What Is DeFi? Understanding Decentralized Finance
Bitcoin has inspired a global movement centered around taking power away from financial institutions back to you. In this article written by Haithem Kefi, we explain how traditional finance is being challenged right now.
What is DeFi?
DeFi stands for "decentralized finance" and is a subset within the cryptocurrency space.
DeFi is a class of financial products that are autonomous computer programs like apps, built on a blockchain and governed by “smart contracts”. Smart contracts are automated enforceable agreements that do not need intermediaries to execute.
DeFi aims to democratize finance by replacing centralized institutions with peer-to-peer relationships that can provide a full spectrum of financial services, from everyday banking to complex asset trading.
Decentralized finance (DeFi) vs traditional finance
|You hold your money.||Your money is held by companies.|
|Transfers of funds happen in minutes.||Payments can take days due to manual processes.|
|Transaction activity is pseudo-anonymous.||Financial activity is coupled with your identity.|
|DeFi is open to anyone.||You must apply to use financial services.|
|The markets are always open.||Markets close because employees need breaks.|
|It is built on transparency. Anyone can look at a product's data.||Financial institutions are closed books. You cannot see their records.|
How does DeFi work?
DeFi is a technological alternative to relying on centralized financial institutions such as banks. DeFi systems achieve distributed consensus by using smart contracts on blockchains such as Ethereum. Developers write smart contracts to perform specific actions only when certain conditions are met. While Ethereum was the first platform to develop smart contracts, other blockchain platforms use them as well.
A contract that is designed to transfer money could be, for example, programmed to send money from account A to account B on a specific date and time. No one can change the terms of the contract or add an account C as a recipient to steal funds. Moreover, contracts are public for anyone to inspect and audit. This means corrupt contracts will be under community scrutiny.
DeFi runs on a blockchain
A blockchain is the core technology that enables decentralized finance. It is a decentralized, distributed public ledger where financial transactions are recorded in computer code.
A blockchain being distributed means that all parties using a DeFi application have an identical copy of the public ledger, which records all transactions. Therefore, the system provides users with verification of payments and a record of asset ownership that is virtually impossible to alter.
A blockchain being decentralized means there is no middleman managing the system. Transactions are verified and recorded by parties who use the same blockchain. Advocates of DeFi assert that this makes financial transactions secure and more transparent than in centralized finance.
Popular DeFi applications
One of the earliest applications of DeFi was the creation of cryptocurrencies with stable values, known as stablecoins. Stablecoins, by being much less volatile than other cryptocurrencies, are considered suitable for making ordinary purchases.
One example of a stablecoin is DAI, an open-source project on the Ethereum blockchain. The DAI coin is pegged to the U.S. dollar and collateralized by Ether, the native Ethereum token. DAI is purposely overcollateralized by Ether, which enables the value of DAI to remain stable even as Ether's value fluctuates.
Decentralized exchanges (DEXs) use smart contracts to perform the work of centralized exchanges, with the smart contracts providing pricing for each counterparty at or near market prices. Using a DEX allows each party to retain full control of their respective cryptocurrency holdings rather than depositing them in a wallet held by a centralized exchange that may be vulnerable to hacking.
Prediction markets are what enable people to bet on the outcomes of certain events. DeFi prediction markets can offer better odds of winning by modifying the structures of bets. The associated fees are also lower, and market participants can bet on anything in unlimited amounts.
Benefits of DeFi
Defi has several advantages over traditional financial institutions. These are the major benefits:
- Accessibility: anyone with an internet connection can access a DeFi platform. That ease of access means that DeFi transactions occur without any geographic restriction.
- Lower fees: DeFi enables any two parties to directly transact. With no intermediary, transaction fees are significantly reduced.
- Increased transparency and security: because of blockchain, all records of transactions are immutable and available for anyone to review. In addition, the privacy of the participants is preserved as the publicly available transactions do not reveal their identities.
- Functional autonomy: DeFi platforms do not rely on any centralized financial institutions. Traditional financial institutions can face hardship or corruption and declare bankruptcy. The decentralized nature of DeFi mitigates considerably this risk.
Downsides of DeFi
DeFi is an emerging phenomenon that comes with many risks. As a recent innovation, decentralized finance has not been tested on the long term. Some of the risks of DeFi include:
- No consumer protections: DeFi has thrived in the absence of rules and regulations. But this also means users may have little recourse should a transaction go wrong. No similar protections of centralized finance exist in DeFi.
- Software risk: DeFi protocols are software applications that run on the internet with little human supervision. Like all software, DeFi protocols have two main risks: coding errors (bugs) that may cause malfunction, and security vulnerabilities that allow thieves (hackers) to break in and steal funds.
- Collateralization: collateral is a thing of value used to secure a loan. Most DeFi lending transactions require collateral equal to at least 100% of the value of the loan and generally more. These requirements restrict the eligibility for DeFi loans.
- Private key requirements: with DeFi and cryptocurrency, you must secure the wallets used to store your cryptocurrency assets. Wallets are secured with private keys, which are unique codes known only to the owner of the wallet. If you lose a private key, you lose access to your funds. There is no possibility of recovering a lost private key.
In recent years, blockchain has been contributing to the exponential growth of DeFi, causing a disruption in the financial services industry. DeFi is potentially perceived as a cheaper, faster, and more relevant alternative. This new form of decentralized financial technology may eventually impact the future of centralized finance entities.