Powered by blockchain technology, Decentralized Finance (DeFi) or Open Finance has emerged as a sweeping wave of innovation facilitating highly liquid and interoperable financial services in absence of a centralized intermediary. DeFi users can gain permission-less access to highly liquid products such as loans, insurance, payments, margin trading, and more, while holding custody all the while. Compared to conventional finance, DeFi allows lower entry barriers to financial markets, unprecedented transparency, and better competitive offerings for financial products.
It will be perfectly alright to term DeFi a decentralized application environment which is providing a new dimension to the financial ecosystem. DeFi achieves this by replacing intermediaries (banks- for example) with self-execution technology (smart contracts) to reduce cost, bring agility and increase liquidity while offering almost full ownership controls to the investors.
Smart contracts – the nerve center of DeFi
Smart contracts, used as an underlying technology by DeFi, are self-executing contractual agreements written in computer languages. The conventional contract terms are embedded into the code and these automatically execute when the stipulated conditions are met. To ensure verifiability of transactions, a permanent copy is saved on the relevant Blockchain ledger that can be verified on any net-enabled device by community members.
Built on the principles suggested by Nick Szabo, an eminent computer scientist and cryptographer, smart contracts are about embedding disparate contractual clauses, regardless of their nature, format, and purpose, into software designed to facilitate easy execution of valid transactions. Smart contracts discourage any sort of breaching or frauds by making it restrictively complicated.
These automated contracts act as a base for auto-executing value exchange between parties where human trust is to be replaced by predictable if-then processes. In other words, if the predefined conditions meet, the corresponding contract is executed. A simplistic example of a smart contract would be a ticket vending machine where a shopper will get the ticket, if they insert the right amount at the right place.
Role of stablecoins in DeFi
Stablecoins are the cryptocurrencies with their value hooked to a specific reference or asset like gold, euros, and dollars. These are further divided into fiat/asset-backed, crypto-collateralized, and algorithmic stablecoins. The Fiat/asset-backed stablecoins are tethered at the ratio of 1:1 by a private entity asset. For instance, Tether is one such stablecoin backed 1:1 by US dollars. Cryptocollaterized tokens refer to the stablecoins tethered to other Blockchain cryptocurrencies. For example, DAI is collateralized using other cryptocurrencies. Algorithmic stablecoins use algorithmic mechanisms related to buying/selling reference assets to achieve their value.
Termed the backbone of DeFi, stablecoins enable investors to generate yield on their funds while using DeFi protocols, while setting aside the potential adverse effects of market volatility. For instance, if an investor places ETH as a collateral, it carries a risk as the price of ETH may dive down. Using stablecoin, however, eliminates any such risk.
Riding its innovative concept of decentralized financial transactions, DeFi rolls out a string of advantages:
Accessibility and auditability
As a decentralized system that is open to the general public, transactions executed by smart contracts are accessible and accessible to any interested entity. Its code, residing on an open public ledger, allows members to trace the history and public addresses of the transactions. Quality of auditing on blockchain-based smart contracts is simply unmatchable. No one can tweak these transactions as they are practically immutable, ensuring maximum security as well.
Low entry barrier
A trustless ecosystem without any need of mediators has enabled DeFi to eliminate complex prerequisites, tedious formalities, and demolished money barriers. Conventionally, issues like jurisdiction, license, know-your-customer (KYC), and others are associated with the conventional capital securities market. DeFi lowers down the entry barriers thus encouraging more investors to enter the market. Higher participation increases volume, improving liquidity and boosting market health.
Most of the DeFi applications are built on top of the Turing-complete Ethereum platform which simply means it is capable of computing anything. Interpreting in general terms, one can write their own subjective ownership rules, formats, and transition rules. Depending on your objectives, you can create customized business logic.
Independent portfolio management
In DeFi the transactions are directly executed between smart contracts and wallets without any mediating entity. The entire authority for controlling private keys/funds is transferred to the users. It allows them to fully personalize their investment portfolio.
Users can also build applications on top of other contracts. DeFi composability brings in unprecedented flexibility to the system. This allows activities like lending, trading, and registering profits on different protocols in a single block.
String of DeFi use cases
Going ahead than creating better alternatives of the traditional financial practices, DeFi has also promoted innovations like synthetic assets. Here are some prominent use cases of DeFi, creating a new frontier of finance technology.
One of the most popular DeFi use cases is P2P lending and borrowing of assets without the need for a bank account, paperwork, or review process. It even frees the borrower from the most stressful task – finding someone who is willing to lend! In the DeFi ecosystem, you can borrow the required amount directly from smart contracts, provided you fulfil the parameters required, and the interest is automatically adjusted depending upon the demand-supply and other equations. Along with saving time and effort, DeFi based lending and borrowing also takes complexity and guesswork out of the process.
On one hand, this use case of DeFi allows borrowers easy funds, while on the other, it enables people with surplus funds to earn interest on their passive crypto assets.
Fractionalization of costs
DeFi facilitates asset tokenization which reduces the costs of investment, speeds up transactions, and increases security. For instance, it empowers the investors with financial or geographic limitations to participate in global real asset opportunities. After the costs get fractionalized, it becomes easier for anyone to invest. Compared to traditional financial methods, it provides people a more accessible and affordable alternative to invest.
Greater asset control
Contrary to the conventional financial system that has designated authorities such as banks or trading agencies, DeFi allows you to take custody of your funds. It is the only system currently making you the sole custodian of the capital investment. The decentralized system empowers you to distribute, rotate and adjust your funds for the best return potential. Such a control was simply missing in erstwhile centralized ones.
Autonomous organizations without central authority
DeFi acts as an enabler to establish DAOs (Decentralized Autonomous Organizations) where hierarchical management is replaced by self-governing protocols with provisions for automated execution. These self-enforcing protocols guide the group of people to cooperate with one another in a specific manner to achieve the objectives of the organizations. The mechanism distributes the control directly among the shareholders, eliminating the need for central custodian/management.
Create custom derivatives
Derivatives are contracts tethered to underlying entities like index interest rate or asset. The performance of these underlying entities determines the value of derivatives. Generally, these platforms allow you to create assets by depositing collateral to maintain the position. Synthetix is a well-known derivatives platform on Ethereum blockchain.
DEXs (decentralized exchanges) refers to a self-operating and decentralized cryptocurrency exchange that acts without any mediator or central authority. Unlike the centralized systems, buyers or sellers are able to trade without ceding control over their funds to any intermediary. DEXs work on the basis of on-chain or off-chain order books.
In the economy of yield farming the yield aggregators play a central role by strategically leveraging various protocols of DeFi. This helps users immensely in increasing their profits. They lock up or pledge the funds and offer a return on investment, which could be either fixed or variable. Yield aggregators pool deposits together and simplify the experience of yield farming. Once yield aggregators come into the picture, users’ role becomes limited to deposits and withdrawals. Rest of the process, from interest accrual to selling the farmed rewards, is executed by the yield aggregator.
These use cases are meant to brief you about DeFi and are not the end certainly. There are many more DeFi applications with their unique use cases such as prediction markets, insurance, margin trading, payments, staking, and many more.
Decentralization, inclusivity, and extended ownership are some distinguishing characteristics of DeFi, making it an opportunity-builder for the capital securities market. It offers a wider liquidity landscape with zero-barrier provisions and easy entry/exit protocols for financial contracts, going a long way in solving the fluidity challenges of the market while increasing the pool of investors.
Thanks to the composability of DeFi, developers can build their applications upon other protocols with efficiency. The permissionless interaction between protocols/applications with one another enables enterprises to build upon strengths of one another. These characteristics of DeFi make it an innovative financial platform with enormous growth opportunities.
Challenges to the DeFi ecosystem
Like any ecosystem, DeFi too has its own set of challenges:
- Unaudited code in smart contracts is the foremost challenge DeFi faces, creating gaps that are used for exploitation leading to capital loss and even failure of protocol.
- There is also a possibility of collateral-backed protocols using the system to manipulate liquidation.
- DeFi protocols’ dependence on Oracle for off-chain information enables hackers to try and maneuver the oracles to their advantage to create a profitable scenario for them.
- Ethereum is the most popular blockchain when it comes to protocols that collectively create the DeFi ecosystem. However, the Ethereum network often becomes congested, resulting in exorbitant gas fees and constraining speed of transactions.
DeFi has emerged as a major force behind the surge of the crypto ecosystem and it is becoming a frontier of fintech. For many who considered crypto an intruder, this has come across as a surprise. Despite being a new entrant, the technology has garnered billions and continues to attract users. It has sustained itself for a considerably long period, belittling the camp that thought of DeFi as just another bubble. As technology grows and matures, DeFi is set to evolve as well.
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