Decentralized Finance- What Is It?
Based on the events of the past few weeks, the word decentralization is becoming increasingly important. The question must be asked, how will the industry develop? What role will central platforms play in the future and what needs to change? What we can already see is that protocols such as dYdX and GMX are achieving strong growth.
Now let’s imagine the whole world transitioned from traditional financial institutions (banks and credit unions) to decentralized finance. What would happen? A tsunami of innovation that has been bottled up for decades will be unleashed.
This article is intended to serve as a beginners guide and provide an overview of decentralized finance.
What Is DeFi?
DeFi stands for decentralized finance, which refers to peer-to-peer financial services on the public blockchain. Using blockchain technology, these financial services are provided by decentralized applications (dApps).
DeFi can be defined simply as financial applications based on blockchain, primarily Ethereum using smart contracts. It enables users to borrow, lend, insure, trade, and use other financial services. It’s faster, paperless, and doesn’t require third parties, as most things supported by banks are.
In contrast to centralized systems, DeFi is a peer-to-peer network in which each node has equal permission to validate data.
Benefits Of DeFi
- Transparency: Transactions are transparent to everyone involved.
- Cost & Time: Cryptocurrencies that power DeFi dApps allow you to bypass intermediaries who take a share of the transfer and it is significantly faster with no questions and low fees compared to banks.
- Flexibility: Assets can be moved anywhere at any time without asking for permission or waiting for approval.
- Anonymity: Any personal information such as your name or email address is not required.
- Accessibility: Account opening isn’t required, unlike banks. Creating a wallet is all it takes to gain access. After that, you’ll be able to experience censorship-free and borderless content. A DeFi protocol does not discriminate against anyone, but rather equalizes the playing field for all.
How Decentralized Is DeFi Really?
DeFi can be divided into three different areas. A centralized, a semi-centralized and a completely decentralized section.
Centralized platforms are custodial, use centralized determined price-feeds and interest rates. Margin calls are centrally provided. An example here could be Nexo.
Semi-centralize platforms are non-custodial, have decentralized price feeds, decentralized interest rate permission, and permissionless initiation of margin calls. MakerDAO, dYdX and GMX are some of them.
In a completely decentralized platform every component is decentralized. At the moment there’s no DeFi protocol, that is completely decentralized yet.
How Does DeFi Work?
DeFi has many different applications and facets. The most important areas are explained below.
- Payment: DeFi has led to more innovative and creative ways of paying. E.g. reorganizing payments into streams.
- Insurance: There is a risk associated with DeFi. There was a loss of over 156 billion dollars in the DeFi space due to hacks over the last two years. When dealing with large amounts in DeFi, it is necessary to purchase insurance. This is where protocols like InsurAce or Solace come into play.
- Lottery: This is another service that DeFi offers. It is a lottery in which participants receive their money back, and one lucky participant wins all the profit from the shared pot. Many people call it a ‘No-loss’ lottery.
- Fund Management: The transparency of DeFi makes it easy for users to oversee their assets and manage their cash flow to maximize their investment return. E.g. in the newly launched Argent wallet are examples of fund management protocols.
- Lending & Borrowing: One of the biggest services provided by DeFi is lending and borrowing. It is possible for investors to lend their crypto out and earn interest and rewards, while entrepreneurs can borrow funds to establish their businesses. Compound and Aave are two platforms where this can be accessed.
- Trading: With DeFi, peer-to-peer trading of assets is possible without the need for a third party. There are several DeFi trading protocols, including Defi Swap, Binance and Coinbase.
- Buying Derivates: Derivates can be used by traders to hedge and speculate to lower their risk in any trade. There are a number of DeFi-derivative protocols available, including Synthetix and Opyn.
Downsides Of DeFi
Active trading on Ethereum is expensive due to its fluctuating transactions, but L2s like Optimism are trying to tackle this problem. DeFi transfers responsibility from intermediaries to users, making them solely responsible for their mistakes and as smart contracts are written by humans and are prone to errors, code vulnerabilities can jeopardize their security.
Financial products that are borderless, censorship-free, and accessible to all are the goals of Decentralized Finance. DeFi’s success could give open-source communities and individuals power over centralized organizations. But the main goal is to onboard new users and make it as easy as possible to achieve mass adoption.