The advent of DeFi has started a new financial movement that promises to democratize finance and eliminate third parties from the transaction chain.
Well, it might take years, but the journey has begun.
The flaws in the existing financial system have stood in the way of economic progress for too long, and a complete overhaul was long overdue.
The 2008 crisis, primarily due to the poor fiscal policy by the regulators and financial institutions, resulted in the emergence of decentralization and new economic models and eventually led to the re-birth of cryptocurrency.
The trustlessness, transparency, and efficiency of cryptocurrencies led to their popularity over the years. The rise of cryptocurrencies has ushered in a new era of financial movement that operates outside the shackles of centralized authorities and governments. One of the critical outcomes of this shift is DeFi, which promises to become the future of finance!
This post discusses DeFi, how decentralized finance works, its promises, and the role it will play in the future of Finance. Let’s dive in!
What Is Decentralized Finance (DeFi)?
Decentralized Finance (DeFi) is a financial system where people control their funds and the economy at large.
In DeFi, transactions are conducted on the blockchain through a peer-to-peer payment system.
Decentralized Finance works on a new technology stack, decentralized apps (Dapps), operating modes, and protocols that work together to make transactions fast, secure, and seamless.
Most decentralized protocols use crypto as a native currency, store funds in a treasury, and use special codes known as smart contracts to enforce compliance and smooth running of the system.
DeFi is a financial model that replaces centralized authorities ( banks, government, investment companies, regulators, and money managers) with decentralized systems and technologies.
Decentralized Finance aims to eliminate third parties and intermediaries from financial systems making the economy transparent and accessible.
Some of the attractive features of decentralized applications are their open source codes which can be viewed, copied, or edited by anyone.
DeFi also provides enormous rewards, which participants share, and welcomes people from different races and regions.
Crucially, the concept of Defi is no longer fiction.
There are now many decentralized applications in existence.
While considering the maturity of DeFi, it is essential to consider below five metrics to achieve the most effective DeFi activities.
Decentralized lending and borrowing platforms enable people to deposit capital and access cheap loans.
There are also several decentralized marketplaces for trading crypto, stablecoins, synthetics, and non-fungible tokens. Furthermore, there are decentralized insurance protocols and risk-free betting pools.
Although decentralized Finance has made some progress, it’s still several years away from disrupting the present financial system.
However, it’s safe to assume that it has a bright future, considering its feat in its short operating years.
How Does Decentralized Finance Work?
In traditional Finance (TradFi), tangible assets are used as collateral to obtain loans from commercial banks and lending apps.
Borrowers must provide guarantors, after which they start the tedious paperwork, credit checks, and long vetting process. When they eventually pass the loan, the loan comes with high interest.
Borrowing loans in decentralized Finance is effortless and instant. Cryptocurrencies are posted as collateral instead of real-life assets.
The loan is issued immediately when the borrower deposits crypto into the investment pool and fulfills the required condition.
Borrowers do not interact with any intermediary and do not pass through scrutiny. The process takes place on the DeFi platform, and the intelligent contract coordinates the activity.
Layers of Decentralized Finance
Decentralized Finance comprises five layers, all of which stack on each other.
DeFi layers refer to the various protocols, hardware, consumer-facing applications, and software that work together to enable the smooth running of a decentralized financial system.
The layering of the DeFi ecosystem promotes the fast deployment of new protocols. However, a hitch in one of the layers can lead to a temporary halt or collapse of the entire system.
The following are the five layers that makeup DeFi:
Settlement Layer: This refers to programmable blockchains that host intelligent contracts, process transactions, and secure the DeFi protocol. Examples are the Ethereum network, Solana, Avalanche, etc.
Asset Layer: This refers to the utility token of the DeFi ecosystem, locked tokens, and native token of the block it runs on.
Protocol Layer: This represents the smart contracts and the various guidelines that coordinate the activities of Dapp users and developers
Application Layer: This represents the various decentralized applications (Dapps) and consumer-facing interfaces that bring life to the protocol and enables users to interact with the smart contract. Examples are lending and borrowing apps, decentralized exchanges (DEX), etc.
Aggregation Layer: These protocols collect the best trades across the entire Defi ecosystem so that users can enjoy the best service on one platform. Example yield farming aggregators
3 Ways Decentralized Finance Solves The Weakness of Traditional Economy:
Now, what are some of the ways decentralized Finance improves over traditional Finance?
One of the core promises of DeFi is to provide a seamless financial system that handles large volume transactions efficiently.
Some of the ways decentralized Finance achieves efficiency are:
- Financial Inclusion: Decentralized Finance doesn’t operate on a profit-only motive. The most significant promise is Defi’s capability to provide financial services to unbanked people in remote regions who are excluded from the present banking system. In addition, DeFi services are available to everyone regardless of their loan history, credit score, legal record, or background, as long as they meet the condition of the smart contract.
- Effective Remittance: DeFi plans to achieve an efficient financial system by fostering quick and frictionless remittance. Presently, cross-border transfers cost an arm and leg and are incredibly tedious. In Defi, transactions are processed on the blockchain, and fund transfer takes seconds to attract a ridiculously cheap fee.
- Remedy Information Asymmetry: The information gap is another abnormality that undermines the present financial system. This is because some classes of people have better access to information, leaving room for exploitation. DeFi is non-discriminatory, and the code doesn’t care about wealth or class. Codes are open source, transaction records are public, and decisions are collectively made among protocol members, so everyone gets timely information and removes the room for exploits.
- Better Incentive: Rewards are pretty distributed in a decentralized protocol. Therefore, everyone from validators, liquidity providers, and users is fairly rewarded based on their contribution.
2. Huge Rewards
A significant concern in traditional Finance is the inequality in how revenue is shared.
Even though investors own most of the circulating money in the banking system, only a fraction of the profit comes to them. DeFi aims to provide higher rewards to users by opening up different channels to make an active and passive profit.
Some of the ways to earn from a DeFi protocol are:
- Liquidity Provision: Liquidity providers provide the capital in a decentralized protocol. This can be likened to depositing funds into a savings account in a TradFi, only that LPs pocket as much as 5–20% interest in decentralized Finance.
- Yield Farming: Instead of leaving assets idle in a wallet, crypto investors can deposit or lock their coins using a decentralized exchange or lending protocol to earn more crypto. Yield farming rewards can be in the same crypto locked or another valuable token and are calculated yearly.
- Initial Decentralized Offering (IDO): This form of yield farming enables users to contribute to an upcoming project. They buy in on the project token at the fairest possible price. The initial decentralized offering is almost similar to the initial coin and exchange offerings, only that this fundraising method is more secure and trustless.
It is worth mentioning that while DeFi protocols are transparent and eliminate centralized authorities, specific measures are put in place to ensure smooth running and coordination of the system.
- Decentralized governance for dApp administration
- Collective decision-making and transparent voting system that makes it difficult for the member to copy/edit code to create duplicate
- Open source code that makes it easy for the member to audit project smart contact
- Decentralized autonomous organizations (DAO) where code acts as the law and the smart contacts determine the rule of operation.
Many traditional finance products have complex integration. For instance, storing dollars in a Euro account is impossible, and currency conversion fees are exorbitant.
If traditional finance services integrate, interacting with two different platforms usually requires taking permission from the other platform.
Decentralized Finance solves the problem by enabling assets on the identical blockchain to integrate seamlessly and allowing dapps to interact with each other.
This is possible due to the composability of decentralized financial instruments such that even though assets have different interfaces, but similar underlying layers and building blocks.
Composability also enables various components to combine with others and open up new ways to earn, hence why DeFi is called money legos.
The Interoperability explains why investors can buy Ether (ETH) on a decentralized exchange such as Uniswap, swap ETH to UNI, and deploy the UNI in a liquidity pool to earn more UNI or another ERC-20 token.
Another feature that contributes to DeFi interoperability is tokenization. Assets on the same settlement layer (blockchain) have the same token standard, enabling them to combine seamlessly.
Standardization becomes vital as it allows investors to manage their assets effectively, e.g., storing ETH, UNI, DAI, and other ERC-20 tokens on the MetaMask without downloading a different wallet for each token.
When you combine the open-source code and composability of DeFi infrastructure with their permissionless nature, it becomes apparent that DeFi is a minefield of opportunities and unlimited potential.
The Future of Decentralized Finance (DeFi)
Decentralized Finance has grown in leaps and bounds in the last few years. The amount of money locked across the decentralized ecosystem “TVL” has grown from $6.9b to $11.1b in August alone.
This may look insignificant to the uninitiated. However, it shows that the momentum in the ecosystem is unlikely to stop soon, and a bright future lies ahead.
Although decentralized Finance is not the central finance system, it’s widely used by crypto enthusiasts for everyday transactions. Many people believe that DeFi is the future of Finance. It promises better incentives, an efficient economic system, transparent governance, quick remittance, and non-censorship resistance.
However, before DeFi gains global recognition, it must first solve some inherent issues plaguing the ecosystem, such as poor user experience, instability of crypto prices, intelligent contract hacks, etc.
The future of Finance is relatively unclear. But early signs show that it is gradually gaining popularity. That’s not to say that DeFi isn’t without its concerns.
But again, the benefits of an unregulated financial system far outweigh its perils.
Some experts predict a hybrid financial system where decentralized Finance becomes a significant part of the economy but doesn’t replace traditional Finance completely.
If you’re ready to participate in DeFi, there are certain things to note. While unregulated Finance comes with big rewards, it still has some risks. Ensure you consider both the risk and reward before making your decision. It would also help to learn about various aspects of decentralized Finance before investing in it. Good luck!