DeFi stands for Decentralized Finance. It is a fast evolving utility that provides various financial services similar to your bank like lending, borrowing, liquidity farming, interest bearing savings plan, albeit, with your digital assets and a high level of decentralization. To understand decentralized finance more, we have to understand centralized finance first.
In Centralized Finance, the banks, mutual funds, wealth management companies among others hold your money as your custodial authority. It is no secret they make more money using your money and fairly so to a reasonable extent. Let’s say you are purchasing a mobile phone using your credit card. The card details are then sent to the merchant’s bank for verification. This is followed by banks relaying the exact information to the credit card network for clearance. The credit card network checks your balance, eligibility among other factors and processes the request. Once all details are confirmed, the network sends a confirmation to your bank regarding the transaction.
Both the credit card network and bank receive their share of money for providing services to you. And lastly, you pay the outstanding amount on your credit card on a regular basis to keep using the service. Be it for a simple transaction like this or processing your loan application, the banks have an overreaching control on which application they approve. They could give preferential treatment to someone while unfairly working against others. Yes we are all humans and such bias at times comes with nature. Now, this is where Decentralized Finance can be a big difference.
Decentralized Finance & How It Works
Decentralized Finance, theoretically, allows individuals and businesses regardless of their background to take advantage of various financial services offered by crypto projects through open-source technologies like blockchain. The technology, in turn, makes use of its natively embedded smart contracts to automate the process of such services. So, as you see here, there is no requirement of an intermediary to take decisions for you.
DeFi makes use of technologies like blockchain to run transactions on digital ledgers that are distributed and validated by a peer-to-peer network of computers (or nodes) across the world. Transactions are confirmed and updated by independent validators (nodes) through a trustless and secure consensus mechanism to prevent manipulation or collusion by bad actors. The transactions are updated on an encrypted block that can typically store a large but limited amount of data at a certain speed. Once a block hits the upper limit on a network, it is appended to the previous block in chronological order. Information in the previous block cannot be changed making the blockchain network immutable and secure from data tampering.
Today, you can achieve a high level of decentralization and security with Web 3.0 technologies like blockchain, hashgraph, DAG etc. that also aims to process transactions at a comparable speed or beyond that of its centralized peers like Visa, PayPal etc. Further, they provide maximum privacy to its users while being responsibly transparent to agencies like law enforcement when needed. Remember, although the transactions are stored cryptographically, they are stored on open-source technology. This is a win-win for all parties provided underlying crypto projects are committed to upholding the three fundamental principles of Web 3.0 — decentralization, security and scalability.
What Currency is Used in DeFi?
Unlike traditional centralized finances, DeFi’s primary currency is cryptocurrency that is used as collateral, interest earning deposits, for swapping, trading etc. The industry has grown to a point where a vast majority of crypto users are earning passive income by subscribing to various interest-bearing savings and staking plans similar to your banking solutions. As of this writing there are around 3000 cryptocurrencies in the market backed by decentralized projects/foundations and are largely self-governed by each of their community members (public).
A vast majority of DeFi solutions are built as layer 2 solutions on top of layer 1 blockchains like Ethereum through smart contracts. As per Investopedia, a smart contract is a self-executing contract with the terms of the agreement between buyer and seller being directly written into lines of code. The code and the agreements contained therein exist across a distributed, decentralized blockchain network.
With an overwhelming institutional interest seen in DeFi in recent years, the industry was already worth $100 billion by mid 2021. Fiat currency, in contrast, play a smaller yet valuable role in the DeFi world by allowing ordinary people/investors to buy and trade cryptos using legal tenders like the USD or Euro. Users also use legal tenders to buy ‘stablecoins’. They are crypto coins transacted on a blockchain and are backed by more stable securities like USD reserves or gold. The largest stablecoin in terms of market cap, Tether or USDT, for instance, is pegged 1-to-1 with US Dollar. This enables users to buy and trade more volatile cryptocurrencies with a stablecoin that behaves like fiat currencies for instant clearances and prevention of huge losses from slippages.
What is the Future of DeFi
The future of DeFi is interesting and challenging with few generic issues which the industry seeks to overcome in due course of time. Today Web 3.0 that includes DeFi mostly functions on technologies like open source blockchains. Although they have major advantages over its traditional peers as explained above, they are not perfect. As we speak, blockchain for example, suffers from a vicious problem of ‘scalability trilemma’. It refers to blockchain’s inability to allow all its three fundamental principles – decentralization, security and scalability — to coexist at the same time. It further states that one of three principles have to be sacrificed at any given time.
Today, established cryptocurrency networks like Bitcoin and Ethereum are slow and expensive when compared to say Visa or Paypal. The more recent crypto networks are much faster but they are finding it difficult to keep a high level of decentralization and/or security. Further, the DeFi and crypto industry in general is not regulated like the stock market or banking. DeFi is aiming to facilitate borderless transactions that are inexpensive and easier compared to the current remittance system but we are not yet there.
Without regulations, DeFi is vulnerable to rug pulls (a term used for projects that crowdfunds money for seemingly legitimate business cases but end up running away with the money) and a high degree of financial arbitrations/slippages. This is on top of crypto’s infamous volatility issue. Yes, these are some of the challenges in front of the industry to be overcome before it becomes mainstream. But challenges are completely fine when it comes to breakthrough technologies or innovation, right? How else will we know there is more than enough demand for say, privacy or financial opportunities?
Make no mistake, this industry is just over a decade old and there are several projects and nonprofit foundations along with their community aiming to solve today’s issues, and compete with traditional institutions and eventually overtake them. In fact, legacy institutions like banking and money transfer institutions like JP Morgan and Paypal have already launched their entry into DeFi space. As institutional investors are showing, crypto industry-led decentralization is here to stay to transform archaic architectures of traditional finance, healthcare, real estate, government institutions, print media, social media among others. The work is on us to deliver and serve billions of under-represented and under-served people ultimately through truly disruptive innovations like DeFi.
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Opinions expressed in this publication are those of the author(s). They do not necessarily purport to reflect the opinions or views of Shardeum foundation.
About the Author : Snehasish is a Full stack Developer and a blockchain enthusiast who is eagerly setting his foot in Web 3.0. He further blogs about Web 3.0 on his website