If you’ve been keeping a close eye on the most recent developments on the blockchain scene, you probably heard of decentralized finance (DeFi) already. It’s an umbrella term for an entire ecosystem of trends, approaches, and solutions that are now emerging in crypto, fintech, and beyond.
Wondering what decentralized finance is and why so many businesses are getting interested in it?
Keep on reading to find out everything you need to know about decentralized finance together with its benefits and real-life use cases.
What is DeFi?
Decentralized finance (also called DeFi) is an ecosystem of financial applications developed with blockchain technology. These applications are either entirely or partially decentralized. This allows businesses to provide reliable financial services on top of a transparent and secure blockchain network instead of relying on expensive traditional intermediaries.
Since the services of investment funds, banks, or payments providers are no longer required, users get faster and more cost-effective services like loans or transactions.
DeFi is growing really fast as organizations around the world deployed over $2 billion across various applications.
The most common types of DeFi applications are:
- lending and borrowing services,
- exchange services,
- tokenization services,
- monetary banking services like issuance of stablecoin,
- financial instruments like prediction markets or derivatives.
That’s quite a variety, isn’t it? That’s why it’s best to think of DeFi as a loosely defined set of different projects and ideas with one common goal: reshaping the financial services market with blockchain technology.
Why is DeFi a gamechanger?
Decentralized finance brings the promise of disrupting the financial services sector by bringing in blockchain technology and eliminating the involvement of time-consuming and costly intermediaries.
The rise of DeFi could lead to a major disruption by making financial services cheaper and faster for both consumers and businesses. Blockchain also offers better protection against cybersecurity threats that are becoming increasingly common in the sector.
So far, cryptocurrency communities were major recipients of blockchain. But decentralized finance is attracting the attention of policymakers and traditional financial organizations. Still, DeFi comes with significant technical, operational, and regulatory challenges that may hinder its development.
For DeFi to grow, we need greater integration between traditional financial services companies, political stakeholders, regulatory supervisors, and innovative tech startups. They should all work together to define the rules of the ecosystem and support its speedy development.
Benefits of decentralized finance
No intermediaries need to be involved
Traditional financial services companies rely on many different institutions that act as intermediaries. In decentralized finance, you no longer need any arbitrators or middlemen.
Why? Because the application’s code already specifies how to resolve any disputes that could potentially arise. It’s up to the users to keep control of their assets at all times.
As a result, the pricing of financial services will be lower, offering a more permissionless and frictionless financial ecosystem.
No single point of failure
In DeFi, services and products are deployed on top of a blockchain network. All the data recorded on a blockchain is spread across thousands of nodes. This significantly reduces the risk of a potential shutdown, control, or censorship.
Since DeFi applications are based on a blockchain network, they also ensure superior security. They don’t rely on any centralized servers that could become a single attack vector. However, when a user experiences a problem, there’s no one out there capable of freezing or reversing a transaction like in a traditional bank.
The decentralized finance ecosystem consists of applications based on blockchain that are interoperable. This could potentially accelerate the speed of its development and offer customers a broader range of products that work together seamlessly.
Greater access to financial services
Another advantage of DeFi is that it provides access to various services to more consumers. For example, traditional financial services companies rely on intermediaries who need to make a profit, so their services might be absent from locations with low-income communities. Since decentralized finance brings a significant cost reduction, it potentially enables people in underserved areas to take advantage of a broader range of financial products.
Challenges of decentralized finance
DeFi applications rely on smart contracts and the underlying blockchain protocols. A failure in the code could potentially lead to massive losses. While writing error-free code is impossible, developers use many different mechanisms that help to increase its quality. Still, technical problems present a huge risk to decentralized finance services.
Another challenge related to the technical implementation of DeFi is the user experience. The applications and protocols are often complicated, unintuitive, and basically designed for people who are part of the cryptocurrency scene. Even the best products may struggle to gain traction beyond the people who are already familiar with blockchain.
DeFi projects operate without any license in the majority of jurisdictions. Regulators are still working on policies for handling revenue from DeFi, taxation matters, and other key aspects. As DeFi grows, we will need the right regulations to support it.
3 real-life DeFi use cases
1. Monetary value services
DeFi applications are financial obligations, so they cover monetary banking like insurance or mortgages.
How would a mortgage work in DeFi? By using a smart contract, no intermediaries need to be involved in the process – contrary to traditional mortgage issuance, which is very expensive and sometimes time-consuming.
What about insurance? Insurance based on blockchain would also eliminate the need for involving intermediaries. As a result, the transaction’s risk would be distributed between many different parties, reducing premiums while retaining the same quality of service.
PieDAO was created to bring the passive index approach to the world of cryptocurrencies. In traditional financial services, index mutual funds are very attractive because the risk is spread when users diversify their portfolios.
This is the mission of PieDAO. The company provides users with the ability to use a basket of cryptocurrencies to create a portfolio. An index of several crypto coins is called a PIE. The project reduces the risk further by bundling several PIEs to create a product like a mutual index fund. PIEs can represent different types of assets – from crypto to cash and traditional assets.
2. Lending and borrowing
One of the most common types of DeFi applications are open lending protocols. Such applications are open and decentralized to offer many different advantages over traditional systems:
- no credit checks,
- ability collateralized digital assets,
- simple transaction settlements,
- and potential standardization in the future.
Lending services built on top of a public blockchain minimize the volume of trust required in the process, making services faster, cheaper, more available, and less risky.
YouHodler focuses on crypto-based lending with a very interesting feature called Multi HODL. This feature takes advantage of the Barbell Strategy, where 20% of the funds are invested in high-risk assets and 80% in low-risk assets. Users are free to change the balance to any risk they wish (like 90/10 or 60/40). The application allows users to deposit stablecoins into savings accounts that generate a guaranteed annual profit of 12%.
Users can also get a cryptocurrency loan backed by the top 15 coins, with up to 90% loan to value ratio (LTV). So many features in one project is what makes DeFi such an interesting space to watch today.
3. Decentralized marketplace
This part of the ecosystem offers probably the most potential for innovation, with decentralized exchanges as the most interesting example.
Such exchanges allow users to trade digital assets without having to refer to a trusted intermediary to hold the funds. Thanks to smart contracts, trades can be made directly between user wallets. They also require less maintenance work, bringing users much lower trading fees.
Augur is a peer-to-peer, decentralized exchange that rewards users for correctly predicting the future. It’s an open and global prediction market protocol that allows any user to create a market for anything. No single entity controls the protocol – it’s community-owned and operated.
The platform allows participants to buy and sell shares in the outcome of a specific event. The price of the event’s share depends on the probability of an event actually occurring. For example, if you bet that Bitcoin is going to hit $10,000 in one month, a share of either side of this bet will cost half a dollar as the total cost of the shares is one dollar. If you guess correctly, you receive one dollar in return.
I hope that this article helped to see how decentralized finance is on its way to disrupting the financial services sector. All of these amazing use cases of DeFi wouldn’t be possible if not for the stable expansion of blockchain.
If you know any other great examples of DeFi applications, please share them in the comments. So many projects are launched these days that it’s hard to keep track of the DeFi scene.