What is Decentralized Finance (DeFi)?
DeFi or Decentralized Finance refers to a host of financial applications built on top of blockchain networks. It is a step towards truly creating an open-source, permission-less and transparent financial service ecosystem that anyone and everyone can use without a central authority. The end users would have full authority and control over their assets and interact using DAPPS (Decentralized applications). DeFi’s biggest allure is the true democratization of financial services, especially for the unbanked.
Its main tenets are that it is:
- final and fluid
DeFi apps rely on stable coins and digital assets, like DAI or USDC and Ethereum. DeFi’s main improvement on FinTech is that it brings the same concept of Lego blocks to financial applications, giving them the moniker of Money Legos. In other words, the DeFi ecosystem makes it possible to take out a loan on one platform, perform a leveraged trade on another, and exchange it back to the base asset through a decentralized, blockchain-enabled exchange. As a result, composability enables DeFi to have a wide range of use-cases where it outperforms its traditional counterparts. The composability feature enables stacked functioning, and refers to the ability to re-connect different applications built on blockchains, like Ethereum.
Advantages of DeFi
Traditional finance relies on institutions such as banks to act as intermediaries, and courts to provide arbitration.
“The biggest advantages of DeFi is that its permissionless to participate (no KYC, credit score, etc.), same rules apply to everyone, liquidity is ’borderless’ (you can access the market from anywhere & anytime as long as you have internet), and it’s non-custodial so you have full control over your money and you can use it however you want.”
- Smart contracts specifies how the platform functions and manages disputes. The use of smart contracts ensures that DeFi solutions are low cost and easy to use.
- Built on blockchain, it embodies all the benefits of blockchain networks including elimination of a centralized point of failure.
- Because DeFi is an open ecosystem, it’s access is easy for individuals such as low income communities, who under normal situations would not have access to financial services because it doesn’t benefit the intermediaries.
Risks involved in DeFi
The greatest security risks which DeFi industry must deal with are:
- Lack of data – Data collection methods in DeFi are still being developed, but the nature and complexity of available data has increased significantly in recent years.
- Requirement for monitoring transactions – DeFi applications need more comprehensive checks to ensure transfers to the right addresses.
- Compliance issues – The DeFi ecosystem needs regulatory bodies to provide greater support in case of price slippages and regulatory scrutiny. Organizations are emerging to provide better earlier support and one click regulatory solutions.
- System Failure – Since the DeFi ecosystem is not fully established, users need to minimize the risk of potential failure. The last step towards this goal is the financialization of risks through insurances and verified smart contracts.
- Hacking – Since DeFi projects have proven to be successful hacking targets, the DeFi industry is developing sandboxes and clear frameworks for dispute resolution.
- Asset price information – By auditing smart contracts, the DeFi industry is trying to provide ways to detect and solve bugs quickly.
Difference between DeFi and open banking
Open banking refers to a banking system where third-party financial service providers are given secure access to financial data through APIs. This enables the networking of accounts and data between banks and non-bank financial institutions. Essentially, it allows new types of products and services within the traditional financial system.
DeFi, however, proposes an entirely new financial system that is independent of the current infrastructure. DeFi is sometimes also referred to as open finance. For example, open banking could allow the management of all traditional financial instruments in one application by drawing data from several banks and institutions securely. Decentralized Finance, on the other hand, could allow the management of entirely new financial instruments and new ways of interacting with them.
Decentralization is not a universal answer to all problems. It is important to identify use-cases that would benefit from the tenets of blockchain.
Potential use cases for DeFi
Decentralized exchanges are variations of traditional exchanges. The difference is that decentralized exchanges do not require complete custody of an asset – the original owner can maintain custody. Orders are settled directly between wallets in a matter of minutes which means the traded cryptocurrency will be in the user’s wallet without the need to first transfer the assets to the exchange. The upside of this is that unlike certain centralized exchanges, decentralized exchange users are less vulnerable to losing their funds due to a hack or the exchange vanishing with their money. However, that does not mean they are entirely fool proof, as faulty pricing data have caused losses for users.
2. Lending & Borrowing
DeFi allows users to lend and borrow directly, removing a banking intermediary from the entire chain. Balance verifications are based on a blockchain, assets are transferred to a smart contract, and interest rates are deducted without human intervention once the conditions are set.
Loans in DeFi are typically used by margin traders, who give their cryptocurrencies as a collateral. As long as they are able to pay the interest rate and maintain the collateral requirements of a loan, they do not have to rely on a third party to have access to a lending facility.
Non custodial lending has now been made available through collaborations with wallet providers. Over time, other digital assets like IP rights or digital art, could also be used as a lending instrument. The high demand for digital lending today makes the yield or return on investment for individuals leaving their deposits in DeFi platforms – considerably higher than the interest offered by traditional banks, but not without some extra risks
3. International Remittance
Stablecoin based payments have handled over $220 billion worth of assets on blockchain. According to the World Bank, global remittance volume for 2018 was around 620 billion. Stablecoin based payment adoption will enable businesses and individuals alike to receive money from anywhere in the world in under ten minutes for a fraction of the cost of traditional payment relays.
4. Provenance & Ownership
Verifying the source of a document or ensuring a claim of ownership over a digital asset is hard in legacy markets, largely due to their centralized systems. The mutable nature, which means they can be retrospectively changed, of traditional documents, make them easy to forge and, more importantly, difficult to verify. Blockchains offer an alternative to this with Non-Fungible Tokens (NFT) and fractional ownership. Non-fungible tokens are tokens that cannot be divided into smaller fractions or reproduced. They. are used to represent tickets, gaming passes, or even in-game art. The token itself represents ownership of the asset. Fractional ownership makes it possible for individuals to own a smaller portion of very costly assets. This is common in the case of vintage cars, highly prized real estate, and artwork. The asset ownership is proven by individuals or agencies through regional attestation bodies, then issue tokens that represent part-ownership of the asset. Individuals can then trade the fractional tokens with one another os the perceived value of the asset changes. Regulations around this are not entirely clear yet.