Image credits: Forbes
DeFi is short for “decentralized finance,” an umbrella term for a variety of financial applications in cryptocurrency or blockchain geared toward disrupting financial intermediaries.
DeFi draws inspiration from blockchain, the technology behind the digital currency bitcoin, which allows several entities to hold a copy of a history of transactions, meaning it isn’t controlled by a single, central source. That’s important because centralized systems and human gatekeepers can limit the speed and sophistication of transactions while offering users less direct control over their money. DeFi is distinct because it expands the use of blockchain from simple value transfer to more complex financial use cases.
Bitcoin and many other digital-native assets stand out from legacy digital payment methods, such as those run by Visa and PayPal, in that they remove all middlemen from transactions. When you pay with a credit card for coffee at a cafe, a financial institution sits between you and the business, with control over the transaction, retaining the authority to stop or pause it and record it in its private ledger. With bitcoin, those institutions are cut out of the picture.
Irrespective of how vital the current financial services infrastructure is, it is plagued with many problems. The root cause of all of the engendering problems is the presence of centralized, monolithic, siloed institutions. All the transactions taking place today using legacy infrastructure are under the umbrella of a third party. Essentially, this centralized third party can have a say in who would be provided with financial services and who would not be.
The working of these centralized institutions is bound by geographical barriers. It solely depends on a person’s luck if he/she was born in a developed country which would protect their individuality.
DeFi has the power to put an end to problems which the contemporary financial institutions face by leveraging P2P (peer-to-peer) finance. This is possible because of the advent of blockchain technology.
No, it’s risky. Many believe DeFi is the future of finance and that investing in the disruptive technology early could lead to massive gains.
But it’s difficult for newcomers to separate the good projects from the bad. And, there has been plenty of bad.
As DeFi has increased in activity and popularity through 2020, many DeFi applications, such as meme coin YAM, have crashed and burned, sending the market capitalization from $60 million to $0 in 35 minutes. Other DeFi projects, including Hotdog and Pizza, faced the same fate, and many investors lost a lot of money.
In addition, DeFi bugs are unfortunately still very common. Smart contracts are powerful, but they can’t be changed once the rules are baked into the protocol, which often makes bugs permanent and thus increasing risk.
Ethereum / Smart contracts
Most applications that call themselves “DeFi” are built on top of Ethereum, the world’s second-largest cryptocurrency platform, which sets itself apart from the Bitcoin platform in that it’s easier to use to build other types of decentralized applications beyond simple transactions. These more complex financial use cases were even highlighted by Ethereum creator Vitalik Buterin back in 2013 in the original Ethereum white paper.
That’s because of Ethereum’s platform for smart contracts — which automatically execute transactions if certain conditions are met — offers much more flexibility. Ethereum programming languages, such as Solidity, are specifically designed for creating and deploying such smart contracts.
With smart contracts at the core, dozens of DeFi applications are operating on Ethereum, some of which are explored below. Ethereum 2.0, a coming upgrade to Ethereum’s underlying network, could give these apps a boost by chipping away at Ethereum’s scalability issues.
The most popular types of DeFi applications include:
- Decentralized exchanges (DEXs): Online exchanges help users exchange currencies for other currencies, whether U.S. dollars for bitcoin or ether for DAI. DEXs are a hot type of exchange, which connects users directly so they can trade cryptocurrencies with one another without trusting an intermediary with their money.
- Stablecoins: A cryptocurrency that’s tied to an asset outside of cryptocurrency (the dollar or euro, for example) to stabilize the price.
- Lending platforms: These platforms use smart contracts to replace intermediaries such as banks that manage lending in the middle.
- “Wrapped” bitcoins (WBTC): A way of sending bitcoin to the Ethereum network so the bitcoin can be used directly in Ethereum’s DeFi system. WBTCs allow users to earn interest on the bitcoin they lend out via the decentralized lending platforms described above.
- Prediction markets: Markets for betting on the outcome of future events, such as elections. The goal of DeFi versions of prediction markets is to offer the same functionality but without intermediaries.
Ethereum 2.0 isn’t a panacea for all of DeFi’s issues, but it’s a start. Other protocols such as Raiden and TrueBit are also in the works to further tackle Ethereum’s scalability issues.
If and when these solutions fall into place, Ethereum’s DeFi experiments will have an even better chance of becoming real products, potentially even going mainstream.
The DeFi dApp ecosystem is maturing at an astronomical pace. DeFi has the potential to go mainstream when interoperability of chains is addressed, scalability is enhanced, and usability (accessibility, key management, security, UI/UX, etc…) is improved. Web3 developer tools have come a long way. Access to fast, reliable Web3 infrastructure is no more a dream but a reality. Check out QuikNode for the same here. Lastly, the future of this newly found digital economy backed by DeFi would pose a more democratic world for the common man, where he/she would live with a true sense of financial freedom.