Decentralized Finance: Navigating Toward a new Financial Paradigm
Decentralized Finance, popularly known as DeFi, is an ecosystem of financial applications built on the blockchain networks. It aims to build an open-source, permissionless, and transparent financial ecosystem that:
- Eliminates the involvement of any central authority
- Runs on smart contracts
- Enables accessibility to everyone
With no reliance on centralized authorities and the non-existence of governments’ and companies’ regulation, stakeholders convene to build a permissionless ecosystem to make financial services available to everyone. The users interact with the decentralized ecosystem through peer-to-peer (P2P), decentralized applications — known as DApps.
DeFi redefines conventional financial services — such as lending and borrowing, trading, and insurance — offered to enable transferring, storing, and earning digital assets.
Benefits of DeFi
Decentralized Finance harnesses the key principles of blockchain technology to offer greater financial security and transparency, unleash liquidity and growth opportunities, and forge the path for an integrated and standardized economic system.
- No third party involvement
DApps rely on smart contracts instead of the humans for operations. Once the smart contract is deployed on the blockchain, the DApps run automatically, with minimal or no human intervention.
Furthermore, no middleman has control over or access to users’ assets since the majority of DApps are non-custodial — which means that a platform does not hold the private keys of users’ funds.
When it comes to DeFi development, communities play a crucial role. Given that most of the decentralized applications and protocols are open-source, community developers add features and build new apps. A project can be forked to roll out a tweaked version of the original project.
The code on the blockchain is completely transparent for anyone to audit. This builds trust with users as anyone on the network is allowed to comprehend the smart contract’s functionality or find bugs. The transaction activities are public and can be viewed by anyone. This may raise privacy concerns, but the transactions are pseudonymous by default — which means that they are not linked directly to users’ real-life identities.
- Global accessibility
DApps can be accessed from anywhere across the globe. Whether the users are in a country in Asia or Europe, they can have access to the same DeFi services and networks. Although local regulations are applicable, users only need an internet connection to access DApps.
- Permissionless to create and use
DApps can be created by anyone and used by anyone. Unlike traditional finance, DeFi does not have gatekeepers or paper-based accounts. Users enjoy direct interaction with smart contracts.
Use-cases for DeFi
DeFi unbundles the financial stack into services, such as lending and borrowing, credit, and payments, which can be assembled like decentralized applications.
Here are the financial use-cases for DeFi:
- Borrowing and lending
Peer-to-peer lending and borrowing is one of the most widely used applications in the DeFi ecosystem. It offers various benefits over traditional lending and borrowing — such as no credit checks, collateralization of digital assets, and instant transaction settlement.
Since DeFi crypto lending platforms are built on public blockchains, they guarantee cryptographic verification methods while minimizing the amount of trust required. A blockchain-driven lending marketplace mitigates counterparty risk and makes borrowing and lending cost-efficient, faster, and accessible to people.
- Decentralized exchange
A decentralized exchange, also known as DEX or DeFi exchange, is a cryptocurrency exchange that enables users to trade without the need for a central authority to hold or control their funds. The trades are made directly between users, with the help of smart contracts.
As decentralized exchanges do not hold users’ funds, they mitigate the risk of price manipulation as well as hacking and theft.
Smart contracts built on the Ethereum platform enable the creation of tokenized derivatives that derive their value from the performance of the underlying asset. DeFi derivatives represent real-world assets, like fiat currencies, commodities, bonds, and cryptocurrencies.
Tokenization is one of the crucial aspects of decentralized finance. Tokens drive the network and unlock various economic possibilities.
Tokens are digital assets that are created, issued, and managed on a blockchain, which makes them secure and quickly transferable. They provide a digital alternative for users to access, trade, and store value. The popular tokens include real estate security tokens that represent fractionalized properties and platform-specific tokens that incentivize users of a specific application.
A stablecoin is a cryptocurrency that is pegged to a stable asset, such as fiat, commodity, or any other cryptocurrency. Stablecoins were originally introduced as a solution to volatile cryptocurrencies and to make blockchain a viable payment solution. Today, stablecoins are used across the DeFi ecosystem for cross-border transactions, borrowing and lending, and institutional use-cases such as central bank digital currency.
As the Ethereum network transforms into a proof of stake consensus algorithm with Ethereum 2.0, users can stake their Ethereum (ETH) and earn rewards.
The role of smart contracts in DeFi
Most of the decentralized applications are built on smart contracts that use computer code to specify the relationship between parties entering the contract. Smart contracts enable the automation of business processes that currently require manual assistance. They make the processes faster, easier, and reduce the risk for both parties.
Decentralized finance aims to build financial services separate from the conventional financial and political system. This would chart a path for a more open financial system. If successful, DeFi will wrest control from centralized organizations and empower the open-source community and individuals.