Like Cryptocurrency, like Decentralized Finance (DeFi).
Cryptocurrency is not built to fight the existing financial systems, neither is Decentralized Finance. Both are providing alternative means of financial services and strengthening the existing platforms. Decentralized Finance is one of the applications of Cryptocurrency, as it enables investors, holders, lenders, savers, alike to hold, trade, and transact digital assets. Look at DeFi as the most recent breakthrough in Fintech, and as a prime mover to Cryptocurrency adoption.
Like Cryptocurrency, Decentralized Finance (DeFi), operates on various Blockchain.
However, while Cryptocurrency had its first application in Bitcoin, DeFi started with Ethereum. Judging from recent market trends, you could say whatever happens to Cryptocurrency, will happen to Decentralized Finance. For instance, the Cryptocurrency market cap in 2018 reduced to 50 percent, the same as the Total Value Locked (TVL) in DeFi. Currently, according to DeFi Pulse, as the market awakes, the DeFi is $971.7M.
Therefore, this article will help you to understand what Decentralized Finance (DeFi) is, and its associated ecosystems, opportunities, and prospects.
What is DeFi?
DeFi stands for decentralized finance and is typically an open finance movement. It is creating financial systems that are open to everyone who wants to minimize the risk of trusting a central authority.
DeFi is simply a revolutionary financial system, built on Blockchain, Internet, cryptography, among other technologies. Unlike traditional financial institutions where you need a central authority to verify and regulate transactions, DeFi is guided by a smart contract, written on specific protocols between DApps users.
The smart contract is primarily a set of codes written to predetermine the party’s agreement and transaction, further executing automatically once met. On the other hand, DApps are generally referred to as Decentralized Applications. These applications are built across several nodes (computers) across the globe to serve users at different locations.
DeFi and the Traditional Financial System
Decentralized Finance (DeFi) is similar to the traditional financial system by connecting investors, savers, borrowers, lenders, and the rest, but differs in the decision-making process, technology, governance, and transparency.
Here are the differences between Defi and the traditional:
Trustless: DeFi borrows the trustless model of the underlying technology-Blockchain. Unlike the traditional financial system where you need trust to carry out any transaction, DeFi operates a “don’t trust, but verify” transaction model. Consequently, you don’t need to trust any third party before carrying out a transaction, instead, you need to verify the transaction through the hash IDs.
Open: While the traditional financial system is opaque, DeFi is transparent. In conventional financial institutions, you will likely not know the charges, possible terms, and changes in contracts. However, in the DeFi, you operate a distributed ledger technology where you can verify every terms and transaction. Also, it does not allow the third part to mutate.
Interoperable: since DeFi operates a Decentralized Application, DApps, it allows users and developers to build on existing platforms easily. For instance, an Ethereum developer can decide to take advantage of other blockchain ecosystems and vice versa.
Distributed and permissionless: Every traditional financial institution is designed to have a central authority to govern the institutions, but DeFi, operates a distributed financial institution where, units of transactions, DApps, and protocols are scattered across nodes across the globe. Consequently, the central authority governance model of the traditional systems allow a permissible system, while the distributed technology model of the DeFi enables a permissionless system.
By implication, you need permission to transact on the traditional financial systems even when you have met the terms and conditions. However, you only need to be guided by the smart contract to transact on the DeFi. Hence, DeFi is permissionless, and others are permissible.
Digital assets: Traditional financial institutions enable its adherents to hold, save, insure, and transact physical assets like banknotes, real estate, stocks, etcetera. The DeFi opens doors for you to manage digital assets.
If you must manage physical assets in a distributed and automated ecosystem, DeFi helps you to tokenize the assets to hold, save, insure, and transact as needed.
How Decentralized Finance (DeFi) Works
DeFi is bringing financial services to the Blockchain. It uses the enabling technologies and functionalities like smart contracts, distributed ledger technology, consensus, among others, to facilitate investors, savers, insurers, and offer user’s transactions.
In simplest terms, Defi enables users to invest, save, and transact on a blockchain managed system.
To know how DeFi works, imagine that an investor wants to have a certain return on investment, ROI, he will approach a certain financial institution to reach an agreement. The financial institution would likely take time to file terms and conditions and reach a move from one office to another. However, in a DeFi, the investor, at his comfort, opens the computer and logs a DApp, invests his digital assets, and the smart contract guides the transaction.
What happened while the investors opened the DApp is that the DApp hosted a smart contract and made choices from a pool of investment options. As soon as the investment is due, the smart contract reciprocates the agreed profit to the investors without the need for a letter of credits and other documents.
Ethereum Based DeFi and Other DeFi Ecosystems
Although Decentralized Finance (DeFi) championed by Ethereum started earlier than 2018, 2020 could be the year of DeFi, looking at how other platforms like Celo, Algorand, Cosmos, among others are evolving.
Regardless, this article is not comparing other DeFi ecosystems to Ethereum. However, it is worthy to note the dynamics of the market and how different ecosystems are trying to catch up. Last year, 2019, the Maker, an Ethereum DeFi ecosystem, had a market dominance of 85% whereas, it is currently at 54.22%. Therefore, other ecosystems make up a combined significance of the remaining 45.78%. Consequently, it is an indication that different DeFi ecosystems are entering the space.
Prospects in Decentralized Finance (DeFi)
More applications and services: Almost every Defi platform like Maker, Aave, Compound, WBTC, etcetera, started as collateralized loan solutions. Although they are currently adding other services like trading, DEX, derivatives, there are rising needs to meet every financial need of its users. For instance, most of the platforms don’t offer insurance services even when there are tendencies for hacks. Hence, the future of DeFi lies in expanding to various services that can meet all financial needs.
Decentralization: It is interesting to note that the Blockchain space is still having full decentralization challenges. However, there are opinions that decentralization and scalability are not possible simultaneously. Nonetheless, the same applies to DeFi since it’s an application of Blockchain. For this reason, there is a need to future assure decentralization in the space to ensure further that there is no possible central authority.
Consequently, a Decentralized Autonomous Organisation is an ideal DeFi solution to enable everyone to have control over assets and governance.
Portfolio management: While the space advocates and keeps the privacy of users, there is an increasing need to allow users to have their portfolio in one platform to enable ease, flexibility, and better decision making. Hence, developers should see opportunity in providing an all-round portfolio management service in DeFi.
Online transaction made easy: Before the 2008 Bitcoin white paper release, you probably didn’t think a trustless transaction on a peer to peer system would be possible, but now it is. Next is to leverage the DeFi space to make further the trustless online transactions more comfortable and faster.
As against the conventional financial system, DeFi has no central authority, it is cheaper, faster, and enables a more significant population. It will lead the Cryptocurrency adoption in a short while.
Okereke has a passion for researching blockchain and cryptocurrency. He enjoys creating long form educational content to inform others on the opportunities in this space.