What is Decentralized Finance (DeFi)?

Decentralized Finance ("DeFi" for short) is an ecosystem of financial applications built on a blockchain network.

Specifically, the term "decentralized finance" refers to the creation of an open-source, permissionless, and transparent ecosystem of financial services. This ecosystem is open to everyone and operates without the authorization of any central authority. Users have full control over their assets and can interact with the ecosystem through peer-to-peer (P2P), decentralized applications (Dapps).

The core advantage of DeFi is that financial services are at your fingertips, especially for people who are isolated from the current financial system. Another potential advantage of DeFi is that it is built on a modular framework - highly interoperable DeFi applications on public blockchains can create entirely new financial markets, products and services.

This article will introduce the basics of DeFi, including potential applications, advantages and disadvantages.

What are the main advantages of DeFi?

Traditional finance relies on institutions such as banks as intermediaries, and also requires courts to provide arbitration.

DeFi applications can directly skip intermediaries and arbitrators. The code can provide solutions to various disputes that may arise, and users can also take full control of their funds. This approach reduces the cost of providing and using the product, resulting in a more harmonious financial system.

New financial services deployed on the blockchain eliminate single points of failure. Data is recorded in the blockchain and widely distributed across thousands of nodes, making censorship a complex task and reducing the chance of service interruptions.

The framework for DeFi applications is built ahead of time, and deploying applications on it is simple and completely reliable.

Another important advantage of DeFi is to deepen the openness of the financial ecosystem, which can cover more groups who cannot enjoy financial services. The main way for the traditional financial system to obtain benefits is intermediary institutions, which generally do not provide services to areas where low-income groups are located. However, DeFi can cut costs drastically, and low-income people can also benefit from a variety of financial services.

What are the potential use cases for DeFi?

loan

Open lending protocols are one of the most popular applications in the DeFi ecosystem. Compared with traditional credit systems, open decentralized lending has many advantages, including instant transaction settlement, support for collateralized digital assets, no credit review, and possible standardization in the future.

Lending services are built on a public blockchain, minimizing the level of trust required, while being protected by cryptographic verification methods. The blockchain-based lending market reduces counterparty risk, reduces borrowing costs, speeds up lending, and effectively expands the audience.

Money Banking Services

DeFi is a financial application by definition, and money banking services are a typical use case. These include stablecoin issuance, mortgage lending and insurance.

As the blockchain industry matures, the creation of stablecoins is gaining more and more attention. Stablecoins are usually digital currency assets pegged to real assets that can be transferred digitally with relative ease. The price of digital currency can fluctuate wildly at times, but decentralized stablecoins can be used as digital cash for daily use, and can be issued and monitored without a central authority.

Mortgage loans are expensive and take longer to disburse, mainly due to the need for many intermediaries to step in. With the advent of smart contracts, underwriting and legal fees could be significantly reduced.

Insurance on the blockchain can skip intermediaries and spread risk across numerous participants. In the case of the same service quality, the insurance premiums that the policyholders need to pay have been reduced.

For an in-depth understanding of the topic of blockchain and banking, we recommend the article How Blockchain Technology Impacts Banking.

Decentralized Market

Such applications may be difficult to evaluate and belong to the DeFi sector with the broadest financial innovation space.

Arguably the most important DeFi application among them is the Decentralized Exchange (DEX). Through these platforms, users can directly trade digital assets without having to hold funds through a trusted intermediary (exchange platform). With the help of smart contracts, different users can directly complete transactions through their personal wallets.

Decentralized exchanges require less maintenance work, so transaction fees are much lower than centralized exchanges.

Blockchain technology is also frequently used for the issuance and empowerment of various traditional financial instruments. These applications operate in a decentralized manner, eliminating the need for custodians and completely eliminating single points of failure.

For example, security token issuance platforms provide issuers with the tools and resources to launch tokenized securities with customizable parameters in the blockchain.

Other projects support the creation of derivatives, synthetic assets, decentralized prediction markets, and more.

What role do smart contracts play in DeFi?

Most existing and potential decentralized financial applications involve the creation and execution of smart contracts. Whereas regular contracts clarify the relationship between different entities in the contract through legal terms, smart contracts use computer code.

The terms in a smart contract are written in computer code that takes effect by running the code. Numerous business processes that previously required human oversight can now be performed automatically and with guaranteed reliability.

Using smart contracts, both parties can reach transactions more conveniently and quickly, and transaction risks are also reduced. On the other hand, smart contracts also bring new risks. Computer code is highly prone to bugs or bugs that can reveal very important confidential information.

What challenges does DeFi face?

Inefficiency: Blockchains are naturally slow compared to their centralized competitors, which also affects applications built on top of them. Developers of DeFi applications need to take these constraints into account and continuously optimize their products.

User error poses high risk: DeFi applications shift responsibility from intermediaries to users, causing distress for many. Products are deployed on a blockchain that cannot be tampered with, so it is very difficult to minimize losses caused by user error through product design.

Inexperience of users: Currently, users have to work harder to navigate DeFi applications. In order to become a core element of the global financial system, DeFi applications must bring tangible value to users, allowing them to leave the traditional financial system and move to DeFi applications.

Ecosystem chaos: Finding the best application for a specific use case is extremely difficult, and users must have the ability to find the best solution. The challenge comes not only from building applications, but also how to integrate users into the huge DeFi ecosystem.

What is the difference between DeFi and Open Banking?

Open banking refers to the banking system authorizing third-party financial service providers through APIs, allowing them to securely access financial data. In this way, banks and non-bank financial institutions can associate accounts with data. Essentially, it can spawn new products and services within the traditional financial system.

However, the new financial system proposed by DeFi is completely independent of the existing infrastructure. Therefore, DeFi is sometimes called "open finance".

For example, it can securely fetch data from many banks and institutions, managing all traditional financial instruments in the same application.

On the other hand, decentralized finance supports a new financial instrument management model and creates a new way of interaction.

Summarize

Decentralized finance aims to build financial services that are independent of traditional financial and political systems. This will create a more open financial system that effectively eliminates censorship and discrimination on a global scale.

While the idea of ​​decentralized finance is attractive, it is not perfect. Finding the use case that best suits the characteristics of the blockchain is the most critical step in building a set of practical open financial products.

If it develops smoothly, DeFi will replace many large centralized organizations and devolve power into the hands of open source communities and individuals. Once DeFi hits the mainstream stage, it will be obvious whether a more effective financial system can be created.