Decentralized finance (or simply DeFi) is an ecosystem of financial applications built on blockchain technology.
More specifically, DeFi could refer to a mechanism aimed at creating an open, unconditional and transparent financial services ecosystem that is accessible to everyone and operates without any. any central agency. Users retain full control of their assets and interact with this ecosystem through decentralized P2P applications (dapps).
The main advantage of DeFi is easy access to financial services, especially for those isolated from the existing financial system. Another potential advantage of DeFi is its modular architecture based on it — DeFi applications are interoperable on public blockchains, capable of creating fully financial markets, products and services. new.
What are the main advantages of DeFi?
Traditional finance is where institutions like banks act as intermediaries and courts act as arbitrators.
The DeFi application does not require any intermediaries or arbitrators. The code specifies how to resolve any possible disputes, and users are in control of their money at all times. This reduces the costs associated with providing and using these products and allows for a more efficient financial system.
Since decentralized finance is done on blockchains, single failures will be eliminated. The data is logged in series and broken down into thousands of nodes, making censorship or closing of service ultimately a complicated process.
Since DeFi application structures can be pre-created, their implementation becomes much less complex and secure.
Another major benefit of such an open ecosystem is the ease of access for people who do not have access to any financial services. Because the traditional system relies on for-profit intermediaries, low-income people often cannot access their services. With DeFi, significantly lower costs and a wide range of financial services can also benefit low-income people.
How can DeFi be used? — For example
Open loan protocols are among the most popular types of applications within the DeFi ecosystem. Open, decentralized loans have many advantages over the traditional credit system. These include: instant transaction settlement, digital asset security capabilities, no need for reliability testing, and the possibility of future standardization.
Since these lending services are built on public blockchains, they minimize the level of trust required and provide methods of cryptographic verification. The blockchain-based loan market reduces counterparty risk, making it cheaper, faster and more available to borrow and issue loans.
Since DeFi applications are by definition financial applications, banking services are an obvious use case. These may include issuing stablecoins, mortgage lending and insurance.
As the blockchain industry matures, there is a growing interest in creating stablecoins. They are a cryptocurrency that is often tied to real assets but can be transferred digitally very easily. Since cryptocurrency prices can fluctuate rapidly at times, decentralized stablecoins can be used on a daily basis as digital currencies that are not issued and monitored by a central authority.
Due to the large number of participating brokers, the mortgage loan process is costly and time consuming. Thanks to smart contracts, commissions can be significantly reduced.
Blockchain insurance can eliminate the need for a middleman and allow risk sharing among multiple participants. In this way, a lower premium can be achieved with the same quality of service.
It can be difficult to judge this category of apps because it is this segment of DeFi that offers the most space for financial innovation.
Perhaps the most important DeFi applications are decentralized exchanges (DEXs). These platforms allow users to trade digital assets without having to withhold money by a trusted broker (in this case an exchange). These transactions are performed directly between users’ wallets using smart contracts.
Since they require much less work, decentralized exchanges tend to have lower transaction fees than centralized exchanges.
Blockchain technology can also be used to issue and own a wide variety of common financial instruments. These applications will work in a decentralized way, eliminating single error cases.
Security token issuance platforms, for example, can provide publishers with tools and resources to create crypto investment agreements with configurable parameters on the blockchain.
Other joint ventures could allow the creation of derivatives, aggregated assets, decentralized markets, and more.
What is the role of smart contracts in DeFi?
Most of the existing DeFi applications available include the creation and execution of smart contracts. While a typical contract uses legal terminology to define the terms of the relationship between entities, smart contracts use computer code.
Since their terms are written in computer code, smart contracts are able to enforce these terms, also with the help of computer code. This enables reliable execution and automation of a large number of business processes that currently require manual monitoring.
Using smart contracts is faster, easier, and reduces risk for both parties. On the other hand, they also introduce new forms of threats. Because computer code is vulnerable to errors, the value and confidential information contained in smart contracts can be exposed to various attacks.
What are the challenges facing DeFi?
Blockchains are inherently slower than their centralized counterparts, which translates into applications built on top of them. DeFi application developers must take these limitations into account and optimize their products accordingly.
High risk of user error
DeFi applications transfer responsibility from middleman to user. For many of them, this could be a negative aspect. Designing products that minimize the risk of user error is an especially difficult challenge when installed on a blockchain.
Bad user experience
Currently, using DeFi application requires users to put in extra effort. For DeFi applications to be an important component of the global financial system, they must provide benefits that encourage users to abandon the traditional system.
Finding the most suitable application for a given situation can be a daunting task, and the user must be able to find the best solutions. The challenge is not just building apps, but thinking about how they fit into the broader DeFi ecosystem.
What is the difference between DeFi and open banking?
Open banking is a banking system where third party financial service providers are granted secure access to financial data through APIs. This allows for the creation of a network of accounts and data between banks and non-bank financial institutions. This essentially allows for the creation of new types of products and services within the traditional financial system.
However, DeFi proposes a completely new financial system that is independent of the existing infrastructure. Decentralized finance is sometimes referred to as open finance.
Open banking can allow all traditional financial instruments to be managed in one app by downloading data from several banks and institutions.
In turn, DeFi could enable completely new financial instruments to be managed and new ways of interacting with them.
Decentralized finance focuses on the construction of financial services separate from the traditional political and financial systems. This will allow for a more open financial system and possibly prevent censorship and discrimination around the world.
While this is a good idea, not everything can benefit from decentralization. Finding the use cases that are most relevant to blockchain features is an important part of building a useful set of open source financial products.
If this is achieved, DeFi will take power from large organizations, centralize it and hand it over to the open source community and individuals. We will find out when DeFi is ready for general use, whether this will result in a more efficient financial system.