When cryptocurrency was introduced in the year 2009, little did people think that this little piece of innovation and the technology behind it would go on to create a revolution in the field of recordkeeping, transactions, and finance.
Blockchain technology, as we all know, it’s a decentralized, digital, and immutable ledger that helps to keep records securely. This unparalleled level of security is of paramount importance when it comes to the world of finance where authentication and tamper-proof recordkeeping is essential.
However, the world of finance, for a long time, has been in the hands of centralized institutions like governments and banks. It would seem on the surface that this set up is virtually unshakable. People have been so used to the misgivings of the current financial system, and they have gotten so accustomed to the elements of this finance.
Although there might be a little bit of inertia, the new ecosystem of finance facilitated by blockchain technology is already taking shape and is in its nascent stages right now. This new realm of finance is called decentralized finance, and for the sake of convenience, shortened as DeFi.
What is DeFi?
We have already seen a definition of what DeFi is. It is a new system of finance facilitated by decentralized applications.
In essence, DeFi is about removing the concentration of authority from centralized institutions like banks. This makes the entire system less prone to manipulations, more accessible to the general public, and above everything, removes the cost associated with intermediaries and third-party interventions that are designed to bring interest.
This brings the next major question of how trust can be enforced in such a system. The enforcement of trust is adequately taken care of by a small program that is designed to execute by itself and resides right within the blockchain. These programs are called smart contracts.
Introducing smart contracts
As discussed earlier, smart contracts are self-executing programs designed to get into action by themselves upon certain conditions being met. Smart contracts are rigid by nature, and since the program is built within the blockchain, it is impossible to tamper with the functionalities and the manifested executions.
The combination of centralization and smart contracts is what makes the entire ecosystem of DeFi possible. This has given rise to a lot of manifestations that can effectively replace almost every element of traditional finance.
Although there are a few disadvantages that need to be addressed, DeFi brings quite a lot of advantages that can elevate the offerings of the current financial ecosystems.
Advantages of DeFi
Removal of intermediaries - In today’s financial ecosystem, intermediaries consume a lot of costs. It makes simple processes a lot more expensive than they should be. With DeFi, all the intermediaries are removed and are effectively replaced by smart contracts. This makes the entire ecosystem cost-effective and it translates into better interest rates for loans and lower premium and higher quality for services like insurance.
Universal access - Today, access to all financial services is limited to or rather constrained by the availability of the elements of financial service elements like banks. This means that a person who does not have access to a bank cannot avail most of the financial services. With DeFi, the geographic barriers are broken and finance becomes universally accessible.
Widening the scope of investment - With the world of investment becoming global because of DeFi, it becomes easy for any person in any economy to invest in any place on the planet. It serves as a driving force of globalizing access to economic development.
No centralized point of failure - In decentralized finance, the authority is distributed among all the people involved, completely diluting the concentration of power. This decentralization resolves a lot of challenges associated with traditional finance like possibilities of security breaches, cash trading, and trust issues. This is an important advantage considering the fact that most of the hacks associated with cryptocurrency and blockchain have been on centralized exchanges.
Liquidity - by classic definition, liquidity is the ease with which and as it can be converted into cash. In the context of finance, liquidity is a measure of the number of transactions that happen in a financial ecosystem. Since the DeFi ecosystem opens up access to everyone, There is a considerable increase in the magnitude of liquidity.
The different manifestations of DeFi
DeFi is no longer a concept on paper. There are a lot of tangible manifestations that serve as practical demonstrators for the versatility and reliability of DeFi.
Decentralized exchanges
Decentralized cryptocurrency exchanges can be considered the most practical manifestation of DeFi. Since centralized exchanges are susceptible to price manipulation and security compromise, decentralized exchanges can be considered a wonderful alternative for purists of crypto and blockchain technology who sought to preserve the essence of the technology.
The growing relevance and importance of decentralized cryptocurrency exchanges can be filled in the fact that some of the most renowned centralized exchanges like Binance have already kickstarted their decentralized exchange business. In addition, there are a lot of such exchanges springing up left, right, and center.
Decentralized exchanges do not connect trades but users. To encapsulate the essence of their functioning, centralized exchange functions like Amazon but decentralized counterpart functions like Craigslist. The trade is executed by incorporating a smart contract-based ecosystem that takes care to hold funds from getting transferred to the other party until the trade is confirmed by the first person.
Yield farming
The traditional financial ecosystem facilitates a lot of passive methods to earn huge profits. Even in the DeFi method, it is made possible by a process called yield farming. As the name implies, it is a method where you ‘farm’ your ‘yield’ into making a better profit again.
To understand yield farming, we will need to unravel a lot of the liquidity pool. A liquidity pool is a repository of crypto assets from where the financial operations are carried out. In a centralized system, it is possible to manipulate the market by printing or generating more money. However, in the decentralized system, it is not possible to hold money.
Therefore, people who possess crypto-assets can put them in the liquidity pool for gaining interest. The assets that are put in the liquid at the pool will now be available for bottling purposes. The interest gained on these assets dropped into the liquidity pool is considerably high. There might be questions on the guarantee of returns and the safety of these crypto assets dropped into the liquidity pool. It is adequately and reliably taken care of by smart contracts.
How does yield farming work?
The people who deposit their cryptocurrency and crypto-assets into the liquidity pool are called liquidity providers. The liquidity pool provides a marketplace that enables borrowing and exchange of crypto assets and tokens. The platform collects fees and a part of it is paid back to the liquidity providers.
Although the crux remains the same, the nitty-gritty’s might vary with different technologies and approaches. Since these pledged assets cannot fall victim to volatility, most of the deposits are stable coins that are pegged to the real-world as in terms of value.
Crypto lending and borrowing
We have already seen how DeFi can provide a better platform for borrowing and lending without intervention from centralized bodies like banks. Just like any other loan system, a borrower can obtain loans against crypto assets. However, unlike traditional financial systems, the lender is directly connected with the borrower and both of them can agree upon an interest rate. All these details are embedded in a smart contract, and the transfer is directly executed to the account of the borrower.
By understanding the process of borrowing, it will be easy to understand how lending works. The users can deposit their crypto assets and they can earn interest when someone bottles from them. It might take some time before we achieve interoperability and standardization, and once that is done, DeFi will become one of the most cost-efficient methods of lending and borrowing.
DeFi staking
Ever since the inception of blockchain technology and other technology trends, staking has played a major role. Staking has always been the reward system for solving equations to add a block into the blockchain. In the decentralized finance ecosystem, staking presents a lucrative learning opportunity, and it has been found to be additionally practical ever since the announcement of Ethereum 2.0.
Almost similar but slightly different from the classic proof of stake, the DeFi protocol calculates rewards by taking into consideration the quantity of stacked assets in the network and buying the stacker. It also considers the duration of staking, the inflation, and the network issuance rate.
With DeFi staking, it becomes easy for investors to earn passive income, and that too, with relatively low entry fees. For the staking platform, it elevates the possibilities of achieving higher liquidity and in effect, replace the functions of a traditional bank. There are a lot of cryptocurrency exchanges that support DeFi staking.
The challenges in DeFi
Just like Newton’s first law of motion, any process that is already in momentum might take some time to accept changes, however constructive and beneficial it is. With respect to DeFi, it might be difficult for users to leave all the elements of traditional finance. In addition, there are a few challenges that DeFi faces.
The blockchain might be a revolutionary technology, but it cannot be denied that it phases a lot of performance issues. The slowness of the technology percolates into all the applications and ecosystems that are built on top of it. However, since the technology is not even 15 years old, it might take time to mature and become efficient.
The absence of intermediaries might translate into optimized cost, but it also puts the responsibility of the transaction directly on the user. This increases the possibilities of risk on account of human error. Since the transactions are irreversible, it might cause a higher risk when it comes to users transferring funds to wrong accounts, or even worse, when they become victims of social engineering.
The ecosystem is quite cluttered and although there are solutions for almost every activity, they are quite scattered. It will take some time before all the applications are unified, so it forms a suitable use case.
What matters at the end of the day is an impeccable user experience. Today, people are accustomed to paying an additional cost for an enhanced experience. If DeFi has to replace traditional finance, then it will have to present users with such an experience that they are willing to take the benefit of both the enhanced experience and the optimized cost. Today, however, the experience is far less than what could be considered acceptable.
Conclusion
The futuristic possibilities with DeFi have already been established. It is evident that DeFi and its manifestations cannot only impact a small segment of finance but the entire spectrum of it. It might be considered a bit too premature to venture into this space, but if at all Elon musk has taught us something, it is a great idea to invest early into the future.
If you would like to be a part of the DeFi open finance development and expand your services into the different segments of it like DeFi lending platform development and DeFi-based decentralized exchange, you will need to get in touch with a DeFi development company.
The decentralized finance [DeFi] development company will take care to understand your requirements in detail and present you with optimal decentralized finance [DeFi] solutions. It might be a bit too early to call it a perfect solution, but it will surely be good enough for you to make minor changes and take on the world of DeFi once it becomes mainstream… and probably when it shows the slightest signs of it becoming a mainstream financial solution.
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