The world of finance has seen some serious changes in the present decade. The world of cryptocurrency aims to make finance a service available to all without interruption of any middle man. As ambitious it sounds, it has become a reality because of a revolution called Decentralized Finance, or as the young world likes to call it DeFi.
In 2008 a mysterious person called Satoshi Nakamoto came and stormed the world of finance which at the time was an injured lion with a white paper called Bitcoin. As mysterious was Bitcoin’s identity, it was equally difficult for the giants of the finance world in black suits to recognize it. For the wolves of wall street at that time it was just a new ambitious plan which will be forgotten in a few years. Bitcoin somehow laid the foundation for people to realize the potential of Blockchain technology, something which was first introduced to the world in the 90s but was still far from being accepted worldwide.
Another stepping stone came in the form of Ethereum. Developed by a 17 years old Russian teenager named Vitalik Butorin, who started the project with aim of making the world’s biggest supercomputer in form of a blockchain network. Little did the kid knew that his project will one day become stepping stone for 3rd internet revolution or WEB 3.0. For many, it was just a high school project, but today Ethereum has made the giants from Silicon Valley to invest their resources into blockchain technology.
Ethereum leads the way for uncountable new innovations and startups in the world of blockchain technology most of which sought to transform some field of finance.
The Decentralized Finance (DeFi) or Open Finance movement takes the promise of cryptocurrency to make an open thing a step further. Imagine a global, open alternative to every financial service you use today — savings, loans, trading, insurance and more — accessible to anyone in the world with a smartphone and internet connection. World of finance for a better part of history was an industry slow to take up new technologies. But after the introduction of Ethereum, the finance industry has become the new bed of innovations.
This is now possible on smart contract blockchains. Ethereum “Smart contracts” are programs running on the blockchain that can execute automatically when certain conditions are met. These smart contracts enable developers to build far more sophisticated functionality than simply sending and receiving cryptocurrency. These programs have become the new method of bringing automation onboard. From automating payments to selling tokens as salary, smart contracts have added new functionality to all domains of finance.
These programs are what we now call decentralized apps or dapps.
One can think of a Dapp is an app that is built on decentralized technology, rather than being built and controlled by a single, centralized entity or company. The fundamental principle of Dapps that they are decentralized and not controlled by a single entity has led to its widespread use in the fintech industry.
DeFi is now one of the fastest-growing sectors in Blockchain. Industry observers measure traction with a unique new metric — “ETH locked in DeFi” which roughly gives us the amount of money that is currently in use in various DeFi projects. As of writing this article, it is estimated that users have deposited over $942 million worth of cryptocurrency into these smart contracts.
What makes these DeFi businesses so successful is the fact that At their core, the operations of these businesses are not managed by an institution and its employees — instead the rules are written in code (or smart contract, as mentioned above). Once the smart contract is deployed to the blockchain, DeFi dapps can run themselves with little to no human intervention (although in practice developers often do maintain the dapps with upgrades or bug fixes).
Defi has seen multiple innovations in various fields of the financial system. Some of the most common uses in Defi Market are-
Lending: Borrowing/Lending on a public blockchain with much less friction vs. traditional platforms.
Derivatives/Assets: Synthetic assets which are derivatives of other assets allows exposure without having the actual asset.
Decentralized Exchanges: Traders can trade on platforms that do not hold their funds custody
Payment solutions: Traditionally centralized payment solutions can be decentralized to be as effective while staying censorship-free.
DeFi vs. Fintech
Upon first glance, DeFi might sound similar to “Financial technology”, or Fintech for short, which also aims to use technology in order to improve financial services. However, the key difference between DeFi and Fintech is that Fintech merely builds upon traditional financial infrastructure, instead of using something new like blockchain technology. DeFi aims to bring technology into finance in form of distributed blockchain technology.
An example of a popular Fintech service would be Transferwise, an international payments service. Although Transferwise charges lower fees than most banks and currency exchange companies, it still uses bank accounts and other legacy financial infrastructure.
The difference with Transferwise is that instead of moving money across borders and via other middlemen (like banks), Transferwise has bank accounts in different countries.
So, for example, when you send USD to someone in the European Union, Transferwise takes your dollars and then takes money from its EU bank account to give to your recipient. This allows them to charge lower fees and process transactions faster.
However, you still have to trust Transferwise to approve and clear the transaction. Moreover, you still have to get permission to send your money abroad. In most cases, you need to provide identification documents and might not be able to send money to the recipient if they are located in a blacklisted country.
Now counterpart with the DeFi product, Dai, an Ethereum-based project that’s designed to mirror the value of the US dollar in order to protect against the volatile swings that cryptocurrencies can be known for.
With Dai, you do not have to trust a Fintech company or bank to approve and settle your transaction. Instead, Ethereum miners validate new Ethereum-based transactions, including those of Dai, and add them to the blockchain.
Not to mention you can send Dai to anyone with a wallet that supports Dai, even if they live in countries blocked off from the legacy financial system.
This way we can see how the basic features of blockchain that have made it stand out from the rest is the reason behind success of DeFi over other conventional fintech counterparts.
Use of DeFi products are much more convenient to use as anyone with a blockchain wallet can participate in the various transactions of these products.
Humans have always felt comfortable when they do something at their own without the involvement of third party. This combined with the ease with which one can use the DeFi platforms compared to the other fintech counterparts have made DeFi businesses a hit.
Challenges Associated with DeFi
Every high return financial product comes with an attached risk. Thus, it is a given that there will be a list of challenges associated with DeFi as well.
Understanding and securely handling cryptocurrencies tools call for specialized knowledge and attached risk. It becomes a user’s responsibility to take care of their key and holding and follow the process of multi-factor authentication with utmost privacy.
Also, there have been far too many security-related incidents, which have begged the interference of stringent security and privacy algorithms brought in by a sound blockchain development company. While the solution creators have been taking control of the task, as DeFi users you too must keep yourself updated with changed service terms between different wallets, exchanges, and other Blockchain projects.
Lastly, in the case of traditional currencies, investors have benchmarks and historical data to look at before taking any investment decision. The same privilege, however, is not given to the DeFi users. The lack of historical numbers makes it difficult for them to assess the associated risk. This, in turn, makes it necessary for them to perform extensive research on their own.
Even After all these challenges, the DeFi system stands as one of the most promising and revolutionizing market.
The Future of DeFi
DeFi is the latest digital offering of an industry that has been around since the beginning of time. In the time to come, we are poised to see every single financial service we use today under the fiat scheme getting rebuilt in the DeFi and open finance ecosystem.
The first generation of types of DeFi apps rely majorly on using collateral as a safeguard mechanism, meaning, you will have to own cryptocurrency and then offer it up as a collateral for borrowing more cryptocurrency.
We are also already seeing massive innovation happening in the insurance domain as a result of the latest iterations of DeFi apps. A number of today’s DeFi loans are over collateralize — the loans are made inherently safe because of the massive asset cushion kept in the reserve.
In the future, we can also expect cryptocurrency wallets to become the portal of all the digital asset activities. You can imagine it as a dashboard that not just shows the assets that you own but also how much of it is locked up on different open finance protocols like pools, loans, and insurance contracts.
We are also seeing a shift towards decentralized governance and decision-making. Today, despite the focus on the word ‘decentralized’ in DeFi, the projects have master keys for DeFi platform development solutions providers to shut down dapps, for the sake of easy upgrade or to safeguard instances of buggy codes. The DeFi community, however, is looking for ways to enable stakeholders to vote on decisions, introducing a much wider range of DeFi use cases.
The fact that the future of DeFi and the future of money lies in the hand of anyone who can code is nothing less than interesting for us.
Once considered as the sitting duck of technology, finance is someway leading the transition towards web 3.0
Like every change humanity has seen, Blockchain had its healthy part of criticism as well. From handloom workers protesting against power looms to wolves of wall street calling DeFi ambitious high school projects, industrial changes have never been easy. But what no one can deny is the popularity with which DeFi businesses have risen to the top.
From being the currency for drug dealers on the dark web to leading the world of finance, blockchain has come a long way.
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