Additionally, one has to wonder if decentralized technology needs to meddle with financial products and services people are familiar with. It may prove worthwhile to build entirely new concepts, but only if those ideas benefit from decentralization.
Should DeFi prove to be successful, the sky’s the proverbial limit for what developers can achieve. Traditional finance is expensive, slow, inefficient, and far from inclusive. Developers and communities need to address these issues in one way or another.