What is Decentralized Finance (DeFi)
Decentralized Finance, or what is commonly denoted as DeFi, is a broad set of financial tools and applications that are built on top of blockchain systems.
The DeFi ecosystem offers a range of innovative financial services like lending, token issuance, insurance, banking, etc. in an open-source, permissionless, and transparent network. In these types of systems, users get to have full autonomy over their assets while being connected to a whole spectrum of peer-to-peer decentralized applications (Dapps).
DeFi generally requires the execution of smart contracts, a digital agreement bound by computer code instead of legal documents. As such, smart contracts have the ability to self-execute and be able to automate large numbers of business transactions that would have required manual efforts.
Advantages of DeFi Systems
Since DeFI systems are built on top of blockchain networks, they have adopted the same level of security, decentralization, as well as other benefits.
Open systems are great equalizers in the economy. Individuals who normally wouldn’t have access to financial services can participate in these permissionless systems with ease.
Normally, legacy financial services are only available in middle-income and high-income regions because that’s where they are able to profit the most. DeFi platforms have no such bias. Since they exist online, they can be available in any part of the world as long as there is internet access.
In addition, open ecosystems are also censorship-resistant. KYC’s are not even required. Therefore, it wouldn’t matter if you are an adult actress, or come from a low-income family, you can’t be excluded.
No Single Point of Failure
Traditional financial systems have arbitrators and centralized servers, both of which are common attack vectors. A server mainframe could get hacked and system administrators could commit mistakes or deliberately sabotage a system for their own gain.
DeFi applications, on the other hand, run on a network consisting of thousands of devices. This eliminates the single point of failure that normally exists in financial services.
As a consequence, decentralized financial platforms are exceedingly robust and nearly impossible to shut down.
In legacy financial systems, you’d have to canvass several lenders and compare their data in order to get the best interest rates and fees. Moreover, you have to make extra effort to find hidden fees.
Whereas in DeFi systems, you don’t have to go through all that trouble. Important information is stored in the blockchain, which can easily be accessed by anyone. Users can easily shop around for the best DeFi services available, as well as anticipate the risks involved, such as when a stablecoin platform is critically undercollateralized.
With MakerDAO, these risks are easily identified. In banking systems, only the bureaucrats would have access to accounting databases, while the common people are none the wiser. A good example of this is the 2012-13 Cypriot financial crisis, which led the banks of Cyprus to the brink of collapse at the expense of their citizens.
Makes Money Work for You
One of the most attractive features of DeFi is that it allows you to put your money to work. For instance, platforms like Dharma allow users to lend their crypto assets to borrowers and earn interest.
The same system also offers high-interest “savings account” which will not only allow users to hedge their wealth, but also to grow them.
DeFi Use cases
If blockchain is still in its infancy, then DeFi is a ‘fetus’. Yet we have already established use cases that have reformed the crypto space and are unwaveringly disrupting the financial world.
And we’ve only just begun. It’s safe to assume that in a few month’s time, DeFi tech will continue to evolve past even greater heights than what we’ve seen so far.
Lending and Borrowing
Lending and borrowing platforms are one of the most popular types of applications in decentralized finance. These platforms enable anyone to either lend or borrow money, provided that they have enough assets to lock up as collateral.
Decentralized lending and borrowing systems are generally more favorable over their traditional counterparts for several reasons. For one, DeFi platforms allow you to collateralize digital assets like cryptocurrencies, non-fungible tokens (NFT), etc.
Most financial dapps also have instant transaction settlements, which is very convenient. Plus, they require no credit checks whatsoever. For many people, these features are more than enough to switch to decentralized lending platforms.
While it’s true that cryptocurrencies like Bitcoin and Ethereum allow users to send and receive payments across borders, they’ve never been stable enough to use as cash. Most people wouldn’t be too fond of using currencies that regularly fluctuate in value for their daily needs.
There are several DeFi systems that lend stablecoins to users which they can freely use as payment. One particular platform called MakerDAO lets users lock up their assets as collateral in order to generate a stablecoin called DAI, which can be used to top up Visa debit cards using Wirex.
A decentralized exchange (DEX) is a platform that allows users to trade digital assets without the need for a custodian. Instead of letting an exchange take control, DEX users rely on smart contracts to match up the buyers and sellers, as well as execute trades directly through their crypto wallets.
As of 2020, centralized exchanges like OKEx and Binance still hold the vast majority of crypto assets in this space, but that could all change in the future. Decentralized exchanges like Binance DEX, Kyber Network, and others have gained a lot of traction in the past year.
After all, they give users more control and sovereignty over their assets. In addition, they also require less maintenance and have lower trading fees compared to centralized exchanges. With that being said, they still have a long way to go in terms of liquidity, user interface, advanced tools, etc.
Decentralized marketplaces like OpenBazaar are simply e-commerce applications built using a decentralized architecture. You could think of them as Amazon without the Amazon company.
People can buy or sell goods and services using digital currencies. And since there is no central authority, no one has control over your items unlike in eBay or Amazon where you’re at the mercy of the rules of the marketplace.
With this level of autonomy, one might wonder how buyer-seller disputes are settled. After all, once a transaction has been recorded in a blockchain, it becomes irreversible.
And the solution for that is a multi-signature escrow scheme. By creating a 2-3 Bitcoin address, a moderator can be added during a transaction in the unlikely event that the buyer and seller don’t agree. In such a scenario, the moderator or third-party will decide which one he’ll give his vote to.
An issuance platform is a service provider that aims to facilitate the creation, distribution, and management of digital securities. It generally offers an array of services pertaining to KYC/AML compliance, whitelisting investors, security token sale, etc.
Issuance platforms are somewhat similar to securities markets, only they don’t require brokers, investment bankers, or any other middlemen.
One of the most popular security token platforms are Polymath and Swarm. These companies enable anyone to launch their own Security Token Offerings (STOs).
Decentralized insurance protocols enable users to purchase insurance coverages bound by smart contracts. Instead of relying on big insurance companies, a small group of sovereign individuals could simply pool their funds to cover claims.
This removes the need for paying high premiums because it becomes almost a zero-sum game. Smart contracts are not trying to make a profit out of users, unlike insurers.
As of today, insurance is not the most popular application of DeFi, but there are many blockchain companies such as Etherisc that are thriving in the crypto-insurance space.
DeFi Risks and Challenges
Although DeFi offers a lot of benefits that are non-existent to traditional financial products and services, it comes with its fair share of risks and shortcomings. Fortunately, the builders are working hard every day to mitigate and overcome all these drawbacks as much as possible.
Smart contracts are typically open-source, which means everyone has access to their source codes, including malevolent entities. They have have come a long way since The DAO hack, but they still have a lot of room for improvement in terms of security even today.
There have been numerous breaches on DeFi platforms over the last few months, which prove that these systems are not completely secure from hacks.
Security is and should be a priority for financial systems considering that failure usually results in losing several millions worth of user assets.
MakerDAO’s protocol has been reviewed many times by various security research firms to give their users peace of mind. Yet DeFi systems are still fairly new that it’s hard to be confident that any of them can be completely secure from theft.
Systemic risks in decentralized financial platforms normally come down to liquidity and credit risks. If a large portion of borrowers fail to pay back their CDPs (Collateralized Debt Positions) in full, the lenders would not be able to exit.
Another inherent concern, particularly for crypto-collateralized DeFi systems, is that crypto markets are extremely volatile. If the underlying assets locked in CDPs drop hard and fast enough, it could result in mass liquidations, which could lead to a death spiral and/or system collapse.
For now, DeFi systems rely mostly on over-collateralization of assets to mitigate this. By locking up more assets than the amount borrowed, a downward pressure on the asset could be cushioned.
Another precaution is to have a ‘reserve fund’ in case of a “Black Swan Event”. Other financial platforms have their own added unique contingencies as well. However, it would be irresponsible to say that the risk of a permanent shutdown has been eliminated.
DeFi platforms run on top of blockchain systems, which have no access to off-chain data. This unfortunately limits their utility. And the only way to bypass this limitation is to utilize oracles, which give the system access to real-world data such as price feeds, weather information, etc.
In this case, having to rely on an oracle for data would mean to risk having inaccurate or low-quality information. Therefore, the more centralized the oracle network is, the bigger the problem becomes.
Some blockchain systems like Chainlink implement decentralized oracle networks for countering this issue.
The Future of DeFi
It appears that 2020 is still the year of DeFi, with so many projects entering the crypto scene. It is likely that we’ll witness more phenomenal breakthroughs in this sector in the next few months.
If successful, decentralized finance will take power from large financial institutions and hand them over to common individuals. In addition, tedious paperwork and lengthy bureaucratic financial processes will be rendered obsolete.
DeFi will open doors and reach places that the traditional financial services could only dream of as it enables the access of every financial product and service using a smartphone.
Ethereum 2.0 will also play a vital role in bringing DeFi to the next level.