What is Decentralized Finance? The Ultimate Guide to DeFi
Decentralized finance, popularly known as DeFi, refers to the ecosystem of financial applications built on public blockchain infrastructure and smart contracts like Ethereum. It includes protocols, DApps, smart contracts, and digital assets built on the blockchain.
The Ethereum platform has established itself as the primary choice for DeFi applications. It has become the most common platform for creating DeFi applications because of its flexibility and the development of its ecosystem.
Now, let's see the most common examples of DeFi applications that will offer more insights to answer the question about what is decentralized finance.
What are the Elements of Decentralized Finance?
#1. Borrowing & Lending
First of all, borrowing and lending platforms that are built of blockchain are also known as open lending protocols or DeFi lending platforms. It has become the most popular use case among all other alternative finance sectors in recent years.
The growth of Blockchain-based borrowing and lending platforms have been supported by the recent increase in the usage of MakerDao's Dai and other similar protocols. DeFi lending platforms have proved beneficial for both lenders and borrowers.
The users earn interest by lending their crypto assets to DeFi lending platforms. On the other hand, borrowers can receive funds during the time of their critical needs.
A user who borrows digital assets from the DeFi lending platforms will have to pay interest on the digital assets they borrowed. The DeFi lending platforms share this interest income with the lenders and thus it allows users to earn income on their crypto assets.
The key difference between the banks and the open lending platforms is that there are no intermediaries in DeFi lending. Smart contracts connect lenders and borrowers, set the loan terms, and also handles the distribution of interest to the lenders.
The lenders receive higher returns through DeFi lending platforms as there are no middlemen involved in borrowing and lending through them. Blockchain's inherent transparency also instills confidence among the lenders. However, these benefits come with its share of risks which are clearly understood by the lender.
The DeFi lending platform also offers ease in borrowing for the users that have been unable to borrow from the traditional financial institutions like the banks.
However, the borrowers must keep it in mind that the DeFi lending platforms are out of the purview of the traditional finance regulations. This leads to a higher interest rate when borrowing from the DeFi lending platforms.
Furthermore, stablecoins are one of the major parts of decentralized finance. It is a type of digital currency whose value is backed by pegged assets such as dollars, gold, or other major cryptocurrencies. Hence, stablecoins do not share the volatility of its peer cryptocurrencies.
There are four types of stablecoins and these are:
I. Fiat-Collateralized Stablecoin:
The fiat-collateralized stablecoins are backed by individual fiat currencies or a basket of fiat currencies like the US dollar, the Japanese yen, the Euro, or any other major global fiat currencies.
These stablecoins are backed by other major cryptocurrencies like bitcoin or ethereum.
III. Resource-Collateralized Stablecoin:
These types of stablecoins are backed by major physical assets such as gold.
IV. Hybrid Model Stablecoins
The hybrid model stablecoins adopts one or more than one type of collateralization models that are described above.
#3. Liquidity provisioning
Liquidity has always been one of the major concerns for all financial markets including cryptocurrency and blockchain-related ones. It is the backbone that supports the growth of the financial market in general.
Liquidity pools will allow anyone that has some spare cash to participate in decentralized finance. The users with spare cash are known as liquidity providers here. They provide liquidity to DeFi apps or cryptocurrency exchanges in return for a small fee.
Liquidity provisioning was a much-needed feature for exchanges and DeFi lending platforms. It is solving the issue of liquidity crunch for crypto exchanges and DeFi lending products.
Liquidity provisioning is powered by automated smart contracts, which do not yet exist in the traditional financial markets. However, the total volume of liquidity in the cryptocurrency space is pretty small compared to that of the conventional financial markets.
The available liquidity in the cryptocurrency space will keep on growing as it has shown stupendous growth so far. Large investors may soon flock to the crypto market as the liquidity pools are very likely to solve the problem of liquidity risks in the crypto world.
So, what are the main benefits of using decentralized finance applications?
What are the core benefits of DeFi?
Here are four core benefits of decentralized finance.
- Decentralization removes social barriers and brings services from third party providers to everyone around the world regardless of their social standing.
- It brings in technological revolution to the finance industry through blockchain infrastructure. DeFi users are benefited through safe, speedier, and low-cost transactions.
- Generally, DeFi application users remain in possession of their private keys. It is known as non-custodial in blockchain terminology. Thus, DeFi application users have full control of their money without any interference from any third-party.
- Decentralized finance brings in much-needed transparency in the global financial ecosystem. It leads to an efficient market and privacy mechanism.
Next, let’s learn how traditional finance differs from decentralized finance?
How does DeFi DApps differ from traditional finance applications?
Decentralization is the core of operations for DeFi DApps and thus, its operations are not manned by any institutions or their employees. Instead, the rules of transactions are undertaken by the smart contract. DeFi DApps require little to no human intervention after the deployment of a smart contract on the blockchain.
Anyone can audit the code of DeFi DApps as it is available on the blockchain. DeFi DApps are transparent and hence, they are trusted by their users. The transactions made on the DeFi applications are also public and anyone can view it on the public blockchain.
The public nature of DeFi applications may raise some questions about user privacy. However, it is to be noted that the transactions are pseudonymous by default. Hence, no one can know the identity of the person engaging in these transaction activities on DeFi applications.
Decentralized applications are location-agnostic and hence, anyone from anywhere can partake and use its services. The DeFi DApps may have to follow the local rules and regulations. However, if speaking on a purely technical basis, they can be used by anyone with an internet connection.
The DeFi applications also offer interoperability as they can be built combining other DeFi DApps. It also offers an unmatched user experience. The users can use a third party interface if they do not like the interface of the DeFi application they are using.
What’s next for Decentralized Finance (DeFi)?
Today's DeFi DApps are heavily reliant on collateral as a safeguard. A user must offer their crypto assets as collateral to borrow more crypto. DeFi applications cannot rely on traditional identity and credit-card systems like FICO scores. It will have to come up with a universal and privacy-oriented decentralized identity.
Crypto wallets could very well be a portal to all of your digital asset-based activities in the future. It will just be like today's internet browsers through which a user can access information and news, worldwide.
Today's DeFi applications are not a true example of decentralized applications as their developers have a master key for shutting down the DApps. A master key was created for easy system upgrades and also provides a way to shut down the system in emergencies like a buggy code. The developers are very likely to give up their master codes as the code will keep getting better with time. Now, The DeFi ecosystem is moving towards a truly decentralized decision making and governance model.
Decentralized finance technology has brought something revolutionary to change the face of the financial services industry. It has given the power to build financial services to anyone who can code. The answer to the question about "What is Decentralized Finance" will remain the same but its elements will keep on evolving even in the future.