What is Decentralized Finance (DeFi)? What are the Use Cases?
A guide to the world of decentralized finance (DeFi).
Decentralized finance (DeFi) mostly became an alternative to traditional forms of finance. They became so powerful that they became a force to be reckoned with. In this section, we’ll cover anything you need to know about decentralized finance (DeFi).
What is Decentralized Finance?
Decentralized finance (DeFi) is an alternative form of finance where users tend to stay anonymous, all transactions are immutable and transparent, and utilizes blockchain technology to its advantage.
Traditional Finance vs Decentralized Finance
Traditional finance exists for thousands of years and it has evolved into the modern financial system. Initially having lending activities, throughout time, it evolved to policies, foreign exchange, private banking, investment banking, commercial banking, asset management, and central banking. Even with all the advances with International Financial Reporting Standards (IFRS) and Generally Accounted Accounting Principles (GAAP), these issues concern finance with various inefficiencies such as lack of transparency, rigid processes, a high percentage of unbanked population and a lack of inclusivity are some of them.
Lack of Transparency
Even though regulatory bodies, IFRS and GAAP mandate transparent records to investors, shareholders, and for all the public to see, unfortunately, we see lots of accounting frauds and misreporting from the companies to impress their shareholders. Even more, some companies work with regulatory institutions and further this step with the help of the government, especially in developing countries. And as 2008 Financial Crisis showed that most financial institutions and real estate developers were not financially stable as seem and it led to a cascading effect on global financial infrastructure. The crisis became so bad that even major banks faced mounting losses and governments around the world had to bail them out.
Modern financial systems require a long and rigid process for their customers. Whether customers are individual or commercial, they need to present papers, identify, and sign loads of documents just to have a bank account and start transacting globally. Moreover, to get credit, people need credit scores and financial statements to qualify for credit, and financial institutions can reject the request and not allow credit if they fail to provide the necessary documents, and the process is slow.
Even with all the technological development concerning ID verification, there is still a large percentage of the unbanked population for various reasons. Even though most of the unbanked population is concentrated in Asia, Latin American countries have the highest percentage when looking at population.
Lack of Inclusivity
Financial institutions can exclude some groups of people on the grounds of government regulations, lack of proof-of-documentations, and geographical restrictions are some obstacles concerning unbanked populations. Even if governments take any measures they can and some become successful, there are still problems with inclusion. Especially when major states impose sanctions on various countries, most institutions and governments are obliged to comply. Considering the Russian government and institutions have been kicked out of the SWIFT network, the Russian government and institutions were suspended and their foreign accounts frozen. Considering the influence of major governments, the problem of inclusivity is yet to be solved.
Inefficiencies in International Transactions
International transactions are known to be slow and cumbersome. Even though the SWIFT network enhanced transaction speed, the complexity of transactions requires at least a few days, even if not weeks, in some extreme cases. Even more, banks from all around the world must open their accounts in the US and then transfer the sum to other clients around the world, making the process costlier.
Financial institutions, like traditional institutions, are known to be centralized. Top executives tend to take decisions and implement them to lower ranks. Even more, their infrastructure tends to be centralized, and they concentrate all their means (business and technical) on one side. Considering a few instances where financial institutions had to shut down their operations due to various technical difficulties, many people had a hard time reaching out for their services. In one instance, Turkish bank Akbank had suffered a database crash, and all their servers shut down for 43 hours, prompting claims of a cyber-attack. But after, Akbank’s executives explained the situation as a database crash, making the crash one of the longest in history.
What are the Attributes of Decentralized Finance?
Transparency is known to be the most important feature concerning decentralized finance. Because all transactions are recorded on the blockchain, every record on a DeFi infrastructure can be seen by others via nodes or block explorers. Considering transparency is an important issue in finance, DeFi provides transparency to all stakeholders and other people alike.
DeFi provides inclusion to all people around the world, regardless of geography. While modern financial infrastructure excludes various groups of people for various reasons, to get into DeFi, you need a crypto wallet and some funds to interact with the system, making it inclusive all around the world.
While international transactions tend to take at least a few days, transactions on the blockchain generally take seconds, or in the worst case, only hours are needed to finalize and record the transaction. Considering DeFi is much faster than traditional financial infrastructure, cross-border transactions would become much faster.
Because blockchains are known to be anonymous, people can hide their identities by using wallet addresses. While all their transactions can be traced through various means, the wallet owner’s identity is quite difficult to be found. Even though various measures are implemented to find the wallet owner’s address, it is still difficult to find the owner of the wallet address unless specified by the owner.
One of the biggest features of DeFi is the fact that it can be programmed by other people. Whether it’s open-source development by protocols or others creating their tokens or their infrastructure from scratch. If the community doesn’t like one of the applications, the same application with better features can be created for the benefit of the community. Moreover, smart contracts allow open development, and it eliminates the need for unnecessary hassles.
Because of its inclusive nature, participating in DeFi is quite easy. A mobile device, crypto wallet, and funds are mostly enough to participate in the ecosystem. Even though some protocols restrict the participation of users with various means, it’s still much easier than traditional finance to participate and most applications wouldn’t mind unless your wallet is blacklisted.
In the blockchain, all the records of transactions are recorded, and they can’t change. While it’s possible to change the records in theory (51% attack), it requires such resources that it’s simply not worth it to hack the blockchain in most cases. As blockchain grows to have a longer chain, a longer chain is more reliable, and all the chains need to be changed. Due to the blockchain’s structure, all records can’t be changed after the transaction is finalized.
It is possible to connect a DeFi protocol to another chain using bridges. While many applications successfully work on other networks owing to improvements in bridge infrastructure, many applications don’t work with multiple blockchains. However, as most financial institutions are not interoperable, their infrastructure tends to be separate from one another, making transactions much more difficult considering that they also possess custodial functions. Because DeFi allows the custody of funds to its users, it is also possible to work with an interoperable architecture.
In DeFi, you own your own assets instead of a financial institution. Because you have control over your assets, users have to pay attention to their assets and not get their funds stolen for various reasons.
How does Decentralized Finance Work?
Same with all blockchain-based applications, DeFi works on the blockchain and smart contracts. Because smart contracts provide programmability and automation where it wasn’t possible to such an extent, the need for intermediaries is nullified, and it saves further costs and time by increasing speed. Even more, open and free access with anonymity is useful regardless of geography, making it difficult to be tampered with or prohibited by various jurisdictions.
What Problems does DeFi Solve?
Decentralized finance solves most of the problems in the modern financial system. Even though most financial institutions try solving these problems and governments are more inclined to solve them as much as possible, some problems remain that can’t be solved, and it’s expensive for most financial institutions to solve. But DeFi allows all problems in traditional finance to be solved on behalf of the people.
What are the DeFi Protocols?
Decentralized Exchanges (DEX)
Decentralized Exchanges are the first applications of DeFi as tokens found themselves a platform to be traded. While they’re quite easy to use by connecting a wallet and transacting on the blockchain, they tend to have higher commissions and slippage when compared with traditional crypto exchanges. As a result, wider financial inclusion was achieved, and their evolution led to a whole ecosystem benefiting from alternative sources.
Launchpads became popular among projects to raise the funds necessary to be successful. While most projects fail due to a lack of financing, some established projects would get crowdsourcing through launchpads, getting an alternative source which was not possible where venture capitalists or financial institutions would have to appear. As they became an attractive source to raise revenue, they became a hotspot for projects and investors to rack up additional revenue and returns to potential investors.
After DEXs start to appear in space, lending protocols became an integral part of the DeFi ecosystem. Their prominence allowed an alternative and safer means of borrowing. Even if traditional financial institutions take measurements to minimize their credit risk, they may fail to do the assessments or not do them at all due to various reasons. Because lending protocols require a certain percentage of collateral in the first place for borrowers, the failure to repay the debt would be further minimized, and their position would be liquidated, and they would have to pay a penalty fee and a commission for the service. Even more, its algorithmic nature allows automated execution where it’s not possible in traditional lending functions.
Insurance is one of the functions that are available for DeFi. While insurance itself plays a vital role in the global economy, the process is known to be slow, and insurance and reassurance companies face high risks and complex structures where innovation would be next to impossible. And considering the high risks associated with DeFi, insurance firms would tend to stay away from damages, protocols like Nexus Mutual emerged, and the community would allow whether the incident would be worth covering the losses. But as protocols like Nexus Mutual emerges and even major crypto exchanges insure themselves against various risks, removing complicated processes and the community would contribute with their funds.
Derivatives are an important part of traditional finance, and they’re important with their various instruments. Working similarly to their traditional counterparts, they became an important part of the ecosystem. Having the same instruments, derivatives in DeFi are not heavily regulated, matured, and open-source development allowed lots of products to be created. While crypto assets are used in these exchanges, various products were created without any oversight and they function with the community.
What are your thoughts on decentralized finance? What problems does decentralized finance solve that we didn’t mention? Did you use DeFi applications, if you did, how did you find their use? Share your thoughts, comments, and experiences in the comments section below.
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