A large part of the hype and success around cryptocurrencies has been fueled by their premise of ‘democratizing’ money. Bitcoin promised a world where money and payments would flow unhindered by a third party’s presence or authority. It was this promise that attracted enthusiasts, users, and even the attention of the world.
The DeFi, or Decentralized Finance movement is a logical evolution of that premise. What happens when you take the idea of decentralized money and apply it to all your financial concepts – from investments to banking and possibly everything else?
What is DeFi?
DeFi leverages the blockchain’s decentralization principles and enables not just democratized money, but democratized financial systems, products, and more.
The DeFi movement is an ecosystem that is based on public distributed ledgers that allow financial transactions to occur without the involvement of a central authority. While the movement only became popular in 2019, it originated well over a year before that. The movement was initially popularised at DeFi Summits and gained a life of its own soon enough.
The Technology that powers DeFi
The backbone of the DeFi ecosystem is the blockchain, first made mainstream in 2008 by Satoshi Nakamoto’s Bitcoin.
Quick recap – the blocks in a blockchain hold data on transactions, such as the date, time, or amount, secured using a unique cryptographic key.
Every new block is linked to its previous one. Thus, a dependency is created – the records strung together like a chain. Since a blockchain exists across a network, a consensus is necessary to validate every transaction, making it transparent as well as decentralized.
The sheer power of the blockchain also lies in the fact it is immutable. Once a consensus is reached to store a record, it cannot be reversed, removed, or changed.
The Ethereum blockchain took this concept further with Smart Contracts, enabling entire programs to be executed on a blockchain. The advantage would be that these would run completely automated, without the need for trust in any third party.
Blockchain – a network of computers
dApps and Smart Contracts
The goal of DeFi is to offer every possible financial service – from loans and microtransactions to insurance and trading – to anyone with a smartphone and an internet connection.
What makes this possible is decentralized apps (or dApps) – that run on the blockchain or peer-to-peer network of computers, without requiring any central authority. Closely associated with dApps is a smart contract, which is software that helps to automatically self-enforce contracts.
Source: Token Economy
For example, if a business sets up smart contracts for auto-delivery of services, it would require a condition to be fulfilled – in this case, payment for the service – and then the rest of the process would be automated. Smart contracts are self-verifying, self-executing, and cannot be tampered with. Credible transactions are performed without the need for third-party interventions.
A clear advantage here is that smart contracts will help eliminate the possibility of human error. They also open up a world of possibilities – from finding use in:
- Financial derivatives,
- Legal processes,
- Insurance premiums,
- Credit enforcement etc.
DeFi can be an alternative to any existing financial service, and offer many new ones, while also offering many advantages:
#1 DeFi is Permissionless
DeFi is permissionless, which means that anyone can create dApps and participate in those transactions.
#2 DeFi Promotes Transparency
dApp code is permanent and transparent. Any regulator can audit the code, and any developer can check it for errors. At the same time, this transparency does not come at the cost of privacy, since transactions are pseudonymous.
#3 DeFi Enables Autonomy
The absence of a central authority gives considerable autonomy to users. The assets in a DeFi system belong to the owners alone and cannot be seized or frozen by anyone else.
#4 DeFi Accelerates Tradeability For All Assets
Thanks to tokenization, any asset can be tokenized and traded. Anything from art to a small portion of real estate can be traded. Imagine fractional ownership of homes and apartments. Or even art pieces. In 2018, a $30 million luxury condo in Manhattan was ‘tokenized’ on the Ethereum blockchain. The possibilities are endless.
For the most part, the terms dApps and smart contracts are used synonymously, but many believe that we should maintain the difference.
Is DeFi Different from Conventional Finance?
Some believe that the rise of DeFi would serve a blow to traditional finance. For one, DeFi is decentralized and removes intermediaries to achieve lower transaction or service costs.
What would this mean for traditional banks?
Traditional finance revolves around a central authority and exists within clearly-defined legal frameworks, while DeFi is open finance and legal frameworks are still being debated. It seems, then, that rather than competing with each other, the two systems would work best if they supplement each other.
For instance, DeFi could help broaden the scope of existing fintech applications and also introduce never-before-seen business models.
DeFi in the Real World
In the real world, the most significant areas where DeFi is being used currently are:
- The creation of monetary banking services,
- The provision of P2P lending or borrowing platforms, and
- The enabling of advanced financial instruments like derivatives and tokenization platforms,
- Decentralized exchanges,
- Asset management, and
- Borderless finance.
Much like using KYC for identification, DeFi-based solutions are helping businesses monitor, track, and analyze transactions. This helps to prevent fraud – something that has been a challenge for non-crypto digital transactions.
Another aspect to appreciate is that since blockchain has already solved the problem of double-spending, DeFi is built upon a robust and lasting technology.
Multiple projects have come up over the years, each trying to achieve a solution to realize the many possibilities of DeFi.
This project is built upon the Ethereum platform – the most popular platform for DeFi projects. It provides both developers and users with a single point of integration to access all DeFi protocols.
In other words, smart wallets can interact with DeFi products. Any developer can build products or business models, and be assured of security and composability. By October 2019, Instadapp had recorded over 26,000 transactions from more than 4500 users.
The Lightning Network protocol operates on Bitcoin, and as the name suggests, it aims to solve its scalability problem – in this case, the ability to process high-speed transactions.
The Lightning Network achieves this by adding another layer to the Bitcoin blockchain. It is this extra layer that is used for transactions. If successful, this could enable instant micropayments with a minimal fee for anyone with a smartphone and internet.
Dai has been claimed to be the world’s first unbiased currency. It is decentralized and essentially a stablecoin project. Stablecoins are cryptocurrencies that are pegged to stable real-world currencies such as the US dollar. Such a project aims to protect DeFi services from market volatility – an advantage that earlier cryptocurrencies like Ethereum and Bitcoin could not offer.
Despite its promise, DeFi faces the challenges all new, promising technologies share in delivering substantial breakthroughs. In DeFi’s case, it’s in mainstream finance. The reason is, it’s not so easy after all.
To begin with, the tech is in its early stages, and it is difficult to place so much trust in something that isn’t fully understood. The risks are relatively high, and there can be general apprehension about it.
- Over two years ago, $300 million worth of ETH was lost forever due to errors in the code, as a developer accidentally took control of many wallets, and in an attempt to undo this, locked up the amount permanently. This incident exposed two significant challenges – smart control vulnerability and user error.
- Governance remains another aspect that requires significant coordination and deliberation. External governance, legal issues, and internal governance need to be considered – something that users often do not think about.
- Yet another example is that of market volatility. Several DeFi applications may depend on markets, and unpredictable markets could prove to be a challenge.
The Future of DeFi
A larger part of DeFi’s potential applications are futuristic, but quickly making their way to reality and measurable adoption. Despite the challenges to overcome, an equally enthusiastic developer community is intent on achieving solutions. For example:
- Atomic swaps are helping to solve the problem of interoperability.
- Stablecoins (cryptocurrencies that attempt to maintain a stable value against the US dollar) could potentially solve the market volatility problem.
2019 was already considered the year of DeFi. Some believe 2020 will be too.