What is DeFi and why will it change the world?
Last update: July 2020.
Let’s start by directly answering the question that brought you to this article: What is DeFi (Decentralized Finance)?
What is DeFi?
A little context on the emergence of DeFi
DeFi originates from blockchain technology. To understand this novel financial concept, it is important to delve into its origins. Let’s see what differentiates them from traditional finance (bank accounts, savings, and loans, use of national currencies, among others). Additionally, we will take a look at their benefits.
In 2009, the enigmatic Satoshi Nakamoto launched Bitcoin. He defined it as “A User-to-User Electronic Cash System”. This innovative notion allowed laying the foundations for a global, decentralized, neutral, censorship-resistant, and open platform. The premise is to replace – or complement – the traditional system of value exchange.
In the Nakamoto white paper, the operation of a new type of Distributed Registry (DLT) is described, where through a consensus protocol accepted by all network participants, a copy of the transaction book can be dispersed, avoiding a central point of failure or control. In other words, intermediaries (financial institutions) would no longer be necessary to carry out a transaction.
This first public blockchain is Bitcoin.
Ten years after its invention, thousands of projects have emerged that operate under the same principles. These principles entail the decentralization that blockchain offers. Bitcoin, being open-source, has allowed enthusiasts and programmers from around the world to contribute to its development, and even create new similar projects.
All these new currencies that are based on blockchain -or similar technologies- are known as cryptocurrencies and are the raw material of DeFi.
The guardians of money
Just as in their time countries separated the power of Church and State, Bitcoin’s proposal is similar: to separate money from the political/economic system.
Currently, the potential of these decentralized systems (blockchain and cryptocurrencies) has not been able to fully show their potential. Until crypto assets are massively adopted by the population, access and exit ramps (e.g.: exchange houses and banks, places where you buy and sell cryptocurrencies) are essential. Although only 5% of the population owns cryptocurrencies, it is a growing technology.
From a simplistic perspective, the power of the States is based, among other things, on the control of the issuance of money. The administration of these assets is exercised by banking institutions and financial intermediaries.
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These guardians receive compensation for the provision of their services; and citizens, by relinquishing autonomy over control of their money, obtain the promise of effective safeguard and convenient access to their funds.
However, traditional systems have proven not to be infallible. Global financial crises (such as the one that seems to be in the making due to the COVID-19 pandemic) characterize this point and demonstrate that when control is in the hands of few actors, the accumulated risk tends to threaten the stability of the entire system.
DeFi as an evolution of the fintech movement
The fintech (financial technology) movement consists of the direct involvement of the technology sector in the generation of new – and more efficient – financial services and tools.
Measures such as PSD2 in Europe have opened a necessary floodgate for innovation in the sector. This regulation establishes a framework for access to information that was once exclusive to banks. This has made the emergence of efficient financial tools and applications more flexible, something that until a few years ago was impossible to imagine.
Top fintech companies
It is anachronistic that in an era dominated by exponential technologies such as Artificial Intelligence, Machine Learning and supercomputer networks, a system as slow as SWIFT continues to protect most international banking transactions.
Fintech represents an evolution and its advantages are obvious. But, in the midst of this cocktail of accelerated innovations, what will be the next step after the adoption of these applications?
In a context where citizens gradually become more aware of the value of preserving control of their personal information and the importance of privacy in the midst of the digital age, we cannot disassociate the fintech concept from pro-decentralization of information ideas. We were talking about at the beginning (the Bitcoin / Blockchain pairing).
Source: https://link.bitcaribe.net/zerion | Evolution of traditional finance.
Fintech is undoubtedly a necessary link in this new wave of decentralized applications for the management of financial affairs, and the response of a generation that understands digital transformation as an unstoppable, necessary, and positive process.
How are DeFi different from traditional Finance?
The autonomy offered by DeFi will displace the central control exercised by governments and Large Companies.
As can be seen in the comparative graph above, among all this network of decentralized financial solutions stands out:
- Regardless of who creates or maintains a DeFi service, there is complete transparency in its operations.
- Users control access to their money. Custody is not in the hands of a bank.
- Free access. There are no geographic restrictions or reliance on identity documents to manage these digital monies. Furthermore, DeFi could facilitate access to money for more than 1.7 billion people who do not have a bank account.
- Absolute control of money by users.
Some point out that DeFi is a rebranding of another similar concept, “Open Finance”, a notion that has been hanging around libertarian forums and occupying sporadic gatherings in universities for more time.
DeFi today. Some applications and services.
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Lightning Network:
It is a network of payment channels that works on Bitcoin. Allows instant transactions in BTC. It has more than 12,500 nodes and a processing capacity of $9 million; Lightning Network has in turn served for fintech companies, such as foldapp.com, to offer payments for products and services (air tickets, department stores, coffee shops, etc.) with bitcoin. Here is one more example of the fintech / DeFi combination.
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MakerDAO y DAI:
A platform that supports the value of a stablecoin anchored to the dollar, DAI, through a system of Guaranteed Debt Positions (CDP) in ether (ETH). This project maintains 54% of the volume that circulates in the DeFi ( $514.2 millon).
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Compound Finance:
It is a decentralized protocol over Ethereum that allows users to earn interest through lending their crypto assets. It offers variable interest rates, automatically adjusted by an algorithm. In some cases, you can pay up to 12% annual interest (APR)!.
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Decentralized Exchanges (DEX):
They are platforms that make the exchange of crypto assets possible, allowing you to maintain control of your private keys at all times. In Dex.ag you can see the main rates of 10 DEXes.
Source: https://medium.com/alethio/the-defi-series-a-closer-look-into-user-community-356a8d8ba2f5 | The main DeFi applications are listed on the https://defipulse.com.
DeFi challenges
As with many blockchain-based solutions, one of the biggest barriers to entry for DeFi protocols is how complex they are technically for the average user. Therefore, concepts such as private keys, cold wallets, confirmation times, and hardfork are difficult for the common user to understand.
However, there has been a lot of progress. Dharma, a Silicon Valley startup that offers loans and interest payments on DAI, is an example of simplification and a friendly interface.
Another challenge that DeFi faces is the eventual fragility of smart contracts. The activity and functionality of these platforms are regulated by so-called smart contracts. If they are hacked or there is a back door in their code, they could put users’ funds at risk.
It is worth noting that the main DeFi products are often continuously audited by prestigious computer security firms.
On the other side of the coin, being open-source, its development does not stagnate and progress remains in the hands of thousands, but millions, of programmers worldwide.
Nevertheless, there is still a long way to go. We will see in the months -or years- to come how these technologies advance and what will be the benefits around the world.
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