Categories: DeFi NewsGuides

What is DeFi?

The hottest name in cryptocurrency today has to be DeFi or decentralized finance. DeFi has to be the one innovation that has had the most impact on traditional finance in recent times. It combines new-age banking solutions with conventional practices to deliver an innovative approach to finance.

Technically, DeFi employs automatically enforceable agreements or smart contracts built on blockchain technology to provide banking services without involving intermediaries such as banks or lawyers.

But exactly what is Defi?  When people ask, “what is Defi?” it can be roughly defined as an ecosystem of permissionless financial applications built using public distributed ledgers. It is a way to offer traditional financial services, including lending, payment, asset management, in a decentralized setup.

What is all the buzz around Decentralized Finance?

Value Locked in DeFi Source: DeFiPulse

So, why is DeFi the center of the universe right now? Since 2017, the value locked in ‘Decentralized Finance’ contracts has grown to touch $6.9 billion at the time of writing. Such a massive growth has percolated into virtual assets and tokens as well, resulting in a huge rise in DeFi projects.

Most projects are built using Ethereum technology. In fact, DeFi developments affect Ethereum price movements. Many tokens have risen four to five times in value in the past two years. For example, Synthetix Network Token registered a 20-fold rise on the back of explosive growth in the realm.

Why is DeFi Important

Decentralized economics merges traditional banking with next-gen technologies, including blockchain. It is often called ‘Open Finance’ since it incorporates inclusive arrangements to build decentralized solutions aimed at the financial segment. The projects serve the consumer’s traditional economic needs, including lending, savings or checking accounts, trading, and many more.

DeFi is evolving quickly, and it now includes every facet prevalent in the traditional industry. First, the DeFi revolution is helping people in remote areas get access to money through safe channels. It has opened a huge portal of opportunities that traditional finance missed to date.

Secondly, the functionality, safety, and accessibility on offer by Defi applications are far ahead of conventional financial solutions. All you need is a smartphone with a decent connection. The global expansion potential is practically endless. Most crypto analysts regard DeFi as the most vibrant and innovative sector in the entire crypto and blockchain realm today.

DeFi tokens are outperforming their crypto counterparts by a huge margin. Most of the DeFi projects have huge potential to leave an indelible mark on the financial sector for years to come. At present, the projects are at a nascent stage, yet they have achieved a huge following. As the industry blossoms, DeFi is sure to develop into a credible alternative to the traditional banking system.

What are Decentralized Applications?

Decentralized applications are a huge part of the entire DeFi spectrum. Apps are central to understanding the DeFi’s capabilities and how it operates. The dApps are applications built on blockchain that functions to serve financial operations through a decentralized network. Whether it is blockchain or other DLT-based foundation, the idea is to build a decentralized framework. Thus, DeFi applications are not under any central organization or monitoring authority.

How dApps are Taking Over Traditional Finance

The dApps are fully automatic and are driven by smart contracts that define the various financial functions. These pre-programmed contracts work flawlessly as per the initial fed values and protocols. Most importantly, smart contracts can handle a diverse range of functions, including client approval and payment processing. Think of them as money legos that can be expanded as per the developer’s choice.

Source: Dappradar

DeFi progress currently depends on Ethereum evolution. Most value is locked in Ethereum based projects. The programmatic flexibility and scalability of Ethereum will define how fast Defi financial products progress.

Vital DeFi Components

The realm of DeFi apps is growing at a tremendous speed. The applications serve myriad purposes, helping save time and money. Today, almost every sector has a relevant DeFi application. As the sector undergoes expansion, the dApps also expand their outreach to serve more clientele. Here are some common DeFi applications characteristics:

Open-Source

Most DeFi apps follow open-source protocols to remain decentralized and serve a wide range of audiences. The public coding helps get multiple programming inputs. The auditing remains transparent besides offering superior security and functionality. Open-source codes are known for their security and stability.

Transparency

When it comes to DeFi, the concept of transparency acquires a whole new meaning. Transparency is inherently ingrained within the decentralized realm, and DeFi is no different. Since most dApps are built on Ethereum blockchain, which inherently offers superior transparency in terms of transactions, payment processing, functionality, and smart contract mechanisms. Unlike traditional banking, the entire blockchain-related interaction remains in the public domain.

Another key difference is that individuals are not connected directly with a bank’s specific account per se. Instead, the system employs a numerical address, and the underlying account itself remains pseudo-anonymous. Information about crypto assets remains secure at all times. The accounts do have owners and can be traced back if need be.

Global Outreach

There is a dearth of banking channels in developing nations. Decentralized Finance is helping empower the downtrodden with safe banking solutions. DeFi developers are building next-gen financial platforms that can be used in remote areas with minimal internet connection.

Besides developing nations, Defi services also serve developed regions where traditional banking flaws have disrupted financial channels. Age-old banking and currency systems are now being upgraded with new technologies. The unbanked masses and the traditional clientele are both getting on the DeFi bandwagon. Whether it is a village in Hawaii or a New York City, numerous types of Defi services are available at the tap of a button.

Permissionless

There are no gatekeepers in DeFi, and the power is available for anyone. Anyone can access or develop a DeFi application with minimal limitations and permissions. Unlike licensed players, DeFi is open-source and therefore far better accessible.

DeFi Lending Rates -Source: DeFiRate

The conventional bank account does not give much freedom, and approvals are a huge concern. Interest rate related hassles are kept at a minimum. The decentralized world skips unnecessary regulatory mechanisms and thereby deliver the best open finance products.

Interoperability

Interoperability is at the heart of the DeFi revolution since it is meant to bridge new-age and age-old banking channels. Interoperability ensures that seamless functionality is maintained across diverse blockchain platforms. DeFi solutions or money legos must operate across myriad networks and platforms to serve its diverse clientele.

Decentralized solutions are designed to remain accessible to developers, users, critics, and everyone. Also, users must be able to deploy stablecoins, trade at an exchange, use wallets, and do so simultaneously. Therefore, interoperability is crucial to the Defi applications since these money legos require deployment in diverse blockchain environments.

Flexible

Flexibility is one characteristic that is at the core of DeFi apps. A flexible environment, especially Ethereum blockchain, allows the developers to remain in sync with changing financial scenarios. Platforms must remain flexible to offer newer functionality and integrate with other platforms/networks. Users should be given independence in designing their interface and interaction protocols for a smart investment.

DeFi in Lending – Next Era of Lending Solutions

Lending is one area where DeFi shines. Over the past two years, DeFi lending solutions have really taken off big time. The traditional loan approval process is cumbersome, time-consuming, and confusing. Large banking giants rule the lending realm and have a monopoly in their respective regions. Negotiating with lending companies for a suitable loan is nothing short of harassment.

DeFi has redefined lending by designing innovative consumer-centric products. The new-age DeFi powered financial system delivers flexibility, better rates, faster processing, more money lender options, and so much more. Ethereum is also gaining a foothold in the lending arena. There has been a sea change in the lending sector ever since the introduction of decentralized apps.

Compound – Redefining Lending

Compound dApp is where DeFi really shines the brightest. It has shown the world how lending can be an interesting concept by empowering both the consumer and the lender. Compound gives users the ability to lend their cryptocurrency out to other users without any intermediaries. In return, the lenders earn interest, which is also in crypto assets form. From an investment perspective, lenders and borrowers are matched as per smart contracts making it a far safer process than today’s lending scene.

Additionally, smart contracts also manage the payment of interest rates as per the changing market conditions. There is no third party or intermediaries involved in the process. Compound has been so successful that many similar dApps have been built on the same interest rates pattern.

Decentralized Exchanges – Bringing Together Tomorrow’s Traders

A Decentralized exchange represents the coming of age of the crypto realm. This DeFi use case offers more security and safety features to crypto users with minimal human intervention. Peer-to-peer lending is ideal for serving the unbanked and those looking for more flexibility. The streamlined user interface and enhanced security are perfect in today’s cyber scenario.

Unlike the centralized, traditional money market or Coinbase, decentralized exchanges are more transparent, secure, and efficient. Conventional products are vulnerable to thefts, security breaches, and hacking scandals. A quick Google search reveals a history of exchange crashes causing huge losses to users.

Decentralized exchanges don’t suffer from such issues. Smart contracts ensure money or digital assets are not held directly, and blockchain hides the user data. Wallet-to-wallet interaction promises more security for your digital assets. There is no centralized point to attack in a decentralized exchange.

Uniswap – Next Step in Lending Ecosystem

With the introduction of ‘Automated Market Making,’ the Uniswap platform changed the way users trade. The innovative smart contract mechanism allows instantaneous settlement between parties. The live rates offered to the traders help execute trades with confidence unlike other traditional type of trades. The ‘Pooling’ feature further allows the users to earn interest via lending without any third party involvement.

Next-Gen Savings Powered by DeFi

Savings are the life-blood of the financial industry. Be it small-term saving accounts or pension funds, savings are crucial to a working professional’s life. DeFi products are helping redefine the way savings are done in today’s age. Collective interest-earning apps are helping users save money and earn more interest on their collective kitty.

MakerDAO – The King of Decentralization King

Maker stablecoin allows pegging of other stablecoins with the US Dollar by backing it up by crypto collateral. In other words, users can now deploy crypto without worrying about the volatility that plagues cryptocurrencies such as Bitcoin and ETH.

Source: MakerDAO

Users can build their very own DAI stablecoin using the Maker Oasis dApp. Furthermore, dai stablecoin can then be used for various purposes, including trading, transactions, and much more. In a way, Maker can be termed a decentralized reserve bank offering dai as a panacea.

DeFi Evolution – What the Future Holds in Store

Today, DeFi products are dependent on a collateral model to safeguard investor interest. As DeFi evolves, borrowers will build their credit history, allowing them to borrow sans collateral. Such an identity-based mechanism would require a universal decentralized identity mechanism built upon solid financial and economic credentials.

Vulnerabilities in the smart contract must be plugged to further secure the dApps from hacking attacks. Over-collateralization must be avoided to develop lending credentials at par with today’s lending institutions.

Evolutionary DeFi to Power Next-Gen Finance

Improvements in the user experience will help bring more users to its fold. The First-generation DeFi ecosystem lacked an interactive user interface and website browsing experience. Latest dApps focus on user interaction to appeal to a wider audience. Just like crypto assets, Ease-of-use remains a key design criterion.

Crypto wallets will also undergo evolution to offer more features and functionality to the consumers. In the future, all-inclusive crypto wallets will be the flavor as consumers seek a one-size-fits-all solution for all their crypto investments interaction. One crypto wallet must serve as a universal gateway for comprehensive digital asset management. Imagine a home page that shows all your holdings with a single click, including loans, collateral, holdings, trading activity, and more.

Merging Traditional Finance with DeFi Concept

Decentralized governance is another interesting area emerging out of the DeFi ecosystem. Initially, many DeFi solutions have centralized characteristics, including ‘master keys’ to control certain functions. For example, an emergency shut off valve in the hands of the developer team can help secure the dApp in the event of a hack.

Merging Traditional Finance with DeFi

However, the evolution of DeFi demands that governance protocols be shared with the stakeholders. Decentralized Autonomous Organizations are fast emerging as decision-makers helping stakeholders exercise more control instead of banks. Today’s financial institutions have a lot to learn from the multi-dimensional approach of decentralized economics.

DeFi is Here to Stay

Monetary issues have always been central to human civilization. Money, in one form or another, has been driving human endeavors for millennia. For decades, the U.S dollar ruled the scene. Today, crypto is doing the same thing, albeit on the cyber front. We might see a complete overhaul of the financial realm and the abolition of fiat currency in the future.

Future Trajectory of DeFi

Cryptocurrency and blockchain are emerging as next-gen technologies with the potential to script enormous social change. As societies evolve, new technologies power human needs. Today, decentralized technologies powered by Ethereum are doing just that. Various type of Dapps deliver financial services using smart contracts and a technological twist to disrupt the traditional system.

Future Trajectory of DeFi

DeFi solutions are setting benchmarks in both the financial and economic sectors. The old fiat currency ways are being challenged. Fast-moving economies are adopting the latest decentralization technologies to serve their citizens with the best banking solutions available. DeFi solutions represent the cusp of democratic ideals by offering highly transparent financial system that is truly decentralized. In a way, DeFi means more power to the people.

Unlocking a Parallel Economic Model

Something truly remarkable is happening in the financial system – cryptocurrencies are empowering the unbanked. The concept of money is changing as people accept the new normal, i.e., digital assets. Large financial institutions are looking at crypto in a new light. The world is witnessing a quantum leap in banking channel development. It is rare to see an entire sector transforming so fast in such a short time and that too from scratch.

DeFi will soon catch up with conventional fiat financial services. Evolutionary patterns always include ups and downs, which help bring improvement phases. DeFi will also undergo suitable corrections in the future before it establishes itself as the ‘De Facto’ financial mechanism to serve the masses. Till then, there’s ample scope for technological improvements. Surely, DeFi is here to stay.

This post was last modified on April 13, 2021 4:23 am

Gurpreet Thind

Gurpreet Thind is pursuing Masters in Electrical Engineering at University of Ottawa. His scholarly interests include IT, computer languages and cryptocurrencies. With a special interest in blockchain powered architectures, he seeks to explore the societal impact of digital currencies as finance of the future. He is passionate about learning new languages, cultures and social media.

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