Decentralized finance (DeFi) is a new financial innovation, spawned alongside the cryptocurrency revolution.
However, DeFi has evolved into something attached to crypto, yet bigger and more significant.
In this article, we will cover:
- What DeFi is
- What its uses are
- The challenges the DeFi ecosystem faces
- Impacts on traditional banking products and services
Decentralized vs. Centralized Finance
First, let’s break down the basics.
You’re already completely familiar with centralized finance.
- You use a currency issued by the central bank of a national government.
- You use banking services catering to the needs of everyone participating in the national economy.
Centralized finance, which includes every mainstream financial structure and institution, is defined by:
- Regulations and compliance with frameworks
- Centralized decision-making
- Intermediaries that enforce and abide by these rules
Decentralized finance, or DeFi, offers the opposite approach. The DeFi space uses recent technology, which we will go over, to:
- Remove intermediaries (‘Middle men” like brokers or agents)
- Automate the processes that central banks and national economies use and are subject to
Instead, DeFi is a space that enables transactions between two peers, whether individual or business.
It is open to all, and transactions are listed publicly and cannot be deleted or tampered with.
Is cryptocurrency decentralized finance?
Cryptocurrency and DeFi are often used so closely together that they may seem interchangeable. But the terms are not the same.
Cryptocurrency technology was built on the concepts of decentralized finance. But DeFi is now a wide umbrella that covers cryptocurrencies, among other concepts. So, DeFi and crypto are closely related but are not quite the same.
Cryptocurrencies are decentralized currencies without a central authority figure.
Normal currencies have central banks and elaborate government oversight.
With crypto and DeFi, there is little human oversight, and its pricing and security are both decentralized. Prices are determined by supply and demand as assessed by algorithms.
Cryptos are digital currencies. Their technological underpinning is meant to make transactions secure and honest, without needing intermediaries.
There are many cryptocurrencies on the market now., Bitcoin being the biggest by far. Many of their most crucial aspects are decentralized, and they fit the description of being well within the DeFi space.
What is decentralized finance (DeFi)?
DeFi refers to the broader movement of using the technology that enabled cryptocurrency to:
- Secure financial transactions
- Decentralize financial services
- Cut out middlemen in finance
- Enable open, secure, and transparent finances
Blockchain
“Blockchain” is a technology based on a decentralized ledger – an online record of all transactions.
It served as the foundation of Bitcoin and all other cryptocurrencies. It continues to be used widely for this. But it has also been applied in a new, rich ecosystem of decentralized applications. In the same way the blockchain applies to transactions, it can be applied to any kind of data.
Blockchain is essentially a digital record of transactions stored in a series of digital blocks. At least that’s what it is in crypto. It can also store transparent data with a high level of security. So, it can be applied in many other ways, as it currently is in many DeFi applications.
In the blockchain, every block contains a list of transactions and one cryptographic hash that attaches a string of data of any length and represents it as a single reference value. They also contain a reference to the last block in its chain.
All this adds up to:
- Immutability (common crypto jargon for “cannot be deleted or tampered with”) and thus transparency
- Tight security
- No requirements for centralized human-run structures
This technology is used to provide a new kind of decentralized finance market. There are DeFi lenders, exchanges, and more.
To make sense of this, we should look at smart contracts.
Smart contracts
Smart contracts are coded contracts “written up” by coders with a very specific skillset.
They are written (coded) with a set of specific instructions. Once the specific conditions are met, the contract “self-executes”. That means that the conditions of the contract are automatically assessed and carried out. There are no lawyers or adjudicators.
Smart contracts offer a type of decentralization that cuts out the need for legal and financial intermediaries. They enable direct, peer-to-peer transactions.
DeFi would be severely limited without these smart contracts. They are normally applied towards:
- Lending
- Trading
- Supply chain management
- Internal voting systems
- Insurance
- Gaming
- More
What are the disadvantages of DeFi?
While DeFi has many proven advantages and enormous potential, there are downsides, too.
DeFi applications are new, and very complex. Unlike many applications people have gotten used to, DeFi apps need you to have a high level of technical knowledge.
Without an adequate understanding of concepts like smart contracts, you face many risks. Some of those risks include serious threats to your financial wellbeing.
DeFi also exists in a relatively unregulated space.
This means that ignorance can leave users in a particularly high-risk state. This may lead to situations where users are taken advantage of. Lack of regulation can leave little possibility of holding others accountable.
Also, most DeFi apps use some cryptocurrencies as collateral when it comes to lending. This means users may also face the risks of crypto market volatility, which is infamously intense.
Another issue of DeFi applications is that blockchain networks can face speed issues. They can also be difficult to scale up for the same reason. The more traffic received, the slower the network runs. At some point when scaling, there are few ways around this problem.
What does DeFi do that banks do not?
DeFi offers many features that banks do not, starting with decentralization.
There are always a great many intermediaries in financial transactions and services. There are also barriers to access determined by humans working with strict rules/SOPs (Standard Operating Procedure).
DeFi is a diverse space that can cater to the needs of a wide range of people.
Users can make their own decisions based on the transparent resources available to them.
DeFi makes it so you do not need to worry about how much you can trust human intermediaries. Instead, you need to be able to trust the DeFi solution you are using. Of course, that means being very careful about which platforms you choose to use.
DeFi protocols are far less rigid than banking infrastructure.
They are open to what is known as “permissionless innovation”. That means they can be programmed far faster and do so much more. However, that requires that the user has a certain minimum level of technical understanding and skill.
DeFi projects and apps often have excellent interoperability. So, it’s fair to say the room for innovation is much wider. If banks were to try to recreate this success, they would likely need to learn a lot from the DeFi ecosystem.
Could DeFi replace banks?
For a small minority of people, it largely already has.
But for the overwhelming majority, it is far too early to say that banks could be replaced.
History teaches us that we should never say never and that the unexpected always happens. DeFi as a concept is young. But it has also been widely embraced in a very short timeframe.
We cannot bank on DeFi replacing banks anytime soon. You can expect the DeFi space to expand and improve. You can also expect banks to adapt to it and even adopt aspects of it. But the banking industry as such isn’t going to disappear.
Regulatory frameworks within the banking industry are strict and complex. Bringing cryptocurrencies into the mainstream regulatory frameworks around the world has already proved difficult. But great progress has been made in some areas.
It is more likely that DeFi, to some currently unknown extent, will slowly merge with traditional banking.
Conclusions
Decentralized finance is a new and exciting space.
It has a lot of promise, but also a set of unique challenges that differentiate it from previous financial revolutions.
Read our other articles on cryptocurrencies and related topics here
Photo by Joshua Mayo on Unsplash