What is Decentralized Finance (DeFi)?
Well, the idea is very simple. If all traditional financial institutions (banks, exchanges) are just a software that is controlled by a single governance body, then why not to make all these institutions on standalone of Ethereum smart contracts or another blockchain?
This is how protocols appeared and now allows trading crypto on decentralized exchanges without the participation of an intermediary, lending, managing monetary policy and issuing stablecoins, rebalancing assets, creating derivatives, insuring risks, and generally do everything that traditional financial institutions do.
DeFi -is not a single product or company, but a set of products and services that replace financial institutions such as banks, insurance companies, bonds and money markets. It’s an ecosystem of financial applications that is built on top of blockchain networks that allows you to use them without centralized organizations. The code specifies the resolution of every possible dispute, and the users maintain control over their funds at all times. This reduces the costs associated with providing and using these products and allows to create a more frictionless financial system.
According to DeFi Pulse, the total value locked at the beginning of 2019 was about $ 275 million, reached 20 billion in December 2020, and now is $ 49.9B. This is an indicator of the rapid growth of the DeFi ecosystem.
The main advantage of DeFi services is hidden in the name itself. Decentralization. Thanks to it, the control over it is evenly distributed among many players. No overregulation, transactions are transparent, fast in execution, and there is no long chain of intermediaries. This is convenient, for example, when lending. There is no intermediary bank, that means that the one who gives the loan does not have to share the profitability with the bank, that accepts deposits at one interest rate, but issues loans at a much higher rate. There is no such gap in DeFi lending.
DeFi services are also governed by smart contracts and voting. Smart contracts make it possible to establish the rule of law in the ecosystem, to create clear rules of the game.
As in the case of the blockchain itself, services using opensource protocols are more trustworthy: they can be verified, they can be modified, and can be used in other services.
What are the potential use cases for DeFi?
- Stablecoins. A building block of decentralized finance. Unlike cryptocurrencies such as Bitcoin or Ethereum that are known for their price volatility, a stablecoin is engineered to remain “stable” at exactly 1.00 units of fiat. Most stablecoins are pegged to the USD, but some are in other fiat currencies like the Chinese RMB.
- Decentralized lending. Programmatically take out a loan on the blockchain. No bank account is required.
- Decentralized exchanges. Buy and sell cryptocurrencies through a blockchain, rather than a centralized exchange like Coinbase. In principle, a machine can trade on it!
- Collateralization. Provide digital assets to collateralize your decentralized loans, providing the lender some recourse in the event of default.
- Decentralized Identity. Identities are used in the context of smart contracts for things like assessing your creditworthiness for a decentralized loan.
- Composability. Snapping together DeFi functions that make different things, much like software libraries. For example, if a contract takes in crypto and generates interest, the second contract could automatically reinvest that interest.
- Risk management. High returns in DeFi are often accompanied by even higher risks. Fortunately, new tools are arising to help to hedge these risks.
Decentralized Finance is focused on building financial services those separate from the traditional financial and political system. The main task of decentralized finance is to become an alternative to the banking sector and replace the traditional technologies of the current financial system with open source protocols. And to open access to decentralized lending and new investment platforms for a huge number of people in order to allow them to receive passive income from cryptocurrency assets, as well as save assets on fees for transfers, loans and deposits. If ICO was about raising capital, then DeFi is about all other functions of the traditional financial system. This would allow to create a more open financial system and could potentially prevent precedents of censorship and discrimination all over the world.
If everything is successful, DeFi will take power from large centralized organizations and put it in the hands of the open-source community and the individuals.