Decentralized Finance (known as DeFi) is a concept that takes further cryptocurrency’s promise to make payments universally accessible without intermediaries – no matter where they are in the world.
DeFi has continued to gain prominence in recent times, with everyone talking about it. If you’re looking to understand what DeFi is all about and how it works, you have come to the right place. This guide will provide information about the following:
- What DeFi is
- History in centralized finance
- Pioneers that made it to mainstream
- The future of DeFi and finance
- How DeFi could help the society
What is DeFi?
Also referred to as Open Finance, DeFi is an abbreviation for Decentralized Finance, which is an assortment of financial applications built on top of blockchain networks. It refers to an open-source ecosystem of applications that allow for permission-less and transparent financial transactions and operates without a central authority.
The DeFi or Open Finance movement aims to shift attention to the possibility of a new monetary system built on blockchains with better transparency and fewer restrictions. DeFi relies on self-executing, complex logic smart contracts designed to execute automatically when certain conditions are met in the place of third parties or intermediaries.
Intended to serve as an alternative to traditional banking, DeFi provides an opportunity for everyone to access financial services with ease, including savings, insurance, loans, trading, and many other significant financial activities. Unlike traditional services, all of these are accessible to anyone globally with an internet connection and a device for accessing a service such as a computer, smartphone, or tablet.
History in centralized finance – people lending money to the bank and getting interest
Before we proceed further, it’s vital to explore the history of centralized finance to understand what DeFi is all about. A complete study will be overkill, so we will examine it briefly. The history of centralized finance can be traced to the invention of money by humans to simplify trading. Money evolved overtime and passed through the following phases:
- Commodity money: Objects with value in themselves were exchanged for other objects of similar value. E.g., gold, alcohol, tea, cannabis, cocoa beans, etc.
- Representative money: Objects that had little intrinsic value in themselves but represented a value. E.g., claims on a commodity like gold and silver certificates.
- Fiat money: This is the type of money we are familiar with today – paper money. It has no intrinsic value but is established by government regulation (legal tender).
The emergence of money gave rise to the first banking services, which saw merchants giving loans to farmers around 4,000 years ago. It was a common practice worldwide, including Assyria, India, Ancient Greece, the Roman Empire, China, etc.
This trend continued until the 12th century, when people interested in visiting the Holy Land had to deposit their values with a local Templar brand, received a document stating the value of their deposit, and used it to retrieve their funds when they got to the Holy Land.
The rebirth of centralized banking occurred around the same time as the emergence of the Templar when the first Italian banks were established in the 12th century in Venice. They operated primarily as investment banks in that they organized finance for long trading journeys and other areas that would also aid the development of the economy. Banking services of this sort soon spread all over Italy and Europe.
So what exactly was wrong with centralized banking?
There are different answers to this question. The first is that the government has full control of legal tender, which means governments can carry out any decision they see fit. For instance, the government could decide to declare any means of payment to be invalid at any time.
The second sin of centralized banking was that the apex bank had control of the money supply, thus fostering complete dependency on the central banks and governments. This affects how strong a currency could be as experts opine that the stability of a currency depends on its resistance to government controls. Going further, the two points above bring us to the third: the possibility of the government intervening in the free market.
From the times of Nero and other Roman Emperors to more recent times like the Great Depression in the U.S. and the attempt to implement a Planned Economy in socialist countries, government interventions have occurred at different times throughout history. All such interventions have led to disastrous consequences.
Perhaps, one of the biggest issues with centralized finance is that it encouraged loans at high interest rates. People and companies interested in obtaining loans from banks had to accept very high-interest rates as a condition, which became a major way the centralized banking system earned profit.
For the curious reader, you can learn more about the history of banking.
DeFi pioneers that made it to mainstream
To summarize, decentralized finance is the opposite of centralized finance; instead of relying on banks for getting loans, interest on money, etc.
Decentralized finance makes it possible for anyone worldwide to take part in financial services that historically were available to a small minority.
Most DeFi projects are built on the blockchain Ethereum, so it makes sense that they didn’t exist until Ethereum was launched in 2015. Although there were tons of such projects, some have successfully made it to the mainstream while others trudge behind. Examples of such projects include:
- Synthetix (previously known as Havven)
The future of DeFi and finance
One of the questions many people beginners generally ask is, ‘What does the future of finance look like with DeFi in the picture?'
We can have an idea of what the future will look like by considering the problems DeFi intends to solve. For starters, an estimated 1.7 billion people worldwide are currently unbanked in that they have no access to banking services.
With DeFi, there is a better chance of reaching these people to send and receive money no matter where they are as long as they have a smartphone and data. It solves the problem of accessibility as they can be in faraway lands and still make payments, borrow cryptocurrencies, and earn interest, among other things.
Additionally, DeFi has been widely highlighted as an alternative to traditional finance for many reasons with many advantages over it. For instance, traditional banking systems require the personal information of their customers with every transaction. The data is susceptible to data theft and unauthorized sharing with other institutions for marketing purposes at the cost of your privacy.
DeFi solves this problem by giving everyone access to banking services without giving up their personal data. Another challenge that DeFi addresses is that of high interest on loans.
Many agree that loan rates are high because of legacy costs, but this is often at the detriments of high-quality projects due to financial constraints. For instance, an entrepreneur may target an annual return of 20 percent, but if the lending bank offers a credit facility with an interest rate of 15 percent per annum, this profitable project may not be pursued.
In contrast, DeFi cut down on interest rates since there are no intermediaries. That’s not all, users can lend out and borrow large sums of money anonymously, and the interest rates are set automatically in accordance with demands and supply. Going further, DeFi also solves a major problem in an aspect of centralized finance – centralized exchanges.
Centralized exchanges require customers to deposit funds in their wallets, meaning the exchange controls the private keys to all funds held within it.
This defeats the vision of cryptocurrency to enhance payments without intermediaries and implies that the funds may be subject to arbitrary withdrawal holds or delays or even theft from hackers.
DeFi solves this problem via smart contracts. In other words, DeFi allows customers to interact with exchanges and decentralized finance products by depositing and withdrawing their funds from smart contracts as they please. Plus, there are no intermediaries since DeFi apps are permission-less and anonymous. This allows users to interact freely as they please with anyone.
Going by all the points above, it makes sense to say that DeFi itself is the future of finance, especially since billions of dollars have been put so far into the ecosystem within its short lifespan.
How DeFi could help the society
Having touched on the key areas of what beginners should know about DeFi, let’s move on to the benefits of Decentralized Finance to society.
Before now, critical data within the financial markets was only in the hands of a small group of stakeholders who determined pricing, access, and every other type of data that could be released.
With decentralized finance, there is a democratization of data in how it is sourced and presented. It will enhance equality by using crypto-economic incentives to drive the supply, share and use of transparent and crowd-verified data.
Lending has always been a big issue in the banking industry as the interest rate is typically high, making it possible for people to get them. Plus, those willing to accept the loans despite the rates are faced with the challenge of providing collateral.
DeFi has seen the innovation of no-collateral loans and credit facilities with very low interest rates since there are no intermediaries that operate their businesses around fees.
Decentralized exchanges (DEX) have also become a hot topic of discussion in the cryptocurrency community. Rather than have a centralized exchange serve as the middleman between users, DEX encourages a non-custodial platform, which means users are in charge of their private keys.
This implies an emergency of a peer-to-peer type of marketplace that allows crypto transactions to take place securely. Uniswap is one of the major players in this category.
With regards to asset management, DeFi also holds a variety of distinct advantages. These benefits to the society include non-custodial ownership of assets, composability to seamlessly plug in DeFi products with other products, automation, global access, financial inclusion, and more.
Although you may find it worrisome that there are no safeguards to protect their funds, the good news is that DeFi products are increasing in number and are becoming more user-friendly and educational to help enlighten people on how they can properly manage their digital assets.
Many people worry that there are no safeguards or custodians to protect their assets and that losing them may be final. While this is true, it’s important to note that there is a range of DeFi insurance products that can help minimize the risk of this happening.
At the time of writing, there are more than 10 DeFi insurance providers that operate in the stead of traditional insurance companies, and their goal is to create an ecosystem based on transparency and accessibility.
One of the biggest challenges of recreating traditional financial products on a blockchain is that of price volatility. Price volatility has been an issue that held back mainstream adoption, leading to the creation of stablecoins. These are cryptocurrencies pegged to real-world currencies like the U.S. dollar, while others are pegged to commodities like gold and silver.
Stablecoins allow users to create their own cryptocurrency, lend out money with it, make payments, earn interest on their own crypto, and do a lot more.
The areas mentioned above through which DeFi benefits society align with its key principles: permission-less, autonomy, and transparency.
Decentralized Finance aims to build financial services that are independent of the traditional financial and political system. This would allow for a more open financial system and help prevent restrictions, manipulations, and discrimination worldwide.
Although DeFi is new and has many potentials, it has not yet attained perfection as more work is being done to strengthen its security and improve it.