Decentralized Finance (DeFi) is a highly promising, rapidly growing sphere – thanks to blockchain technology. It has a lot to offer when it comes to the future of finance. DeFi is developing fast to revolutionize the whole financial world, including insurance, borrowing and lending, investment services, custodial services, banking services, asset trading, savings, checking accounts, and more.
People are simply realizing that they can control their finances personally, easily and effectively thanks to blockchain and cryptocurrencies. All you need is a smartphone in your pocket. Thus, the decentralization of finance is becoming a contentious topic as people are becoming more and more disillusioned with the centralized financial sector.
Centralized vs. Decentralized Finance
Centralization: Centralization is defined as some form of centralized control, which, in the field of finance, basically refers to governments, central banks and banking institutions. Historically, these centralized systems were needed for the payment infrastructure and were important, for example, for cross-border transactions. The centralized finance is not immune to forgery, fraud, questionable practices, non-transparent lending processes, and more. Also, this centralized system is apparently not accessible to many. That’s why about 30 percent of adults globally remain unbanked in 2020.
Decentralization: DeFi (Decentralized Finance) is the new monetary and financial decentralized system built around the public blockchains. This decentralized system keeps identical records on a peer-to-peer network, with no single point of failure (as in centralized systems). It is permissionless (it doesn’t need anybody’s permission, not even that of any authority), and resistant to censorship. DeFi makes use of decentralized applications (DApps) – programs functioning within decentralized networks.
By utilizing blockchain technology, DeFi can effectively replace intermediaries and institutions. Instead of centralized contracts, you can use decentralized smart contracts; instead of centralized borrowing and lending, you can go with the decentralized route through the blockchain, and so on. DeFi minimizes costs and maximizes the efficiency of financial services.
DeFi can replace intermediaries and institutions.
Let’s have a look at three spheres where DeFi can make your life much easier:
- Decentralized loans.
- Decentralized exchange (DEX).
- Automation of financial processes.
DeFi and Decentralized Loans
With your smartphone and access to the internet, you can easily manage your assets on your device today, including your online banking and taking loans online. How much will you gain from your fixed deposit (i.e. if you lend your money to the bank) and what interest will you pay if you borrow money from the bank? You may be astounded by the fact that if you put your 1,000 USD into a fixed deposit (effectively lending your money to the bank), you might gain around 25 USD (2.5%) in a year. But if you need to borrow 1,000 USD, you will pay an interest of around 145 USD (14.5%) after one year.
This difference of 12 percentage points (2.5% vs 14.5%) is really striking. Why is that so? Well, the intermediaries take this huge cut. True, the intermediaries carry out all kinds of functions: They need to review the borrower’s credit, bear the risk of delinquent debts, send reminders to debtors, etc. But does it justify the difference of around 12 percentage points? What is the solution?
You might be thinking of “P2P” lending that has been around for many years already. While simplifying the process of borrowing and lending, “P2P” lending still relies on intermediaries, and it isn’t decentralized. Apart from the weak regulation and risks of losing your investment, one of the big flaws is that they are kind of on the edge of the traditional financial system.
How the Things Get Better With DeFi
With DeFi, you can use smart contracts that perform all the functions of intermediaries. Smart contracts can be programmed to accept deposits, manage deposits, handle collateralized loans, liquidate collateral assets, and more. The blockchain technology makes all of these processes immutable – they cannot be changed, terminated or manipulated by anybody, and are always executed according to the predefined conditions. Yes, once set up and running, a smart contract cannot be changed by anybody, not even by its developers.
The examples of DeFi tokens and platforms are MakerDAO and Compound. These decentralized platforms serve to set up capital pools with smart contracts to allow lending and borrowing of assets through blockchain. Some more examples of DeFi tokens: Chainlink (LINK), Aave (LEND), Synthetix Network Token (SNX), Dai (DAI), Kyber Network (KNC), 0x (ZRX), Swipe (SXP).
Currently, decentralized loans are the fastest growing part of the DeFi space, indicating a continuing demand for borrowing and lending. It also clearly shows that loans are here to stay and belong among the standard and established financial services.
Interestingly, the central bank of China has already started experimenting with digital Yuan DCEP (Digital Currency / Electronic Payment). If it is successful, you will easily be able to lend out your digital Yuan to somebody anywhere in the world, using just your smartphone, all with no intermediaries. The code programmed into the process should make everything transparent and safe.
DeFi and the Automation of Financial Processes
Thanks to computers and programs, many processes can be automated and carried out with the utmost effectiveness and reliability. Still, many operations in the financial sector have not been left to automation, the main reason usually being the lack of trust. Is it acceptable to you that your money will somehow be transferred from your account automatically? Well, in the first place, you will want to be sure that your funds are safe. At this time, this is typically ensured by a centralized entity and intermediaries.
Companies use intermediaries and outsourcing to allocate payments, collect income from subsidiaries, distribute money to accounts, such as management accounts, cost accounts, and tax accounts, etc. Banks also provide services to help their clients in these spheres. These operations are typically complex and difficult, and any agreements must be adjusted and resigned whenever the terms and conditions change.
By using DeFi with smart contracts you can have various scenarios with all kinds of conditions for all kinds of payments, money distribution, bill collection, and more. Thanks to blockchain technology, all these processes can be traced online. Everything is fast, transparent, with negligible costs.
DeFi and Decentralized Exchange
It is important to see the differences between the centralized and decentralized exchange.
Centralized Exchange: Such a traditional exchange functions through a centralized platform that makes all trades possible within this platform. The very centralized nature leaves it open to attacks and hackers who can take advantage of some central point-of-failure and make off with huge amounts of money. Historically, there are a number of exchanges that were hacked and suffered considerable losses; some of them had to discontinue their operations.
Decentralized Exchange: A decentralized exchange (DEX) does not hold any assets directly. DEX is a cryptocurrency exchange without any central authority or a third party service. These decentralized exchanges allow trading directly between users, peer-to-peer, with no intermediary. The transactions between wallets are typically executed with the use of smart contracts. The advantage of DEX is their “trustless” nature – you don’t have to trust the exchange since it is you who holds the funds in your personal wallet. Thanks to all this, there is no central point-of-failure that hackers could exploit. DEX also provides privacy, since you can stay anonymous.
The advantages of decentralized exchange (DEX) are obvious, and this seems to be the direction for the near future.
The Advantages and Benefits of DeFi
Decentralized Finance (DeFi) brings in many benefits and advantages to users. DeFi makes the financial services and opportunities available to a much wider scope of users, all with much lower costs, helping the unbanked, and lowering the entry requirements that are typical in the current money sector. DeFi has the potential to restructure the financial industry as we know it.
DeFi can create a new kind of financial system that is completely decentralized, distributed and built on the open source technology of blockchain. With no intermediaries and no central point of failure and control, these systems are more effective, while simultaneously being resistant to censorship, but remain fully and transparently auditable. Also, DeFi systems won’t be easily affected by fraud, manipulation, corruption or other issues. On top of that, these new systems are faster, more powerful, more secure and able to take care of all the transactions transparently and reliably.
DeFi as a Promising Technology
Just from our examples of decentralized loans, decentralized exchange (DEX), and the automation of financial processes, you can see how promising the technology of DeFi is. That’s why the DeFi user base has been steadily growing since 2017.
In contrast to the traditional financial system, the world of DeFi offers open access to everybody, including the unbanked, resistance to censorship, full programmability, transparency and credibility, all as natural parts of the underlying layer utilizing the blockchain technology. In addition, it allows ordinary people to manage their own finances and personal data, removes intermediaries that typically make equivalent services just more expensive, and reduces risks due to the nature of smart contracts. Similar to staking cryptocurrencies in the PoS (Proof of Stake) consensus, DeFi also makes it possible to generate passive income from cryptocurrencies that the user owns.
Clearly, the concept of DeFi (Decentralized Finance) is one of the most fascinating these days. For wider adoption, the cryptocurrency scalability issues have yet to be addressed. This is the aim of Ethereum 2.0, which also promises lower gas fees and faster block times after it is fully implemented in 2021.