We are all aware of blockchain's potential to disrupt the global economy as we know it. In fact, much has already been done to achieve this goal, with growing investments in cryptocurrencies driving a booming transactional market where companies like Bitcoin and Ethereum are kings. But even with the impressive steps in cryptocurrencies (…)
20% of people saying they have used or owned crypto in the past).
You could argue that it's only a matter of time before these numbers increase. And while that may be true, the global adoption of cryptocurrencies still falls short of the promise of a complete economic revolution. Yes, local money would be replaced by a more global currency (or currencies), with all the effects that this might entail. But what if we took the concept of decentralization a little further? Then we will find decentralized finance (DeFi), an alternative that would use the main idea of blockchain and apply to practically all things financial.
What is DeFi?
Before we delve into what this all means, let's look at what DeFi is. Professor and author Philipp Sandner defines it as “an ecosystem composed of applications built on distributed public ledgers, for facilitating permissionless financial services .”
As you can certainly notice, the most significant difference with blockchain is that it extends the concept of using decentralized ledgers to the entire financial system, not just currencies. A world powered by DeFi would use blockchain for more than just purchases. It would be used to save bills, secure loans, make investments and trades, obtain insurance, and pretty much anything you can imagine that involves a financial institution.
To do this, DeFi uses decentralized applications (often called dApps). We've discussed dApps on our blog before, but the concept is worth updating. A dApp is an application built in a decentralized environment (such as the peer-to-peer ecosystem of a blockchain). As such, it is not controlled by an institution, organization or company.
A dApp does not reside on a single server, depending on a specific team to keep it running and maintained properly – it is stored on a network of devices (or nodes), which is why we say these applications are decentralized. Lastly, dApps are open, meaning they can be accessed from anywhere over the internet. That's what that “without permission” in Sandner's definitions points to: anyone can participate in them. What's more – anyone can create a dApp, often with the help of a dApp development company to ensure technical expertise and successful deployment.
In short, DeFi is a financial system that works on a peer-to-peer network using a multitude of dApps. For this to work smoothly, we need to add one last thing – smart contracts. If you are familiar with blockchain technology, you certainly know that smart contracts are what make it all happen. If you don't know what smart contracts are, they are programs or protocols that execute, control or document a contract, agreement or negotiation.
In other words, when you enter into a smart contract, you agree to specific terms and conditions – just as you would with a regular contract. What makes it smart is that these contracts have automated features that check whether conditions have been met and terms have been followed. If all of them are met, the smart contract can trigger a specific action, from depositing money into a digital wallet to granting an insurance policy.
Providing this insurance policy is one of the things DeFi is trying to achieve with new, more sophisticated dApps. The idea is to move from just guaranteeing monetary transactions to covering all transactions in the financial world.
How DeFi differs from traditional financial services
All of the above may seem like an elegant plan for the future of the financial sector. What you may not know is that DeFi is already among us, albeit on a small scale. There are many DeFi dApps that you can use today to bypass traditional financial channels. From lending money to earn crypto interest to borrowing and making advanced investments, the DeFi world is flourishing.
Naturally, there is still a long way to go, mainly because there is no company or organization advocating DeFi. There are people from all over the world contributing to the development of DeFi, from crypto aficionados and blockchain experts to QA outsourcing teams doing the testing. This myriad of interests and approaches can bring many things to the table, both positive and negative.
All stakeholders are working to differentiate DeFi dApps from traditional banks. That's why you may find several differences between them and the typical financial services you use, including:
- DeFi dApps are automatically managed. The traditional system relies on financial institutions and banks to carry out its operations. DeFi replaces them with rules determined in smart contracts. dApps use these smart contracts to govern all transactions automatically, with virtually no intervention from operators (we say virtually because there are cases where dApps need to be patched or updated).
- The network is completely transparent. One of the biggest criticisms of the traditional financial system is how “closed” it is, as you can never see the entire ecosystem and its flow. DeFi is the opposite of this: the underlying code is open for everyone to see and contribute to its development, from smart contracts to transactions. You could argue that opening transactions to the public puts people's privacy at risk. But because DeFi uses pseudonyms, operations cannot be linked to specific people.
- dApps can be accessed from anywhere and at any time. Since the DeFi system is the same for everyone in the world, you can access it from anywhere via an Internet connection without any service limitations (at least from a technical point of view). There are also no business hours, so you can make a transaction at any time according to the terms of the smart contract.
- DeFi is not permissioned. We said this above, but it's worth repeating because this is a core aspect of DeFi. The permissionless nature allows anyone with an internet connection to enter, without you having to request a service or bypass a monitoring entity to obtain a grant. Because smart contracts are individual, inflexible, and govern all transactions, the sole guardian of all DeFi movements and actions are the terms of the smart contracts.
Are we ready for DeFi?
That's the big question, isn't it? As it stands, DeFi seems like a beneficial path to follow as it offers more flexibility, availability, transparency and security for everything related to the financial world. Of course, for this to happen, countries around the world would have to abandon cash and massively adopt cryptocurrencies. It seems like more of a political decision than anything else, but DeFi could use some improvements to prepare for a future where this decision becomes a reality.
For example, today's DeFi dApps don't lend crypto to anyone who doesn't already own crypto. It still relies on collateral as collateral, mainly because it does not have a developed identity system that allows for unsecured loans. Then there is the security of smart contracts which are (and probably always will be) in the crosshairs, as someone with enough knowledge could hack the open source of a dApp and exploit it. Finally, user experience is a limiting factor for adoption today: dApps still need to work on their UX to attract a more massive audience outside the blockchain niche.
These and other challenges are preventing DeFi from gaining more traction than it is already getting. However, despite its limited popularity, it is impressive to see that there is a radical alternative to the financial world we know today. Of course, it may be in its early stages. Still, if technologies and the general opinion about them continue to change, the DeFi ecosystem could become the future of the financial industry.
