Finance has been one of the most interesting innovations by humans. Beyond the concept of money being used as an instrument of a transaction, finance put science and data studies into managing large amounts of money, especially by corporate entities and governments.
For a long time, finance has always been centralized. There was some regulatory body like the government or a bank controlling finance… until recently!
The digital, decentralized, and immutable ledger called the blockchain has brought a completely new perspective to finance evident in the heralding of cryptocurrency. The entry of cryptocurrency and the increase in the adoption of the blockchain technology by tech giants like IBM and finance leviathans like JP Morgan has prompted a lot of enthusiasts and the world at large to look at decentralized finance, commonly abbreviated DeFi.
What is decentralized finance?
Finance as we know is not just a single entity but an ecosystem made of multiple elements that add up to the grand total. Similarly, decentralized finance also refers to an ecosystem of financial applications. The only difference between classical finance and DeFi is that all the apps are built on the top of blockchain networks.
The meaning of DeFi is to create an open-source, transparent, and completely permissionless financial ecosystem that functions beyond borders and without the intervention of any central authority. It aims to facilitate peer to peer interactions through decentralized applications.
What are the main advantages of decentralized finance?
The biggest benefit of DeFi is that it facilitates easy and borderless access to financial services. It brings all the benefits of today’s networked finance to places where the current banking system hasn’t reached yet. It opens up a lot of opportunities for places that intermediaries classified as low-profit communities. DeFi is modular and interoperable. DeFi applications have the potential to create new finance products, services, and an entirely new market!
It is to be remembered that decentralized finance has the capacity to bring all the advantages of its parent technology, the blockchain. It does not need any intermediaries or arbitrators, both of which translate into additional costs in traditional finance. This also ensures that the users maintain complete control over the funds at all times.
Since the entire ecosystem is built on the blockchain, the possibilities of encountering single-point failures are illuminated. Since the entire data is spread across all the nodes of the blockchain, it makes censorship and shutdown almost close to impossible, or at least, extremely complicated. It also enables fast deployment as all the apps can be built in advance.
What are the potential use-cases for DeFi?
Almost every financial service handled by today’s ecosystem can be handled by decentralized finance as well.
Borrowing and Lending
The landscape of borrowing and lending could be revolutionized and completely transformed by introducing DeFi. Open letting protocols are one of the most popular and expected applications in the DeFi ecosystem. Decentralized borrowing and lending have many advantages over the traditional method of doing the same, including instant transaction settlement, collateralization of digital assets, elimination of credit checks, and possibly, a standardized procedure in the near future.
Since the entire process happens over public blockchains, the amount of trust required is quite minimal. The smart contracts enable establishing trust by using cryptographic methods of verification. This also reduces the costs involved in establishing trust through arbitration, the possibilities of counterparty risk, and overall, makes the entire process of lending and borrowing faster, cheaper, and more available.
Monetary Banking Services
Finance today immediately conjures up doubts about banking. Decentralized finance can issue stablecoins, mortgages, and insurance just like a traditional bank would.
Stablecoins deserve a special mention here because one of the most dubious attributes of cryptocurrency is its volatility. Stablecoins, however, unlike other crypto assets is stable in terms of value and can be transferred in the digital realm with the utmost ease. Stablecoins have the potential to be used as instruments of everyday transactions, bringing decentralized finance closer to reality.
Smart contracts can effectively replace intermediaries. This makes sure that the usually expensive and time-consuming process like mortgages are completed almost instantly. Smart contracts can be expected to bring down the fees related to underwriting and legal processing. Just like mortgages, even the insurance domain can do away with intermediaries, resulting in lower premiums without compromising on the quality of service.
Perhaps the most practical, challenging, and congenial-for-innovation arena when it comes to DeFi is decentralized marketplaces. One of the most common manifestations of decentralized marketplaces is what the world knows as decentralized cryptocurrency exchanges.
These platforms, just like any other crypto exchange, allow traders to transact digital assets without the involvement of a trusted intermediary to hold their funds. The trades are effected directly between the users, enabling true smart contracts. Decentralized exchanges ensure that users are always in complete control of their crypto funds. Since they do not demand a lot of maintenance work, the transaction/training fees are lower in decentralized exchanges than their centralized counterparts.
Needless to say, decentralized exchanges bring all the advantages of blockchain, cutting out custodians, the costs, and illuminating the possibilities of single points of failure. The same set of advantages can be extended to security token issuance platforms where tokenized securities can be launched for procurement on a blockchain with a lot of customizable parameters. It also opens up possibilities for creating derivatives, prediction markets, and synthetic assets.
What role do smart contracts have in DeFi?
So far, we have been talking a lot about costs being saved by the elimination of intermediaries. Intermediaries perform the difficult task of establishing trust between the transacting parties. The role of these intermediaries is handled by smart contracts. The third-party trust-enabling entities use legal contracts to specify the terms of the relationship. In a similar way, a smart contract uses a computer code.
The smart contract, however, goes beyond the just specification of terms. It can enforce the terms through the same code and can be programmed to execute itself upon certain conditions being fulfilled. Smart contacts can automate a business without requiring any manual supervision.
The smart contract, in essence, is a self-executing code that governs the terms and conditions of a financial transaction and the relationship between the transacting parties. It makes the entire process faster and easier, and also reduces the magnitude of risk.
What challenges does DeFi face?
The biggest challenge with respect to DeFi going mainstream is the smart contract itself! Smart contracts, on paper, do present a lot of advantages, but at the end of the day, it is nothing more than computer code. It also faces vulnerabilities, and it is possible that the value and the confidential information logged in smart contracts could face this risk.
Blockchain is a nascent technology and it is just over a decade old. It faces a lot of performance issues, and they are inherently slower than what their centralized counterparts are capable of. People who develop DeFi applications should take this into consideration and ensure that the products they build are optimized for this level of performance.
Intermediaries have been thriving and existing for a reason… No finance genius will want to spend their money on something that does not hold any value! The intermediaries have been responsible for upkeeping the trust in the transaction. When these intermediaries are eliminated, there is an increased risk of human error. There is a possibility that products that minimize the risk of human errors can be designed on the top of immutable blockchain. However, it will take some time before those products see the light of the day.
The immature nature of the blockchain and the decentralized ecosystem means that it could be challenging to find a product or an application that is suitable for a specific use case. It requires a thorough knowledge of both finance and technology in addition to the newest products to find the best for you! When you build a product, it is not just about the development skills involved but also about how perfectly they can fit into the existing DeFi ecosystem.
The success of most products that are in vogue today can be attributed to usability. However, most DeFi applications require extra effort from the user. If a user does not see a tangible advantage in shifting from the traditional banking system to the DeFi ecosystem, they might offer resistance to move from their well-established comfort zone.
What is the difference between DeFi and open banking?
If the difference can be encapsulated in a single sentence, it could simply be said that Open banking is still centralized. It is a banking system that third-party financial service providers are provided with access to financial data through secure APIs. Open banking enables networking and data transfer between banks and non-banking financial institutions. This enables hatching of new products and services but within the traditional centralized financial ecosystem.
DeFi, however, is not an extension or an improvisation but a completely different financial system that is independent of the current infrastructure. DeFi is beyond open banking,it is open finance!
Decentralized finance is the usual revolution that any technology-enabled sector undergoes. While until now, technology has only been focused on making the existing banking processes better and the traditional finance more accessible, DeFi builds a whole new world altogether.
Just like any other innovation, this one as well should be considered with a pinch of salt. Decentralization might look lucrative on the surface but it does have its fair share of disadvantages. The good news, however, is that all these disadvantages can be handled with the growing knowledge and improvement in blockchain technology.
DeFi has the credentials it takes to displace the financial power currently in the hands of large centralized organizations and place it directly in the hands of users, or at least, an open source community. It might seem like a utopian dream, but it is getting closer to reality than all of us imagined it to be!