Decentralized finance, or DeFi, uses cryptocurrency and blockchain technology to simplify people’s financial transactions by cutting out the middleman. Traditional financial systems run on a centralized infrastructure that is managed by central authorities, institutions, and intermediaries, such as credit companies, banks, and governments.
DeFi aims to replace these institutions with peer-to-peer relationships that can provide a whole range of services, including banking, loans, mortgages, share dealing, purchases and more. Available to anyone with an internet connection, this technology is truly decentralising finance and giving the power to individuals.
Blockchain and Cryptocurrency
The two main technologies at the centre of decentralized finance are blockchain and cryptocurrency. Blockchain is a decentralized, distributed public ledger which records financial transactions in computer code, ensuring everyone involved has an identical and encrypted copy.
This provides users with payment verification, anonymity, and a record of asset ownership that’s almost immune from fraud. Users claim that DeFi makes financial transactions safer and more transparent for all parties when compared to their more centralised alternatives.
Most decentralised finance applications are built using the second-largest cryptocurrency platform in the world, Ethereum. Easier to use then Bitcoin, it offers more flexibility and multiple DeFi applications, making the cryptocurrency popular with developers, as well as investors who like to trade Ethereum.
Popular uses of DeFi
- Decentralised Exchanges (DEXs)
Decentralized exchanges are online cryptocurrency exchanges that enable users to exchange one currency for another, without a central authority being involved. Whether it’s GB Sterling for Bitcoin or U.S. dollars for Ethereum, a DEX connects users directly allowing them to trade cryptocurrencies safely on a peer-to-peer basis.
Lending and borrowing protocols are popular DeFi applications, allowing lenders and borrowers to connect directly and agree their own fee, rather than go through a bank. Using smart contracts parties are automatically matched, and an interest rate calculated, providing an important income stream for crytpo assets.
This includes a whole range of options, from margin trading to derivatives and token swaps. Decentralized exchanges charge trader’s lower fees and faster, more secure transactions.
Online marketplaces are a type of e-commerce site where numerous third parties can provide products or services to customers. Everything from Digital art, NFT’s, freelance gigs and limited-edition goods.
DeFi payment systems are streamlining the whole payment process, not just for users but for financial institutions as well. This development has opened up the market, allowing global customers access no matter their geographical location or proximity to banks or lending institutions.
Stablecoin is a cryptocurrency that is pegged to a more stable asset or assets, such as precious metals, the dollar or other cryptocurrencies. Intended to remove the volatility afflicting crypto and make it a more viable and safer payment solution, they have become increasingly popular.
DeFi apps can offer interest-bearing accounts that can earn more than traditional savings accounts, while yield farming and liquidity mining are also proving to be popular ways to make money.
The applications for DeFi are endless, with prediction markets, staking, asset management, gaming, derivatives, data and analytics and tokenization just some of the many uses for this exciting technology.
Benefits of DeFi
DeFi uses the Ethereum blockchain to increase financial security and transparency, unlock growth opportunities and liquidity and helps support a better integrated and standardised financial system.
But what are the main benefits to this technology that is revolutionising finance?
- Money Legos: DeFi protocols and applications are designed to complement each other, allowing developers the flexibility to build on top of existing protocols, customising and integrating third-party applications – often referred to as ‘Money Legos’.
- Transparency: Every transaction is broadcast to and verified by other users on the network.
- Permissionless: No matter where they are in the world, anyone with an Internet connection can access DeFi applications built on Ethereum.
- Ownership: Custody of assets and control of personal data remains with the customer at all times.
- Security: Blockchain’s decentralised architecture increases security and the ability to easily audit transactions.
The Downsides of DeFi
DeFi is still an emerging technology with exciting potential, but with any new process, there are downsides to consider.
Regulation: The growth of DeFi means national governments are looking at regulation, potentially blocking or hindering its progress.
Scalability: Still in its infancy, nobody is yet sure if DeFi will stand up to the stress test of constant, widespread use.
Lack of Consumer Protection: A lack of regulation and rules has accelerated DeFi’s growth, but it means that users have nowhere to go for help should a transaction go awry.
Keys: Crypto wallets require a unique code to unlock, but if the code is lost, you lose the ability to access your assets.
Hackers: The success of cryptocurrencies and digital assets mean they are a target for hackers.
Future Of DeFi
DeFi may still be in its infancy, but its promise and potential are revolutionary. Investors will gain more independence and have far greater creativity over their assets and dealings.
Ethereum 2.0 promises to solve many of the current concerns, but the road to its acceptance is a long one.