The advent of cryptocurrencies has turned the traditional financial market upside down. Blockchains paired with cryptocurrency have opened a new, radical vision of the future that big tech and everyday consumers are investing in. One umbrella term that has emerged in this context is decentralized finance or DeFi — a futuristic vision of the financial world consisting of public, secure, peer-to-peer, and near-instantaneous transactions.
What Is DeFi?
DeFi is a broad term covering emerging financial products, instruments, and services not tied to traditional governing authorities like banks, exchanges, and brokerages. DeFi runs on secure, distributed public ledgers leveraging blockchain technology and smart contracts.
No regulatory oversight in DeFi allows users and organizations to make financial transactions in real-time. Since DeFi is peer-to-peer (directly between two users without any routing via a centralized system), decentralized finance companies are commonly global while offering typical financial services like lending, insurance, trading, earning interest, and investing. Cryptocurrency is one of the most recent examples of decentralized financial systems.
How Does DeFi Differ from Centralized (Traditional) Finance?
While the services offered by DeFi systems are similar to those of traditional, centralized financial systems, there are areas where they are fundamentally different.
- Banks and other regulatory authorities store money for their customers in centralized finance. In DeFi, money is stored in digital wallets that the customer owns and controls.
- Centralized finance works via mutual trust. Customers place their faith in banks and other financial institutions that store money, hoping they will not invest in risky borrowers or plans. The Great Recession revealed that these institutions could easily break this trust. DeFi removes these middlemen, allowing consumers to own their money and control its flow.
- Transactions in centralized finance are routed via several regulatory authorities before they are approved, which often takes multiple days. Payments via centralized methods are also prone to bottlenecks, bias, and country-based regulations. Meanwhile, financial transactions in DeFi happen almost instantaneously.
- Centralized finance ties user identity to each transaction, while in DeFi, payments are anonymous.
- Centralized financial instruments must approve consumers’ submitted applications before making transactions. Additionally, centralized financial institutions gatekeep a great deal of information from customers for regulatory reasons. This process has perpetuated several socioeconomic biases. On the other hand, DeFi is available to everyone and has public ledgers, meaning anyone can look at the data and understand how the system works.
- Centralized financial markets are human-operated and have standardized daily start and stop times accordingly. Conversely, DeFi markets are globally operated and are always open.
How Does DeFi Work?
DeFi is based on the same technology that drives cryptocurrencies, the public blockchain. A blockchain is a list of distributed and secure ledgers containing transactional data.
Blockchain is comprised of data blocks that have transactions recorded in them. These blocks are chained together to form a complete ledger. The peer-to-peer, public nature of blockchain means anyone can access the blocks, but only verified users can validate the transactions. Once the transactions in a block are verified, it is closed and encrypted. A block’s information cannot be altered without changing the entire chain of corresponding connected blocks that house the same data. This makes modifying blockchains impossible, further enhancing security,
Applications that handle transactions and run the blockchain are called decentralized applications or DApps . DApps leverage peer-to-peer financial transactions, which means two users can directly exchange currencies for goods or services without third-party systems or authorities. Most DApps in DeFi utilize the Ethereum network.
Ethereum’s Role in DeFi
Ethereum is the world’s second-largest cryptocurrency in market share after Bitcoin, with a market cap of 27 Trillion dollars (19.19% of the total crypto market) at the time of writing. Ethereum blockchains drive around 70% of DeFi’s entire infrastructure, as ether tokens are the preferred dApp currency. There are a few reasons for this.
- Ethereum has expanded into a software platform that developers can utilize to build DApps that natively take advantage of secure and public blockchains, ether tokens, and peer-to-peer technologies.
- DApps built on Ethereum work seamlessly with each other, enabling users to access several markets and applications easily.
- Decentralized cryptocurrency, smart contracts, and tokens in DeFi are built on Ethereum, ensuring greater freedom, security, anonymity, and speed.
What Can You Do with DeFi?
DeFi allows consumers to leverage all centralized financial activities, including:
- Sending money Instantaneously: Consumers can use DeFi to send and receive money across the globe instantaneously. With no intermediary bottlenecks, two users from anywhere in the world can engage in direct, immediate transactions.
- Streaming Money: DeFi and its apps allow users to stream money over the globe. In this context, streaming money means continuous payments over time. An example of this is sending salaried paycheck to employees.
- Lending and Borrowing: DeFi offers a worldwide lending network, enabling peer-to-peer lending and borrowing. Decentralized lending is an anonymous exchange of funds between two parties where the borrower provides collateral. The collateral is automatically transferred to the lender if the loan is not repaid. DeFi also introduces pool-based borrowing, where multiple lenders provide funds (pool) for borrowers.
- Exchanging Currency: Customers can exchange one currency for another via decentralized exchanges. For example, users can exchange ether tokens for U.S. dollars.
- Trading and Derivatives: DApps like dYdX, Augur, and Polymarket help traders and users delve into advanced trading. In DeFi, the market is open 24/7, granting users complete control of their assets. Derivatives in DeFi are gaining significant market interest due to the absence of intermediaries and quick transaction speed.
DeFi trends are shifting how the world thinks about money and financial institutions. As blockchain-based concepts like the metaverse and Web3 come to fruition, DeFi and DApps will continue to evolve from proof of concept to proof of stake. Ultimately, the success of DeFi will depend on the long-term reliability and adoption of blockchains. Overall, the battle between centralized finance and DeFi should benefit consumers, as it will create more avenues for investing, trading, and saving for users.