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What is Decentralized Finance (DeFi)?
Decentralized finance (or simply DeFi) refers to an ecosystem of financial applications built on blockchain networks.
Specifically, the term ” decentralized finance ” can refer to a movement to create an open-source, transparent, and inclusive financial services ecosystem, accessible to all and operating without a central authority. Users will retain full control over their assets and interact with this ecosystem through peer-to-peer (P2P) and decentralized (dapps) applications.
The main advantage of DeFi is easy to access to financial services, especially for those isolated from the current financial system. Another potential advantage of DeFi is the modular structure on which it is based: interoperable DeFi applications on public blockchains have the potential to create entirely new financial markets, products, and services.
The Decentralized Finance (DeFi) or Open Finance movement goes even further in this promise. Imagine a global and open alternative to all the financial services you use today – savings, loans, commerce, insurance, and more – available to everyone in the world with a smartphone and an Internet connection.
What are the main benefits of DeFi?
Traditional finance relies on institutions such as banks to act as intermediaries and courts to act as arbitrators.
DeFi apps don’t need intermediaries or arbitrators. The code determines the resolution of all possible disputes, and users always control their funds. This reduces the costs associated with providing and using these products and provides a smoother financial system.
As these new financial services are deployed on top of blockchains, single points of failure are eliminated. Data is stored on the blockchain and distributed across thousands of nodes, making it difficult to censor or possibly shut down the service.
Since frameworks for DeFi applications can be built in advance, their deployment becomes much easier and more secure.
Another major benefit of such an open ecosystem is the ease of access for people who would not otherwise have access to financial services. Because the traditional financial system relies on intermediaries to make a profit, their services are usually absent in low-income communities. However, with DeFi, costs are significantly reduced and low-income people can also benefit from a wider range of financial services.
What are the possible use cases for DeFi?
Borrow & Lending
Open lending protocols are one of the most popular types of applications included in the DeFi ecosystem. Open and decentralized borrowing and lending have many advantages over the traditional credit system. These include instant settlement of transactions, the ability to guarantee digital assets, no credit checks, and possible future standardization.
Because these lending services rely on public blockchains, they minimize the required level of trust and ensure that cryptographic verification techniques are used. Blockchain loan markets reduce counterparty risk, make borrowing and lending cheaper, faster, and more affordable for more people.
Monetary banking services
Since DeFi apps are financial apps by definition, money banking is an obvious use case. These can include stablecoins, mortgages, and insurance.
As the blockchain industry develops, more and more attention is paid to creating stablecoins. This is a type of crypto asset that is usually tied to real assets but can be transferred digitally relatively easily. Since cryptocurrency prices can sometimes fluctuate rapidly, decentralized stablecoins can be adopted for day-to-day use as a digital currency that is not issued or controlled by a central authority.
Largely due to the number of intermediaries that must be involved, the process of obtaining a mortgage is costly and time-consuming. The use of smart contracts can significantly reduce underwriting and litigation costs.
Blockchain insurance can eliminate the need for intermediaries and allow risk-sharing among many participants. This can lead to lower insurance premiums for the same quality of service.
This category of apps can be tricky to gauge as it is the DeFi segment that leaves the most room for financial innovation.
Perhaps one of the most important DeFi applications is Decentralized Exchanges (DEX). These platforms allow users to trade digital assets without the need for a trusted intermediary (exchange) to hold their funds. The exchange takes place directly between users’ wallets using smart contracts.
Because they require much less maintenance work, decentralized exchanges generally have lower trading fees than centralized exchanges.
Blockchain technology can also be used to issue and secure ownership of a wide range of traditional financial instruments. These applications will run in a decentralized manner, eliminating gatekeepers and eliminating single points of failure.
Security token issuance platforms, for example, can provide issuers with the tools and resources to launch tokenized securities on a configurable blockchain.
Other projects could enable the creation of derivatives, synthetic assets, decentralized prediction markets, and more.
What is the role of smart contracts in DeFi?
Most of the existing and potential applications for decentralized finance involve the creation and execution of smart contracts. Whereas an ordinary contract uses legal terminology to define the terms of the relationship between the parties who enter into a contract, a smart contract uses computer code.
Because their terms are written in computer code, smart contracts also have the unique ability to enforce those terms through computer code. This allows you to reliably perform and automate a large number of business processes that currently require manual control.
Using smart contracts is faster, easier, and reduces risks for both parties. On the other hand, smart contracts also create new types of risk. Since computer code is prone to errors and vulnerabilities, the value and confidential information locked in smart contracts are at risk.
What are the challenges facing DeFi?
Poor performance: Blockchains are inherently slower than their centralized counterparts, leading to the creation of applications based on them. DeFi app developers should consider these limitations and optimize their products accordingly.
High risk of user error: DeFi apps transfer responsibility from resellers to the user. For many, this can be negative. Designing products that minimize the risk of user error is especially challenging when products are deployed on top of immutable blockchains.
Poor user experience: Currently, using DeFi apps requires extra effort on the part of the user. For DeFi apps to become a central part of the global financial system, they must provide tangible benefits that encourage users to move from the traditional system.
Cluttered Ecosystem: Finding the best app for a specific use case can be challenging, and users need to be able to find the best choice. The challenge is not only to build apps but also to think about integrating them into the broader DeFi ecosystem.
What is the difference between DeFi and open banking?
Essentially, the operations of these companies are not controlled by the institution and its employees – instead, the rules are written in code (or smart contract, as mentioned above). Once a smart contract is deployed on the blockchain, DeFi decentralized apps can run on their own with little or no human intervention (although in practice, developers often maintain decentralized apps with updates or bug fixes.).
The code is transparent on the blockchain, so anyone can audit. This creates a different kind of trust among users since everyone has the opportunity to understand the specifics of the contract or find errors. Any transactional activity is also available to everyone. While this can cause privacy issues, transactions are pseudonymous by default, which means they are not directly related to your real identity.
Dapps are built to be global from the start – whether you’re in Texas or Tanzania, you have access to the same DeFi services and networks. Of course, local regulations may apply, but technically most DeFi apps are available to anyone with an internet connection.
“Permissionless” to create, “Permissionless” to participate – anyone can create DeFi Apps, and anyone can use them. Unlike today’s finance, there are no custodians or long-form accounts. Users interact directly with smart contracts from their crypto wallets.
Flexible User Interface – Don’t like the interface with a specific application? No problem – you can use a third-party interface or create your own. Smart contracts are like an open API that anyone can build an application for.
Compatibility – New DeFi apps can be created or compiled by combining other DeFi products like Lego pieces – for example. Stable coins, decentralized exchanges, and prediction markets can all be combined to create entirely new products.