What is DeFi and Why does it Matter?
With any new technology, it’s important to ask — what problem does it solve and who does it benefit?
This question often sparks debate and backlash around what real use cases blockchain technologies have. While many ideas are being explored, one of the most promising are blockchain-based financial applications, broadly referred to as Decentralized Finance (DeFi).
If you’re not familiar with DeFi yet, it’s worth paying attention. It’s been working for years and is solving genuine pain points of individuals and businesses globally. Also, by making sense of DeFi, you’ll better understand the potential applications of blockchain technologies more broadly.
Traditionally, we rely on centralized entities like banks to fulfill our basic financial needs. We trust them to protect our savings, provide us with loans and facilitate day-to-day payments. It’s hard to imagine a world without them, but that’s exactly what DeFi promises.
This vision — of banking without the banks — is made possible by smart contracts, which are computer programs stored on the blockchain that automatically run when certain conditions are met.
By leveraging smart contracts and blockchain infrastructure, DeFi has a number of advantages over traditional financial institutions. It’s:
- global and permissionless: users are no longer limited to local banking services, but can instead access DeFi apps from anywhere in the world
- trustless: since smart contracts automatically execute, human intervention isn’t required, meaning you don’t need to rely on, or trust, third parties
- always-on: DeFi is available 24/7, and isn’t limited by opening hours
- transparent: the code of DeFi apps as well as data on their usage is publicly auditable
You might still wonder why any of that matters, when the financial services you use daily are for the most part, fine. It’s important to understand that there are many different participants within the global financial system, each with unique contexts and needs. Some may be similar to you, while others face entirely different circumstances.
Why is DeFi valuable?
To help you understand the value of DeFi, we’ll explore how DeFi applications benefits users including:
- unbanked individuals
- financially savvy individuals
- individuals, businesses or nonprofits transacting globally
1) Unbanked individuals
Many of us take for granted the fact that we have bank accounts and can access basic financial services. Unfortunately, approximately 1.7 billion people are unbanked, due to factors such as geographical limitations, distrust in financial institutions or the inability to meet minimum requirements. In fact, there may be little to no economic incentives for banks to cater to these potential customers.
However, the World Economic Forum estimates that 1.1 billion have access to a mobile phone. This presents a large opportunity for DeFi to connect the unbanked to decentralized financial services. Unlike traditional institutions, DeFi is able to scale financial services products to anyone around the world with minimal costs. For example, DeFi applications like AAVE or Compound would allow the unbanked to earn interest on their savings or even borrow money.
2) Financially savvy individuals
On the other end of the spectrum are individuals who are savvy enough to be saving and investing, and who might even have a mortgage or investment properties. They’re already in a great position, but DeFi could make things even better.
As with any other industry, a major benefit of automation is lower costs. Think about how much it costs your bank to employ their staff, use office buildings or operate physical branches. Since smart contracts can cut out intermediaries like banks, this means DeFi applications are more cost efficient. These savings are passed onto individuals who use DeFi applications, through higher interest rates on savings — again, using applications like AAVE or Compound. For example, for every additional 1% you earn on a balance of $10,000 is an extra $100 saved per year.
What’s more exciting is that the open and transparent nature of smart contract code means code and DeFi applications are composable. In other words, they’re like digital LEGO blocks which can be combined in unique ways. For example, Yearn is a DeFi application which automatically reinvests your savings to optimize your earnings. If AAVE has better rates than Compound, it’ll direct your funds there. In contract, if you wanted to do the same with your traditional savings, you’d be manually setting up new accounts and transferring money between those accounts.
3) Individuals, businesses or nonprofits transacting globally
In our increasingly globalized and digital economy, individuals and businesses both have growing needs to make and accept payments in foreign currencies. For example, when individuals are shopping online for international goods, or when businesses pay salaries to global staff. The problem today isn’t that we can’t facilitate international payments — but it is expensive and often slow.
Blockchains naturally alleviate this problem since crypto tokens can be transferred globally and instantly. However, while the value of most crypto assets fluctuates wildly, it’d make most sense to transact and store wealth in stable currencies. DeFi’s answer to this are stablecoins like USD Coin (USDC), Tether (USDT) and Dai, which are designed to maintain a stable price. You can think of these stablecoins as a digital-only form of cash, which lets you leverage the benefits of crypto infrastructure.
Using stablecoins, users can pay anyone around the world, at any time, without paying high fees or waiting for banks to open. On the other side of the transaction, businesses can receive payments instantly without high international transaction fees. Similarly, nonprofits can use applications like Endaoment to fundraise from global donors quickly. More importantly, the open data of blockchains means the movement of funds by nonprofits is more transparent, and can be more closely scrutinized.
What are the risks of DeFi?
Despite these benefits, there are risks you need to be aware of when using DeFi applications. This includes:
- Smart contract risk: since smart contracts are created from computer code, they can be prone to hacks. In 2022 alone, hackers have stolen over $3 billion of assets, with DeFi being the primary target; and
- A lack of consumer protection: if you lose your funds due to a hack or a scam while using DeFi, no-one is obliged to help or reimburse you because as we know, DeFi removes intermediaries who would typically provide that support
On the plus side, the openness of blockchain code means that with every vulnerability that’s exploited and fixed, the DeFi industry becomes safer overall. Everyone can learn from everyone else’s mistakes and experiences, which is unlike the siloed nature of traditional financial institutions.
Currently, there’s still friction around the experience of using DeFi, but as with any new technology, user experience problems will be solved. Companies like Coinbase, Argent and Minke are already working to abstract away that complexity into slick mobile apps. In time, there’s a chance DeFi will fundamentally change how we all engage with financial services. As blockchains achieve greater scalability, it’s possible we’ll see a blockchain-based payment network operating at the scale of Visa and MasterCard. For the benefits that DeFi can, and already brings, it’s a no-brainer to try to make it work.
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