Decentralized Finance (DeFi) is a term that has been taking the cryptocurrency ecosystem by storm since the mid-2020 when projects like Compound, OMG Network, and Avve gained increasing popularity due to the myriad of possibilities they opened to investors of all levels.
But why did these platforms create such a stir among cryptocurrency enthusiasts?
In short, DeFi has created the potential to move away from centralized banking services, not only for payments but also in a holistic sense.
Specifically, What is DeFi (Decentralized Finance)?
Decentralized Finance (DeFi) is a new financial ecosystem built on decentralized blockchain networks that offer similar financial services previously available through traditional bank services and centralized financial institutions.
Historically, financial services have been accessible only to a privileged group of people depending on different factors like work situation, nationality, capital requirements, location, lifestyle, security concerns, and regulatory compliance.
These barriers prevent people worldwide from accessing financial services to take advantage of saving and investing opportunities. While these ideas may seem esoteric, they have a significant impact on billions of people.
According to the world bank, one-third of adults around the world, equivalent to more than 1.7 billion people, have no access to banking services. With banking being one of the most basic financial services in the industry, other services are more than likely to be less accessible than it.
These difficulties in accessing financial services originate from the centralized nature of traditional financial systems. Not only do financial institutions have to comply with local regulations, but they also look after their own interests and, as such, restrict access depending on what they consider risk factors.
Using blockchain technology, individuals and organizations can create highly automated, decentralized, and secure platforms to provide users with the same benefits as traditional financial systems, allowing them to be part of the global financial market.
But accessibility is not the only benefit that Decentralized Finance brings to the table as their digital nature, and lack of central authorities means that they can be easily integrated into each other to create complex systems that can fulfill different purposes.
There is no need to go through the bureaucratic processes centralized and traditional institutions require, which means faster transactions globally, and much lower costs, at least in theory.
DeFi’s potential to revolutionize financial markets drove the success of the movement in 2020 and early 2021, allowing it to go from $989 million in locked value to $40.29 Billion in just a year.
The Benefits of DeFi
The DeFi sector has a dominance of over 15% in the cryptocurrency market at this time, which is impressive for a niche that could arguably just started forming back in 2020. But what are the benefits of DeFi driving this trend?
As previously mentioned, DeFi does not have a central authority. With no central authority, this means, there are no intermediaries or arbitrators required as the platforms automate transactions by using smart contracts.
While we will talk more about smart contracts later on, for now, it is sufficient to say that they are digital contracts that can automatically execute an outcome depending on the fulfillment of its conditions.
This decentralization not only allows DeFi systems to be frictionless but also trustless. As no intermediary can change the outcome depending on their opinions or convenience, and both parties agreed on the conditions upfront, there is no need for trust between the parties as the system ensures neutrality.
Another benefit of this decentralization is that it eliminates single points of failure as the platform runs across multiple machines (nodes), ensuring the platform’s continued access and functioning as long as it has supporters.
Decentralization also prevents censorship or interference from governments on third parties, as well as changes to the platform only wanted by a minority of participants. In other words, DeFi makes finance fair and eliminates unfair advantages that centralized authorities currently have.
While DeFi systems generate gains for the platform, these gains are used to incentivize users who are participating in the ecosystem and ensuring its functionality, not a for-profit entity that can take advantage of the platform’s success.
If the projects grow, it is the users who benefit from it, not the entrenched interests.
As DeFi platforms are not located in a specific location, they can offer their services to any person who has access to the internet without discriminating based on any of the entry barriers required by traditional financial institutions.
Other benefits of DeFi include lower costs, a broader range of financial services, being community-driven, fasts settling-transactions, high levels of transparency, and increased security when compared with centralized platforms.
How Is DeFi Being Used?
Unfortunately, it is not really possible to list all of the applications DeFi has at any given time as it is a fast-evolving ecosystem where developers are constantly finding new approaches, integrations, and use cases.
A comprehensive list of the use cases for DeFi would include the following:
- Asset management
- Compliance and Know-Your-Transaction (KYT)
- Decentralized Autonomous Organizations (DAO)
- Data and analytics
- Developer and infrastructure tooling
- Decentralized Exchanges (DEX)
- Lending and borrowing
- Margin trading
- Monetary banking services
- Prediction markets
- Synthetic assets
- Trading, and many more…
The difficulty of defining use cases is also increased by the fact that DeFi is an umbrella term that covers a broad range of uses and philosophies, with some platforms being only partially DeFi. However, some use cases are the most popular and the ones that most users will be attracted to, so let’s talk about some of them.
Borrowing & Lending in DeFi
When it comes to borrowing, this is one of the most difficult services to get access to with traditional institutions due to barriers like credit history and salary, making it one of the most popular applications of DeFi.
By using open and decentralized protocols, DeFi platforms allow users to access loans instantly and collateralize their assets without any of the traditional barriers, creating new financial opportunities for people around the world.
Those interested in generating passive gains by lending their assets can also take advantage of these platforms by removing the need for trust between them and the borrower, having a wide range of assets they can lend, and reducing counterparty risks.
Platforms like Aave, Compound, Maker, and Darma, are popular options for those looking to lend or borrow crypto assets.
Decentralized Exchanges (DEXs)
Another application that is growing in popularity, DEXs are the decentralized version of traditional exchanges like Binance, Kraken, and Coinbase. While they are not limited to cryptocurrency, crypto exchanges are the most popular for DEXs.
The use of DEXs allows investors to quickly trade cryptocurrency without the need for registration processes, Know-your-Customer (KYC) requirements, and the paying of fees to the exchange runners.
Decentralized Exchanges usually have a wider listing of cryptocurrencies available, making them an excellent choice for investors looking to jump early on recently-created projects.
While DEXs have lower fees and transaction times and reduce risk by removing single points of failure, they also imply more risk when it comes to user mistakes as no central authority can intercede on behalf of the users if a mistake occurs.
Uniswap is the most popular DEX at this time, but other platforms like 1Inch, PancakeSwap, Mdex, and Sushiswap have gained popularity over the last months.
DeFi Savings Account
While not as popular as other applications, DeFi saving accounts are starting to emerge and be offered by big players in the crypto space. These platforms allow users to deposit fiat or crypto in their virtual saving accounts to generate higher interest than traditional saving accounts.
Different platforms use different approaches but most of the time they make use of lending pools to generate gains on behalf of the account owner, as well as yield farming and other strategies.
Different platforms use different approaches but most of the time they make use of lending pools, yield farming and other strategies to generate gains on behalf of the account owner and token holders through.
Popular platforms in this use case include Argent, Dhara, and Pool together, but the list continues to expand as exchanges like Gemini start to offer these services.
While tokenization has been around in the crypto ecosystem for years, applications on financial services have continued to grow over the last months. By creating a virtual representation of any kind of assets in the form of a token, tokenization platforms can create new ways to interact with them over blockchain networks.
The tokenization of assets can range from collectibles in video games to financial assets like gold and shares, adding the benefits of being easily transferable, divisible, and transparent by representing ownership over the asset and tracking its changes.
Applications of tokenization can be seen in industries like insurance, real estate, derivatives, and participation.
The tokenization made Ethereum the most popular blockchain network for developing tokenization projects and DeFi as a whole, as the abstraction it provides goes beyond cryptocurrency.
The Technology Behind DeFi
Decentralized Finance is the result of years of technological innovation in the software industry but mainly the development of blockchain technology. By distributing computing power needs, data storage, and consensus among many nodes, blockchain allows the decentralization of systems while providing high levels of transparency.
Every node in a blockchain network can see the status of the entire network at any given time, which means that it is theoretically impossible for a single entity to manipulate the data or status of the network.
Nodes communicate with each other every time a new transaction occurs in the network, reaching a consensus on the validity of the transaction and approving/denying it depending on the assessment.
We also mentioned smart contracts earlier in this article and the role they play in removing the need for intermediaries for the users of a platform.
What Exactly Is a Smart Contract?
A smart contract is a contract defined in code, a piece of software that can determine, evaluate, and enforce the conditions established beforehand without the need for intervention from any other party.
If you were to bed with a friend on the result of a football game, a smart contract would automatically give the earnings to the winner without any of the parties being able to retract from it. Of course, this would require both parties to escrow their part beforehand.
This automation and impartiality provided by smart contracts powers DeFi systems by allowing users to use all of its use cases without worrying if other parties are acting in bad faith. As long as the conditions established in the contract are fair, the other party can’t take advantage at any point.
The benefits of using smart contracts on DeFi applications include autonomy, trust in the platform, safety, backup, high speed, increased accuracy on the outcomes.
By combining Smart Contracts with other tools like Oracles, developers can create complex systems that are not limited to the data contained in the network, allowing them to act as a bridge between different networks, protocols, apps, etc.
In terms of financial services, these qualities of smart contracts allow them to effectively replace financial institutions that have played the role of mediator for most of human history, giving the power back to the users and preventing bad financial practices to create economic crises.
Ethereum’s Role in DeFi
It is currently impossible to talk about Decentralized Finance without mentioning Ethereum. It has been the most popular blockchain network in the development of the niche and its growing popularity.
If Bitcoin paved the way for cryptocurrencies and blockchain networks like Ethereum to emerge, Ethereuum did the same for multiple applications such as Decentralized Finance.
Ethereum is not limited to using smart contracts to settle simple transactions like transferring a cryptocurrency from one person to another. It also enables users to create their own cryptocurrencies, creates private networks that can interact with each other, customize smart contracts, and much more.
You can think of Ethereum as a Lego set and DeFi as one of the many things you can build using its pieces.
The rule of Ethereum as the leading smart contract blockchain network allowed DeFi to take advantage of the trust the network had created over the years and its multiple features. Ethereum allows new platforms to interact and collaborate to offer a wide range of services within its ecosystem.
ETH Gas Prices Explode
However, the popularity of Ethereum for Decentralized FInance was not entirely positive. While the symbiosis truly benefited both the network and the platforms which used it, the popularity of DeFi created congestion and high transaction costs for everyone using the network.
High gas prices resulted in niches such as blockchain gaming and other users who use the network to perform low-value transactions unable to use the network. Would you pay $10 to transfer or pay for a service worth $20?
Ever since the booming of DeFi, Ethereum users have been dealing with not only increased fees and but also slower transaction settlements. As a result, some dApps (Decentralized Applications) have decided to migrate to other platforms or use Layer 2 (L2) solutions built on top of Ethereum to bypass the performance issues and high gas prices.
The development team behind Ethereum is currently working on Ethereum 2.0, an upgrade to the network that is expected to solve these issues and open the door for new applications for the network. With delays in Ethereum 2.0 release date, there is still a lot of speculation on the future of Ethereum and DeFi on Ethereum.
DeFi’s Role in the Blockchain Ecosystem
While the Ethereum Network and applications running on it have been facing challenges over the last months, this does not mean that DeFi is not increasing in popularity and continues to provide more services than ever.
While Ethereum is far from done as it is still the most popular blockchain and can continue to operate, the struggles it experienced due to the increasing load provided by Defi have resulted in new blockchain networks gaining traction.
Projects like Aragorn, Tron, Algorand, and Matic, have been attracting some of the platforms that have decided to migrate from Ethereum, forcing them to offer more benefits and improve their infrastructure.
Other projects like Polkadot and Cardano, built around the ideals of scalability and performance, have been gaining relevance in the blockchain industry despite not being entirely developed.
Decentralized Finance has played an important role in powering the blockchain industry since early 2020 by creating a competitive ecosystem full of innovation, and users receive the benefits.
The Future of DeFi
While it is impossible to predict the future, DeFi seems to be on a path toward increased adoption and continued growth. More people see the benefits of decentralized systems and take control over their financial assets while also losing trust in traditional institutions.
However, while DeFi’s future seems bright, it still has multiple challenges to overcome before becoming mainstream and offering a real alternative to centralized systems for most people. Some of these challenges include the poor performance previously mentioned, user error risks, bad user experience, need for technical skills, and complexity.
There is no such thing as a perfect system, and while DeFi provides multiple benefits of decentralization, the opposite is also true. One of the main concerns for new investors is the complete responsibility they have over their transactions, which means that any error will not be reversible in most scenarios.
A Safer Way to Do Business
This immutability of the transactions makes it harder for users who do not wish to risk the stability of their financial situation on the slip of a finger. By minimizing the risk of user error, DeFi platforms are likely to facilitate the transition.
Similarly, as no authority is operating as a central authority, DeFi users must put extra effort when interacting directly with the system, as no representative can act on their behalf. While there are platforms that allow users to allow as fund managers, for example, it is up to the user to find the right fund, understand the platform, join the fund, etc
The innovations within the DeFi ecosystem can also harm its users as there is a wide catalog of applications offering similar services with minor differences. While you might have 10 banks to choose from in your country, there are hundreds of DeFi platforms providing services that could work as a saving account, for example.
Choosing between all these platforms requires some level of technical knowledge to understand what it does and how to use it, which is no easy task for most people as they are not used to technical and financial concepts.
These are only some of the challenges that prevent DeFi mass adoption, with some of them being faced by other use cases such as cryptocurrencies and Non-Fungible Tokens (NFTs), but the community is addressing them in different ways.
After all, credit and debit cards were concepts hard for people to understand at some point, right?
DeFi is one of the most exciting applications of cryptocurrencies and blockchain technology we have seen in years due to its potential to revolutionize the world as no other use case has before.
If successful, DeFi will change how people interact and think about money, creating a world where we truly have control over our finances by being able to choose how we want to interact with it on a global scale in just some clicks.
While it might sound cheesy, DeFi could take power back from large financial conglomerates who have historically placed their interests before those of their users. These institutions caused the financial crises that governments had to bail them from and dictated when and how we make use of our money.
There is still a long way until DeFi is ready for mass adoption as it is not only a matter of the technology being there. However, the times seem to be right for decentralizations as freedom of speech, personal responsibility, freedom, and other ideals continue to play an increasing role in today’s society.
As a community-driven movement, DeFi’s future will depend not only on those developing the code that allows the platforms to run but also on those who use them.