Defi stands for “decentralized finance” and refers to an ecosystem consisting of financial applications built on top of blockchain systems. Also described as a concept that facilitates decentralized networks and open-source software to build different types of financial products and services, Defi realized the development of decentralized financial apps (DApps) with blockchain technology. To understand Defi, one must understand the mechanisms of blockchain.
DeFi has disrupted traditional finance — Where central certifying authorities like central banks are required to print money (Currencies) in transaction facilitation. We should also understand that currencies are created for transactions to improve economic productivity. Defi decentralizes centralized operations by creating open, global, and accessible alternatives (with an internet connection) to every financial service in modern days — think loans and insurance. Cryptocurrency, as an arm of DeFi, improves economic productivity as autonomy speeds up transactions.
Traditional finance was first disrupted 11 years ago with the invention of the first primary cryptocurrency, Bitcoin. Cryptocurrency also paved the way for DApps when it took off with DEXs.
DeFi is sometimes referred to as “Lego Money” because DApps can be stacked on top of one another to maximize returns, which were not possible in a CCE. In a CCE, one will not have full custody of h/her assets, security may be compromised, and fall victim to system manipulation by the exchange. However, despite the risks, a CCE provides high liquidity and volume that will benefit traders. CCEs are also more beginner-friendly than DEXs, where one can incur significant losses from carelessness, to be explained further below.
Again, DeFi is about autonomy — which means that intermediaries or arbitrators are excused. Users of DEXs have complete control of their funds as the code defines the settlement of any future disputes, reducing costs associated with asset management (i.e., Brokers). Single points of failure from a centralized system are also eliminated as data is recorded on the blockchain. DeFi is transparent as data is publicly available, and individuals may check reserves of a DeFi bank for rates and transaction data.
DeFi further counters the pain points of individuals’ inaccessibility to central banks in some developing countries. Often, intermediaries like traditional banks take a commission from individuals, which is less than ideal for low-income earners.
The recent hype of DeFi came about as Covid-19 slapped the world’s financial system with issues from value decrement in fiat currencies that have resulted in a loss of public confidence. People are seeking alternatives to the traditional banking system and are turning to DeFi products like cryptocurrencies.
The US Securities and Exchange Commission (SEC) embraces DeFi by approving an ethereum-based fund, Arca, in July 2020 — A sign of financial innovation acceptance. In traditional unsecured lending, borrowers and lenders must know one another’s identities, and lenders must assess whether a borrower is credit-worthy. Such tedious processes have ideated the selling product of DeFi, a crypto loan.
The automated system in DeFi quickens the process of borrowing. Global job losses have rendered many non-creditworthy, resulting in possible poor cash flow from sustaining pre-covid commitments (Car, housing, etc.). People can now borrow money instantly with DEXs without the need for income documents or Know-Your-Customers (KYC) processes. Additionally, users can earn from crypto loans with margin trading. As earlier mentioned, while there are system manipulation risks from CCEs, one should always be cautious with personal private keys to prevent assets loss when using Dex.
Major financial institutions are also beginning to get involved in DeFi, with 75 world biggest banks testing on blockchain to speed up their payment processes as part of the Interbank Information Network. Also, big players of asset management funds like Grayscale have jumped on the DeFi bandwagon as it managed over the US $5.2 billion of cryptocurrencies in the first half of 2020.
DeFi’s innovative features have emerged as an essential cornerstone of the crypto space. The recent DeFi hype has demonstrated that blockchain and crypto’s marriage are bound to scale new heights and enable wider global accessibility to financial services, with more major financial institutions picking up on decentralized ecosystems.
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