What is DeFi?
- In A Few Years’ Time, Life Without DeFi Might Be Hard to Comprehend.
- What is DeFi, how did it develop, and why does it have the potential to change society?
In the years that follow after the launch of Bitcoin, almost everyone who studied it excitedly believed it had all the necessary qualities needed to replace the global financial system. In hindsight, this was a premature expectation.
Bitcoin only does a tiny part of what makes up the global financial industry. At its core, Bitcoin facilitates online payments and holding of money with no central authority.
Payments is not even the core business of old financial institutions; the core products of major financial institutions include services such as savings, credit, asset management, forex, insurance, and several other financial services.
If you have saved your wealth in Bitcoin, you can only stand to profit if the price of Bitcoin goes up. Bitcoin does not provide a way to access credit, nor does it entitle you to any dividends or interests.
For these services, and others, you had to go to platforms run by corporate entities, such as cryptocurrency exchanges that are mostly centralised in nature. In every practical sense, these centralised platforms are like the banks that many in the Bitcoin community have been trying to avoid.
But all along, the solution to accessing all kinds of financial services without going through centralised platforms was in blockchain-the technology on which Bitcoin runs.
In 2013, Vitalik Buterin was just a 19-year-old mesmerized by the technical implementation of Bitcoin. He had spent the last few years looking through its core protocol while he contributed to an online Bitcoin magazine.
He concluded that the technology behind the cryptocurrency (blockchain) was more powerful than many realised, and saw the potential of it supporting more applications than just a digital currency. However, it also occurred to him that the Bitcoin blockchain was too rigid to realise this potential.
For that reason, Vitalik wrote a white paper describing a completely new blockchain. With other developers, they soon built Ethereum, through which most of the other financial services have been delivered.
The core technology of Ethereum that gives it capacity to do a lot more than what the Bitcoin blockchain does is the smart contract. This is the capacity to take agreements, write them in a computer language and then set them to self-execute when the right conditions are met.
Once a smart contract is active, no one can stop, change or redesign it. It exists and acts independently of any individual or organisation (including those who created it).
It is through smart contracts that the blockchain offers all kinds of financial services in a peer- to-peer arrangement. That means that, for example, a lender can enter into a contract with a borrower without a third-party facilitator.
What is a DeFi?
Any application on a blockchain that offers a financial service is known as a decentralised finance (DeFi) application. Indeed, Bitcoin was the first DeFi project that offers a payment financial service.
One other category of DeFi that has since been successfully implemented is the lending platforms – applications where some users offer their money for borrowing to get interest. Borrowers can then take the money to fund and invest in other DeFi projects. Some of the most popular DeFi lending platforms include Compound Finance, Aave, and BlockFi.
A smart contract usually guides all the transactions on the DeFi, including the provision of a collateral.
Meanwhile, if you need to trade your digital assets, you can use a decentralised exchange like Uniswap. It is not owned by a corporate entity, but exists as a decentralised autonomous organisation (DAO).
Another category of DeFi includes stablecoins, which are assets pegged on a real-world asset like the US dollar. An example of a DeFi stable coin is DAI, which is backed by a basket of cryptocurrencies in wallets managed by smart contracts.
What are the advantages that DeFi apps have?
Why should we even care about DeFi? What do they give us we can’t get from centralised financial service providers? The advantages of using DeFi over using centralised financial services are many. They include:
As the 2008 financial crisis proved to us, there are many poor decisions that are made in the backrooms of financial institutions. Some of these decisions can’t be made if everything was in the open. With that said, when they result in losses, they affect the lives of millions of innocent people.
Poor decisions made because of lack of transparency are not limited to conventional financial institutions. Even within the cryptocurrency space processes by centralised entities that have been questioned.
For example, claims of financial impropriety have been made about Tether Limited, the company behind the stable coin Tether. Tether Limited is closely associated with the Bitfinex exchange.
Financial services on the blockchain through DeFi give consumers access to every step involved in the delivery of a service. Because of this, they can see poor decisions way before they impact their financial position.
More importantly, though, it prevents those in charge from making poor decisions.
Even then, critical decisions on DeFi are made by the end users through direct voting. For example, users vote to determine the interest rate borrowers of DAI should pay.
Making financial services less costly
Much of what we pay for financial services goes to set up and maintain hardware and software infrastructure, pay employees, settle overheads and also reward investors for their capital (dividends).
DeFi projects are built and run-on open-source platforms and as a result, the costs are negligible. For example, much of the work that are done by humans in centralised financial institutions is taken over by smart contract applications.
This significantly cuts the cost of financial services. In addition, with DeFi, there are no owners of the platform who need to get rewarded with significant amounts of dividends. Indeed, if there are any dividends to be earned, almost all of it goes to the end users.
Creating more investment opportunities
Investors have, in particular, found new ways to generate value on DeFi. As of the time of this post, over $3 billion worth of digital assets are locked in various DeFi applications.
Something else that is interesting about DeFi platforms is the concept of Money Legos. This is where each investor can design their own strategy, or even a product, by combining activities in different independent apps.
For example, you might notice that borrowing on one app and lending on another will end up giving you enough revenue to offset the loan and turn a profit. You can design and implement this as your strategy.
The different DeFi applications are interoperable through protocols that core developers of the platforms, third party solution providers or individual investors build. This is, in particular, possible because they are all permissionless (you need no go-ahead to build connecting components).
lmproving competition and reducing censorship
To set up a DeFi service is way easier than starting a traditional finance institution. No rigorous paperwork is needed.
They also have a global reach. There are many parts of the world where residents have to put up with poor products because of limited competition caused by regulations. DeFi gives them the opportunity to sample from a longer list of options.
The competition is also most likely to result in the best services being accessible at the list cost possible.
In a nutshell, DeFi could be the lean, secure and more efficient way to deliver all kinds of financial services. Indeed, future generations might end up wondering how we have survived without DeFi, like we wonder how the older generation once made it without the internet and mobile phone.
Disclaimer: The content in this report is from the open source and for educational purposes only, therefore should not be considered as financial advice. We all know that the cryptocurrency market is highly volatile. Therefore, all the financial decisions should be made after doing your wide spectrum research.