A New Financial System : Decentralized Finance

Decentralized finance, also known as DeFi, uses cryptocurrency and blockchain technology to manage financial transactions. DeFi aims to democratize finance by replacing legacy, centralized institutions with peer-to-peer relationships that can provide a full spectrum of financial services, from everyday banking, loans and mortgages, to complicated contractual relationships and asset trading.

Today, almost every aspect of banking, lending and trading is managed by centralized systems, operated by governing bodies and gatekeepers. Regular consumers need to deal with a raft of financial middlemen to get access to everything from auto loans and mortgages to trading stocks and bonds.

As a result, there are few paths for consumers to access capital and financial services directly. They cannot bypass middlemen like banks, exchanges and lenders, who earn a percentage of every financial and banking transaction as profit. We all have to pay to play.

Decentralized Finance (DeFi) challenges this centralized financial system by disempowering middlemen and gatekeepers, and empowering everyday people via peer-to-peer exchanges.

Here’s how that might play out. Today, you might put your savings in an online savings account and earn a 0.50% interest rate on your money. The bank then turns around and lends that money to another customer at 3% interest and pockets the 2.5% profit. With DeFi, people lend their savings directly to others, cutting out that 2.5% profit loss and earn the full 3% return on their money.

You might think, “Hey, I already do this when I send my friends money with PayPal, Venmo or CashApp.” But you don’t. You still have to have a debit card or bank account linked to those apps to send funds, so these peer-to-peer payments are still reliant on centralized financial middlemen to work.

Blockchain and cryptocurrency are the core technologies that enable decentralized finance.

When you make a transaction in your conventional checking account, it’s recorded in a private ledger—your banking transaction history—which is owned and managed by a large financial institution. Blockchain is a decentralized, distributed public ledger where financial transactions are recorded in computer code.

When we say that blockchain is distributed, that means all parties using a DeFi application have an identical copy of the public ledger, which records each and every transaction in encrypted code. That secures the system by providing users with anonymity, plus verification of payments and a record of asset ownership that’s (nearly) impossible to alter by fraudulent activity.

When we say blockchain is decentralized, that means there is no middleman or gatekeeper managing the system. Transactions are verified and recorded by parties who use the same blockchain, through a process of solving complex math problems and adding new blocks of transactions to the chain.

Advocates of DeFi assert that the decentralized blockchain makes financial transactions secure and more transparent than the private, opaque systems employed in centralized finance.

DeFI is making its way into a wide variety of simple and complex financial transactions. It’s powered by decentralized apps called “dapps,” or other programs called “protocols.” Dapps and protocols handle transactions in the two main cryptocurrencies, Bitcoin (BTC) and Ethereum (ETH).

While Bitcoin is the more popular cryptocurrency, Ethereum is much more adaptable to a wider variety of uses, meaning much of the dapp and protocol landscape uses Ethereum-based code.

Here are some of the ways dapps and protocols are already being used:

Open lending protocols are one of the most popular types of applications that are part of the DeFi ecosystem. Open, decentralized borrowing and lending have many advantages over the traditional credit system. These include instant transaction settlement, the ability to collateralize digital assets, no credit checks, and potential standardization in the future. 

Since these lending services are built on public blockchains, they minimize the amount of trust required and have the assurance of cryptographic verification methods. Lending marketplaces on the blockchain reduce counterparty risk, make borrowing and lending cheaper, faster, and available to more people.

As DeFi applications are, by definition, financial applications, monetary banking services are an obvious use case for them. These can include the issuance of stablecoins, mortgages, and insurance.

As the blockchain industry is maturing, there is an increased focus on the creation of stablecoins. They are a type of crypto asset that is usually pegged to a real-world asset but can be transferred digitally with relative ease. As cryptocurrency prices can fluctuate rapidly at times, decentralized stablecoins could be adopted for everyday use as digital cash that is not issued and monitored by a central authority. 

Largely because of the number of intermediaries needing to be involved, the process of getting a mortgage is expensive and time-consuming. With the use of smart contracts, underwriting and legal fees may be reduced significantly.

Insurance on the blockchain could eliminate the need for intermediaries and allow the distribution of risk between many participants. This could result in lower premiums with the same quality of service.

This category of applications can be challenging to assess, as it is the segment of DeFi that gives the most room for financial innovation. 

Arguably, some of the most crucial DeFi applications are decentralized exchanges (DEXes). These platforms allow users to trade digital assets without the need for a trusted intermediary (the exchange) to hold their funds. The trades are made directly between user wallets with the help of smart contracts. 

Since they require much less maintenance work, decentralized exchanges typically have lower trading fees than centralized exchanges. 

Blockchain technology may also be used to issue and allow ownership of a wide range of conventional financial instruments. These applications would work in a decentralized way that cuts out custodians and eliminates single points of failure.

Security token issuance platforms, for example, may provide the tools and resources for issuers to launch tokenized securities on the blockchain with customizable parameters.  

Other projects may allow the creation of derivatives, synthetic assets, decentralized prediction markets, and many more.

Most of the existing and potential applications of Decentralized Finance involve the creation and execution of smart contracts. While a usual contract uses legal terminology to specify the terms of the relationship between the entities entering the contract, a smart contract uses computer code.

Since their terms are written in computer code, smart contracts have the unique ability also to enforce those terms through computer code. This enables the reliable execution and automation of a large number of business processes that currently require manual supervision.

Using smart contracts is faster, easier, and reduces risk for both parties. On the other hand, smart contracts also introduce new types of risks. As computer code is prone to have bugs and vulnerabilities, the value and confidential information locked in smart contracts are at risk.

Since Blockchain platforms are inherently slower than centralized networks, DeFi applications will also be affected. Therefore, developers of DeFi applications need to consider those limitations and find solutions to optimize their products.

DeFi applications transfer the responsibility from the intermediaries to the user. This can be a negative aspect for many. Designing products that minimize the risk of user error is a particularly difficult challenge when the products are deployed on top of immutable blockchains.

Currently, using DeFi applications requires extra effort on the user’s part. For DeFi applications to be a core element of the global financial system, they must provide a tangible benefit that incentivizes users to switch over from the traditional system.

It can be a daunting task to find the application that is the most suitable for a specific use case, and users must have the ability to find the best choices. The challenge is not only building the applications but also thinking about how they fit into the broader DeFi ecosystem.

Decentralized Finance is focused on building financial services separate from the traditional financial and political system. This would allow for a more open financial system and could potentially prevent precedents of censorship and discrimination all over the world.

While a tempting idea, not everything benefits from decentralization. Finding the use cases that are most suitable for the characteristics of blockchains is crucial in building a useful stack of open financial products.

If successful, DeFi will take power from large centralized organizations and put it in the hands of the open-source community and the individual. Whether that will create a more efficient financial system will be decided once DeFi is ready for mainstream adoption.