If you are conversant with the Blockchain and cryptocurrency space, you won’t be alien to one of the most recent innovations in Finance, called DeFI. DeFi, a short form for decentralized Finance, is a new and open financial movement that seeks to give a boost to financial inclusion. Contrary to the traditional economic systems, DeFi platforms allow individuals to self-bank and make a democratic decision about financial services.
DeFi is summarized in the words of Lex Sokolin, Global Fintech Co-Head of ConsenSys, who said;
“We are a stone’s throw away from the global financial industry running on common software infrastructure.”
In affirmation, DeFi is making self-banking possible in such a way that an individual can have access to financial service in a few clicks. Thereby, DeFi boasts of combining emerging technologies like Blockchain, internet, AI, and others to improve and enable programmable money in a distributed network.
In what started as a market dominated by MakerDAo, in a few dollars, DeFI has grown to over $8.75B total locked value according to DeFi Pulse. Also, it started as a solution to cryptocurrency volatility when Tether launcher USDT, a non-algorithmic stable coin, pegged on US Dollar. Today it has grown to a wide range of use cases that will be covered in the subsequent sections.
The mechanics of DeFi
The billion-dollar question is how individuals can transact in distributed and decentralized networks. Well, everything starts with the invention of Blockchain, a distributed ledger technology that allows peer to peer transactions. It is a fact to say that there will be nothing called DeFi without a Blockchain by merely studying the trends and market growths.
Blockchain enables a Decentralized application and smart contract, the functional framework of DeFi. By way of illustration, let’s explain how DeFi works in relation to DApp and smart contract. Meanwhile, the definition represents only the lending application of DeFi.
First, a decentralized application, DApp, is a computer application that runs on a distributed computing system. It enables every user to act as a node on the entire Blockchain, unlike the traditional approach when a user connects to a central system. On the other hand, smart contracts are a set of self-executing codes, roles, encoded on a computer or the DApp to perform specific tasks. In a DeFi, it represents a set of predefined codes that automates transaction between parties.
For a transaction to occur between a lender and a borrower, for instance, what the parties need to do is to interconnect on the DApp to agree with the smart contract. A lender, upon reading the news of how a particular company needs some bucks, reviewed his portfolio, then reached out through a DApp to issue loans to the company or business. Similarly, a borrower reviews the project’s financial requirements to know what interest rate they can pay. In a click, the lender locates the borrower, and both agree on an interest rate.
This time, there are no middlemen between the borrower and lender; instead, both of them interact on the DApp through the help of a smart contract. The contract helps them to agree and disagree accordingly.
Why not conventional financial service providers?
You have learned that DeFi removes the need for third parties or mediators, but what are the implications and successes? Here, you get to know why;
DeFi is built on distributed and shared ledger technologies. Thereby, all transactions are tamper-proof and cannot be changed. Concurrently, when a borrower receives a loan, the individual cannot manipulate transactions.
Since the transactions are performed on a distributed ledger enabled DApp, transactions are transparent. Unlike the conventional system here, a borrower won’t know what goes on within the network or lending decision and vice versa.
The parent technology of DApp, Blockchain, operates a “not your key not your coin” security model. Therefore, DeFi allows the users to have total control of tokens and keys. For instance, most DeFi platforms are non-custodial like Aave, KittieFight, Maker, etc.
Open, permissionless and decentralized
The DeFi ecosystems operate in an open, secured, transparent, and yet permissionless manner. By implication, users do not need to obtain permission to the bank or do similar activities. Also, it is open and accessible everywhere, so every user who agrees to the terms and connects t the DApp can perform financial activities.
Wide range of assets
The traditional financial systems are known for non-digital assets; hence, DeFi enables digital assets. It also allows the individual to tokenize assets or have a digital representation of assets in such a way to create a broader and more liquid market structure.
Because more significant percentages of DeFi platforms are built on Ethereum, people often make a hasty generalization that DeFi is an Ethereum ecosystem application. Although that may be true since over 80% of DeFi platforms are built on Ethereum. However, there are lots of other DeFi ecosystems like Cosmos, Ontology, Celo, etc.
DeFi has a wide range of applications that seems to cover the traditional financial services. DeFi applications and use cases are categorized as follows;
Monetary and banking services
This is one of the first DeFi applications. It was in the quest to solve the inherent volatility and other cryptocurrency problems that such measures were put in place. They include stablecoins, mortgages, and insurances.
Such DeF platforms are MakerDAO, WBTC, among others.
A popular application of a decentralized marketplace is decentralized exchanges. The decentralized market place is a use case that has the highest innovation. Hence, they focus on new ways of enabling Openfinance. For instance, a DeX works on the limitations of the centralized exchanges like liquidity by establishing liquidity pools- an automated market marker kind, contrary to the order book model where traders wait or bidder and takers to fill traders.
Borrowing and lending services
Through the DeFi borrowing and lending platforms, users can access collateralized and uncollateralized loans. Herein, users lend and borrow as needed all within a DApp with the guide of a smart contract.