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Decentralized Finance: Every Bank’s Worst Nightmare

How DeFi is here to disrupt the traditional world of finance.

In 2008, amidst the frenzy and turmoil of the Great Recession, there was a growing paranoia and distrust of banks, with the American financial system essentially collapsing and economic crises arising. In the middle of the turmoil, a white paper published under the pseudonym Satoshi Nakamoto was published, addressing the centralised manner in which people’s money was controlled, as well as the trust placed in authorities to manage their cash. The paper proposed an alternative, Bitcoin, that would eliminate the intermediaries that exist in traditional financial systems, amongst solving other problems identified in the aforementioned. Though the term decentralised finance was not formalised until years later, Bitcoin is widely acknowledged to be the first application of DeFi. In other words, it set in motion the rapid introduction of a decentralised financial system to the wider community.

Modernising Traditional Finance

Decentralised finance, more commonly referred to as DeFi, encompasses all financial products and services available to users on the public blockchain. In its essence, it utilises smart contracts and cryptocurrencies such as Ethereum to provide services that do not require a middleman in the process. In traditional setups, financial institutions pose as guarantors in a transaction, granting them notable authority and power. On the other hand, DeFi relies on blockchain technology, and in turn smart contracts, to eradicate the risks and costs of intermediaries, enforcing a transaction that cannot be altered or deleted.

Take for example DeFi in the context of Ethereum. A smart contract, also known as the Ethereum wallet, that has the ability to hold and send funds can be programmed to make weekly scheduled payments to another Ethereum wallet, wherein the technology will ensure that firstly the transactions are only made when there are sufficient funds, and secondly, no one can interfere with the contract.

DeFi can be stripped down to four layers:

  1. Blockchain technology consisting the transaction history, records and state of accounts
  2. The assets
  3. The protocols (ie the smart contract) that orchestrate the “De” of DeFi
  4. The applications that manage and connect the protocols

The primary benefit of DeFi is not solely the lack of intermediaries. It further implements a financial system that increases the potential of better returns for each individual and is available to anyone with a working internet connection, consequently lowering the barriers to entry. It reflects much of the same philosophy followed by Web 3.0 counterparts: transparency in transactions and provable ownership of assets. Virtually, it eliminates the need for banks by allowing each user to be their own bank, allowing the exchange of assets and financial activity between strangers through the enforcement of smart contracts.

DeFi vs Conventional

DeFi was fundamentally founded and developed after the recognition of an abundance of problems identified in customary banks and institutions. The table below highlights the key differences in the ways in which the two systems work:

Utility of DeFi

For any financial service offered by institutions such as banks, there is likely a decentralised alternative available. The rapid adoption of various cryptocurrencies has led to higher reliance on the new financial system, allowing for the constant development of services every day. Some of the most common uses of DeFi include:

  • Trading: trading crypto assets in a peer-to-peer manner (can be likened to buying and selling stocks without brokerage)
  • Lending: lending out one’s crypto and earning interest on a minute by minute basis, as opposed to monthly installments
  • Getting a loan: loans can be obtained without the hassle of filling out paperwork. DeFi also opens the possibility of getting short-term loans that are typically not offered by traditional banks
  • Saving: crypto can be stored in savings account alternatives that earn better interest rates than offered by banks
  • Access to stablecoins: stable currency, the crypto community’s answer to volatility, is easily accessible

The Ethereum Insurgency

Bitcoin, though hailed as the instigator of the emergence and development of DeFi, had its own set of limitations. Primarily, its use was limited to storing and sending the asset, not allowing users to do much else. This is where Ethereum entered the picture: it took the idea of being decentralised and mobilised it so that it served more than one purpose.

Ethereum is considered the “perfect foundation” for DeFi as it ticks all the requisite boxes. Firstly, neither Ethereum nor the smart contracts that exist on it are particularly owned by anyone, ensuring open-access to all and reinforcing the fact that the rules cannot be changed. Secondly, there is a shared language behind the scenes, allowing a variety of products to work together across the blockchain. Lastly, tokens and cryptocurrency are built into the shared ledger which keeps record of the transactions and ownership. Ethereum also hosts a community of technical members who are able to inspect and monitor bad contracts floating around the system, keeping the open-source in check whilst the code is further developed until such a role is no longer needed.

DeFi Applications

One of the defining characteristics of DeFi is its low barrier to entry. The ecosystem is open for all, no longer restricting innovative minds from building and developing their own programs. Taking the example of Ethereum, the technology makes it easier for people to make their own decentralised applications (Dapp) without having the hassle of waiting for grants and permission.

One of the most popular DeFi applications is decentralised exchanges (DEXs). It conducts online exchanges that aid users in exchanging currencies for other currencies, for instance trading US dollars for an ETH. DEXs directly connect users to one another for the trade, without having to introduce a third party to facilitate the exchange of their money. Additionally, since they run on the blockchain, the process does not require a traditional KYC and does not have to be done during certain operating hours. Another popular application is wrapped bitcoins (WBTC), a way in which bitcoin can be sent to the Ethereum network for direct use in their DeFi system. Users typically use WBTCs to earn interest on the crypto lent out via decentralised lending platforms. There are also so many new ideas and concepts being cultivated every day, with a notable example being yield farming, the practice of scanning DeFi tokens in search for larger returns.

Conclusion

The use and utility of DeFi expands past just simple value transfer; it's a radical innovation that tackles complex financial use cases in favour of a user. It cannot be ignored that the technology is still new and experimental in many ways, however, the rate at which developers continue to address and rectify the problems presents a promising future of the mainstream adoption of DeFi. At its core, DeFi insists on parting ways with the gatekeepers that are vital for traditional financial practices, and instead emphasising an open and inclusive environment that liberates individuals from the financial barriers previously placed.

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Arts DAO

Redefining the collection of value through fractionalized ownership of NFT projects and decentralized governance. Arts DAO seeks to represent Community 3.0.