Over the last couple of years, decentralized finance (DeFi) solutions have taken the world by storm. Their popularity has been rising so much that traditional finance businesses are all looking to develop DeFi applications of their own.
While the benefits of such decentralized applications are diverse, it's always worth starting with the basics and understanding how decentralized finance works.
How a decentralized financial system works
To explain how decentralized finance (DeFi) technology works, we need to look at the three key components; blockchain, smart contracts, and cryptocurrencies.
Blockchain technology works by offering a centralized ledger. Any new transaction is verified through the peer-to-peer network over an internet connection. Once approved, these transactions are loaded into blocks of data, which are then added to a ledger - the eponymous "blockchain" itself.
But who controls the blockchain? The question of control is a very important and naturally valid one; especially in decentralized finance. DeFi's answer to this is the use of governance tokens. These tokens can give certain users more control or power over the blockchain.
Smart contracts are essentially the counterpart to the blockchain ledger. A smart contract is essentially a digital document or agreement that is backed up by automated verification processes. This is possible due to the benefits of the blockchain ledger.
When it comes to digital funds that differ from traditional intermediaries and banks, there are two main types of cryptocurrencies.
Stablecoins are the digital money formats that have values matched against that of a fiat currency. DAI, for example, has a value equal to the value of 1 US dollar. Its value is the same, but it's still a currency of crypto assets; their value is supported by cryptocurrency collateral, rather than direct backing from the US government and its financial reserves. As we'll cover later, there are good and bad elements to this.
On the other hand, there are crypto assets that are not backed by such means, and therefore don't fall into the stablecoin subset. Bitcoin is a classic example. Due to increased popularity and activity over the years, such as excessive yield farming, investing and trading, the value of a singular bitcoin unit increases and decreases via a mutual consensus mechanism. Its value is determined by the market; specifically, how much people are willing to pay real money for it.
If you're interested in looking at the various finance options on the market, we highly recommend DeFI Pulse.
Explaining Decentralized Finance (DeFi)
Decentralized finance applications and systems work differently to traditional finance because they replace key components. In traditional systems and their respective financial applications, all transactions must go through a centralized infrastructure - here, that would be a bank of financial institutions - and a controlled unit of measurement. In this case, the latter refers to fiat money. Under this system, all transactions take place via centralized exchanges.
The DeFi community, however, uses the blockchain ledger to enable decentralized exchanges. As it's a peer-to-peer network, all transactions are nonetheless validated, but no one user "owns" the ledger. However, this also means that decentralized apps can't rely on fiat money alone, as its value is tied to the official institutions. This is where cryptocurrencies are heavily used. In fact, blockchain technology as a whole only gained popularity alongside the rise of crypto space, and applications like this are why bitcoin, the ethereum blockchain, and a growing future for decentralized exchange in finance.
What about fiat currency?
We just mentioned that a decentralized finance (DeFi) system doesn't use traditional currency, such as the US dollar, so how can a DeFi application hope to reach the large-scale market?
That's simple to answer: digital conversions are already available online. While your typical bank account isn't going to support such digital assets any time soon (although many banks are looking into their own cryptocurrencies and associated financial products...), there are numerous businesses and online services for exchanging fiat money into this modern digital alternative. As such, DeFi workarounds are already available, by enabling and supporting this transaction system. We also have stablecoins (as mentioned previously, and many of which are on DeFi pulse, so you can see how well they're doing) too, which helps in situations where a wildly fluctuating value isn't welcome.
How is this better than typical financial institutions?
As the term decentralized finance (DeFi) implies, the key benefits of defi applications lie in their decentralized nature.
In the past, these centralized exchanges were necessary as the banks and governments needed to support a consistent fiat currency. Their role as validators and legal guardians was greatly appreciated, but in today's world, many people (most notably those highly interested in DeFi) feel that this is becoming more of a problem.
Yet this is an overstatement, as they nonetheless still offer a centralized exchange platform. The peer-to-peer network is immutable and secure, yet it doesn't give anyone party more power over the other.
Examples of DeFi Applications
Now that we've explored the basic working premises of DeFi applications and their core components, let's discuss some common areas where such financial services may be deployed.
For example, a DeFI application could act as an intermediary with other systems that you need to use. In the past, you had to connect with your bank, insurance provider, or any other organization with which you wanted to conduct a transaction or otherwise pay for their services.
When it comes to buying and selling assets, the blockchain technology underneath defi applications has key benefits, but that's the tip of the iceberg. Using something like the ethereum blockchain, for example, means that transactions that take place on a neutral ecosystem, are fully verified and secure. What's more, they can also support a transaction for a digital asset, as well as physical assets, which will become an increasing concern in the future.
The one thing for any aspiring DeFi business to take note of here, however, is that such services should be backed by a stablecoin. While users don't want to rely on their bank, a stablecoin will ensure that the value of the asset - not the value of the currency - is maintained.
DeFi apps have already made a name for themselves with decentralized insurance, and continue to do so as the uses of digital money are quickly replacing the paperwork-heavy system of the typical insurance sector. Even without the need to transfer funds, the insurance sector is often plagued by the need to validate property, document activities, and maintain evaluations. And that's not to mention the added fact that there are multiple parties when you consider underwriters.
A blockchain-based smart contract provides an ideal financial service here. With this decentralized insurance, all parties can work together in a process that is quicker, easier, and mostly automated. All parties would also have access to a single source of truth, removing any doubt or elements of distrust.
The added use of smart contracts can greatly enable peer-to-peer lending via decentralized finance. Right now, the need to legally reinforce loans through financial institutions makes borrowing difficult, but smart contracts can add an easy way to verify and authenticate transactions. Without the paperwork or system behind it, P2P lending could become much more commonplace in the future.
It can also help in supporting both secure and unsecured funding, due to the use of smart contracts. Thanks to the ledgers behind them, DeFi loan applications can verify and track not only the total value of money being processed but also the rights and ownership of physical collateral involved.
And if that wasn't enough, we can also look to the speed and automated nature of DeFi protocols. This makes them ideal for flash loans. A smart contract can verify loan applications and then ensure payments are near-instantly made. Such flash loans could make waves in the financial services sector with their ability to cut through most of the paperwork and the typical "X to Y working days" policies still in place.
Of course, the DeFI apps and tools specializing in the loan sector may try to earn interest of their own, rather than providing a free service. It's the central app and respective business that will need to hold the governance tokens but, in these roles, they basically act as escrow holders to oversee processes and provide access to their service.
Investments and Interest
Similar to loans, we can also look at DeFi applications when it comes to investments and interest. For the former, we can once again track the ownership of collateral or, furthermore, the transaction of shares, rights, and other intangible assets. This is an area that DeFi takes in its stride, since the core technology is built around it, and additional applications can provide usability, automated verification, and, of course, secure access to such systems.
Earlier, we mentioned that DeFi services can convert traditional money into digital assets via numerous exchanges that exist in the world. This in itself is also becoming a growing market in its own right. Users can use such services to freely exchange national currencies without fear of market manipulation.
This is due to the automated market maker inherent in decentralized finance applications. The AMM draws funds from liquidity pools, which enables fast conversions. Similarly, the peer-to-peer nature of DeFi protocols also means direct exchange is possible; the smart contracts can act as a third party or escrow service, but in a much faster and affordable way than the traditional financial system would allow.
What's more, they can also allow users to buy and sell in all manner of cryptocurrency funds (take another look at DeFi Pulse!) to earn interest or potentially make a profit.
What about the risks?
When it comes to DeFi risks, one of the biggest criticisms is that, due to the lack of a centralized system and institution, such cryptocurrencies aren't reliable. Specifically, critics of a crypto ecosystem will point to the fluctuating value of bitcoin, as well as other early digital assets, as a warning. When the total value changes so wildly, it becomes a risk.
However, the counterargument to this is that such a system has its own built-in consensus mechanism; the public. Users of the cryptocurrency, whether it's the bitcoin blockchain, the ethereum platform, or something else, as well as the digital services and business applications built on top of them, mutually determine the total value of this digital money. It's free from governments changing interest rates, adding inflation, or decreasing its value due to lending between nations.
Furthermore, you'll also find many "stablecoins" on DeFi Pulse. These are crypto assets that have a value tied to fiat money. This way, DeFi solutions have the choice of which currencies to use for their needs.
There's also the main challenge of legal recognition. In many parts of the world, there is some form of financial institution act that determines who can and cannot conduct certain services, such as providing loans, offering a bank account, conducting transactions, and more. Naturally, this has previously gone to traditional financial services, such as banks, loan providers, and insurance agencies. Decentralized finance, especially with its peer-to-peer potentially, is an immediate disruptor to the status quo.
Are You Ready?
Decentralized finance is a big topic, and this barely scratches the surface of its potential. However, the building blocks, such as ethereum blockchain, smart contracts, and other ledger-based solutions, are developing at a rapid pace, with many companies investing in this technology. As they do so, decentralized finance will become more and more commonplace. We can't wait to see what's next!