Your Guide to Decentralised Finance (DeFi)
October 23, 2020
As the internet grew to become an integral part of our lives, businesses and financing shifted online. With rapid advancements in technology, blockchains were developed. This led to the creation of decentralised digital currencies such as cryptocurrencies.
With this new type of currency people have naturally found a way to either loan, borrow, send or receive money across borders without the interference of intermediaries. This trend is what we refer to as Decentralised Finance (DeFi).
With the help of smart contracts on blockchains, finance and trading have become much more efficient. Smart contracts have led to the invention of decentralised apps or commonly known as dApps. dApps are not under the control of any company or centralised entity; instead, the developer has total control.
These dApps tend to be open source and transparent, providing users with more control over the application with some even offering a share of the revenue. They also can make changes to the code and improve the dApp. Our traditional financial market is on the move to becoming decentralised as transparency is now one of the most important factors for consumers when considering where to put their hard-earned cash. Since the government has control over issuing and regulating the currency, overprinting the currency to deal with a financial crisis may lead to inflation and value depreciation of the currency, which greatly affects the whole economy.
We trust banks and other financial institutions with our money, yet we only receive a small fraction of their profits which can be reflected on our ‘saving accounts’, we only get 0.5% per annum on national savings accounts for example. Corporate control of money is higher due to centralisation. Decentralised finance is here to revolutionise the financial ecosystem.
What is Decentralised Finance (DeFi)?
Decentralized finance—often called DeFi—refers to the shift from traditional, centralized financial systems to peer-to-peer finance enabled by decentralized technologies built on the Ethereum blockchain. It offers an open-source, transparent and permissionless ecosystem without any central authority. Here, users have total control over their assets and can interact with others through decentralised applications (dApps).
People who do not have access to traditional financial systems can easily make use of DeFi and dApps. Access is easy. All you need to do is use a dApp to access the services you require. By doing so you instantly cut out the middleman. Compared with centralised systems, DeFi is more efficient as it generally saves you time and money.
In the past couple of months, DeFi has become so popular that the total market value as of September 2020 is over $9 billion.
Advantages of DeFi
- As we already know, traditional finance is highly centralised with governments having total control and banks as intermediaries. But, DeFi doesn’t require any intermediaries and the users have total control over their assets.
- The code is programmed to handle every possible dispute, and this provides a frictionless financial system.
- The blockchain is more secure as the data is spread across multiple nodes, making it difficult for hackers to enter and remove single points of failure.
- Anyone who doesn’t have access to the traditional financial system can make use of DeFi.
- With no intermediaries making profits, the costs on this platform are relatively lesser. This makes it easier for even low-income individuals to profit from DeFi.
Use Cases of DeFi
DeFi is well known for its open lending protocols. Open lending is much more efficient than traditional lending systems.
These lending services are set up on public blockchain and are protected by cryptographic verification methods. There are instant transaction settlements, collateralised digital assets and no credit checks. This could possibly be a standard lending method in the future. Lending becomes much faster and accessible to more people.
DeFi is mainly concerned with financial applications, so banking services are the primary focus. These services include lending, insurance and mortgages. Cryptocurrencies are highly volatile at the moment, but decentralised stablecoins can be the perfect alternative to traditional cash.
Applying for a mortgage is tedious and time-consuming, but with smart contracts, you can get approved much quicker. It also significantly reduces the underwriting and legal fees.
For DeFi to operate, we require platforms such as decentralised exchanges (DEXes). Such platforms enable users to trade digital assets without any intermediary. The trades take place directly between the user wallet and exchange, with the help of smart contracts.
Decentralised exchanges require minimal maintenance and hence charge lower trading fees than traditional exchanges.
Types of DeFi Applications
The number of DeFi applications is growing. Many of these decentralised applications are born on the Ethereum network due to its transaction speed and scalability. Some of the types of applications entering the world include:
These cryptocurrencies are tied to a traditional financial asset to stabilise the price. USDT is one of the most popular stablecoins.
These exchanges are changing the way people exchange value. For instance, anyone in Australia can trade AUD for Bitcoin with a peer without any intermediaries to carry away any profit from fees.
WBTC: “Wrapped” bitcoins
When someone sends a wrapped bitcoin to the Ethereum network, it can then be used directly in Etherum’s DeFi system. Doing so allows the user to earn interest on their bitcoin.
Imagine a betting market that takes out the middleman. That’s what prediction markets do.
Traditional ways of lending see a large amount of money move to other people or institutions. Traditionally these institutions have been banks, however with a DeFi lending platform, smart contracts are used to the benefit of the lender and the borrower as they cut out the middleman.
Role of Smart Contracts in DeFi
Smart contracts are highly useful in the DeFi application. The whole financial ecosystem revolves around creating and executing smart contracts.
Smart contracts are computer codes that provide terms of the relationship between the two entities involved in the transaction. These contracts can enforce the terms with just a few lines of computer codes. They help automate and execute the entire DeFi application without any manual supervision.
Although smart contracts do make DeFi faster, efficient, and reduce risk, they are prone to have bugs and vulnerabilities. This causes a significant security risk as it contains valuable and confidential information.
Risks of DeFi
Blockchain can tend to be slower than some centralised applications, and this directly affects dApps. The developers of these applications must take into account these limitations and optimise the app.
Due to the lack of intermediaries, the users are responsible for errors. Designing dApps on immutable blockchains that leads to minimal user errors is quite difficult.
For users to transition from the traditional financial system to DeFi, they need to be provided with incentives and promotional offers. This requires more effort from the user’s side as they need to take the initiative.
DeFi has a wide range of applications and use cases, so it can be quite cumbersome to find a dApp for a specific use case. Users need to have the ability to choose the best dApps for different uses. However, the challenge lies in figuring out how the dApps suit the DeFi ecosystem.
DeFi was invented to provide an entirely new financial ecosystem that operates differently from the current traditional finance. DeFi is more open and prevents discrimination as anyone can access the DeFi system and dApps.
Although the idea seems revolutionary, decentralisation is not entirely beneficial here. The blockchain must be characterised to build the optimal financial system.
If DeFi is successful, it will take away the authority from the centralised organisations and give more power to the open-source community and individuals. This will make it widely acceptable and more mainstream.
At the moment, there are various risks involved with DeFi. The performance is not yet up to the mark; there may be user errors; there may be vulnerabilities and bugs in the smart contracts and much more. DeFi is mainly concerned with providing the users with access to basic financial services and with smart contracts and dApps. They are slowly achieving this goal.