Decentralized Finance will make you millionaire in a day.
What is Decentralized Finance (DeFi)? Here’s everything you need to know
Cryptocurrency’s DeFi sector proclaims the end of banks and fintech giants, but what is it and why should you care?
Decentralized finance, or DeFi, is rapidly emerging as one of the most promising applications of cryptocurrency technology. And while it may sound complicated, DeFi is just an umbrella term used to describe financial products and services that are completely independent of any authorities.
Imagine a world where common services such as loans, cross-border payments, insurance, and retirement savings don’t require a bank account or approval from an authority. That is DeFi’s vision essentially, to establish an open standard. This new standard doesn’t leave room for predatory intermediaries or third parties either — and promises to herald a new era of financial efficiency, inclusion, and transparency.
Indeed, those are a lot of bold claims. So in this article, let’s examine this emerging technology, understand how it works, and how it will likely influence your financial life in the future.
What is Decentralized Finance (DeFi)?
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Before we dive into the nitty-gritty of how DeFi works, it’s important first to understand the way things currently work in the world of traditional finance, or TradFi as it is sometimes called in cryptocurrency circles.
Say you want to trade one asset for another, like stocks for cash — you would need an exchange or trading platform to facilitate this trade. Now assume you’re in the market for a new car or house and require a loan. What are your only options? A bank or local credit union, at best. Whether you’re trying to save money for your retirement or transferring money abroad, you typically have to trust one or multiple institutions to achieve that goal.
On the surface, trusting such institutions doesn’t seem too problematic as they’ve been around for decades, if not centuries. Dig only a little deeper, though, and the finance sector’s controversial past, including events such as the 2008 mortgage crisis, can leave you wondering if your trust is perhaps misplaced.
However, even if you aren’t distrustful of modern banking practices, you are undoubtedly affected by them in one way or another. High commissions, arbitrary restrictions, and red tape are commonplace today, despite technology to eliminate these long-standing complaints.
The DeFi sector hopes to eliminate the banking industry's high commissions, arbitrary restrictions, and red tape.
Enter the DeFi sector, which aims to finally fix these issues by eliminating central authorities and intermediaries. What’s replacing them, you ask? An automated computer network that distributes control instead of concentrating it at the top. DeFi applications are typically built on top of decentralized blockchain networks such as Ethereum.
DeFi has the potential to take blockchain technology from serving as a simple record of payment to a full-fledged economy. DeFi proposes recreating these financial services — including loans, cross-border payments, and interest-generating savings accounts — but minus the middlemen and other annoyances.
The crux of the DeFi movement is perhaps best explained by the co-founder of Ethereum, who once said,
Whereas most technologies tend to automate workers on the periphery doing menial tasks, blockchains automate away the center. Instead of putting the taxi driver out of a job, blockchain puts Uber out of a job and lets the taxi drivers work with the customer directly.
Why is DeFi special?
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As is probably evident by now, DeFi’s goals are in stark contrast to PayPal, Robinhood, and hundreds of other fintech companies. The latter often go to great lengths to keep users invested and engaged within their walled ecosystems.
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Beyond that simple distinction, here is a quick summary of DeFi’s advantages and why its proponents view it as a superior alternative to traditional finance.
Since blockchain technology is decentralized and does not rely on central banks or fiat currencies, DeFi is global and borderless.
DeFi eliminates intermediaries. This, in turn, saves users from having to deal with lengthy approval processes, paperwork, fees, and even discrimination.
Besides efficiency, DeFi platforms could potentially offer improved security and privacy, with lower risks of data leaks. In the case of popular projects, at least, bugs and glaring security issues are often peer-reviewed and fixed before updates are released to the public.
Cryptocurrencies have a low barrier to entry. Anyone with a smartphone and internet connection can create a cryptocurrency wallet and enjoy equal access to DeFi services.
Banks often struggle to offer financial services in less developed areas. According to the World Bank, around 1.7 billion people don’t have access to financial services. DeFi doesn’t require identification or other labor-intensive processes and could bank the unbanked.
How do DeFi apps work?
DeFi apps and services rely on a specific blockchain-derived technology called smart contracts. These are essentially digital contracts that execute automatically when some condition is met. Anyone can create and publish their own smart contracts on a blockchain platform like Ethereum. And once signed by the concerned parties, the contract cannot be modified or tampered with.
All of these properties make smart contracts perfect for automatically enforcing the terms of even the most sophisticated agreements in finance, such as loan repayments and insurance payouts. Most notably, all of this is achieved without a single human third-party or higher authority.
Developers create smart contracts just like any other piece of software you interact with. A bundle of such digital contracts is often referred to as a decentralized application, or dapp.
Decentralized applications execute their code on blockchain networks, making them transparent and auditable.
However, developers don’t publish their code to something like the Play Store on your phone. Instead, dapps are uploaded to the global Ethereum blockchain by way of a simple transaction. Once published, users can interact with the dapp or underlying smart contract through new transactions of their own.
Take the following smart contract-affiliated transaction on the Ethereum blockchain, for example.
etherscan defi uniswap transaction
The Interacted With and Transaction Action fields specifically tell us that the wallet owner interacted with a smart contract named Uniswap. More importantly, this particular transaction facilitated a simple swap between a relatively obscure token and Ethereum. As you can see, everything was not only transparent, but also instantaneous — in line with the promises DeFi is built upon.
However, none of this information is particularly worth knowing except as an academic exercise. The frontend for most dapps is far simpler and user-friendly. In fact, you’ll likely use a cryptocurrency wallet on your smartphone or computer to interact with these apps.
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Most Ethereum wallets can talk to dapps these days, and we even explored some of the best options in our roundup of software wallets. As for which dapps in the DeFi space are worth using, we’ll explore some of the most popular projects in a later section.
Will DeFi disrupt the existing financial landscape?
Decentralized finance has plenty of potential to reach the world’s unbanked population — that much is clear. However, if you already have an existing relationship with financial institutions, what does DeFi offer and do better? Here are a couple of examples:
Cashless payments with lower fees
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Did you know that credit card companies like Visa and Mastercard charge businesses anywhere between 1.3% to 3.5% in processing fees? Even though you don’t pay these companies anything out of your own pocket, the opposite party most likely is. In most cases, businesses have to choose between paying this fee or losing business from customers in the long term.
What’s worse is that businesses often factor this cost into the price of goods and services, so you likely end up paying that fee without even realizing it. While merchants could, in theory, offer cash discounts, there are often several hoops to jump through — including listing both cash and card prices on shelves or menus, among other region-specific laws.
A report by the U.S. Federal Reserve revealed that interchange fees topped a staggering $24 billion in 2019. The COVID-19 pandemic likely only accelerated this number as more and more consumers embraced cashless modes of payment.
So how does all of this tie into DeFi? Simply put, credit cards are among the dozens of financial applications that DeFi could replace or overhaul in the coming years. Companies like Mastercard and Visa realize this, and are also leaning towards adopting the technology.
If DeFi is successful, increased competition should lower fees for both merchants and consumers.
For proof of this changing landscape, take a look at Amazon Singapore. In August 2021, it announced an unprecedented 0.5% surcharge on Visa card transactions. It’s probably no coincidence that Amazon and Walmart also began hiring cryptocurrency and blockchain experts around the same time.
Instantaneous loans and lending opportunities
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For decades now, individuals have relied on banks and financial institutions to deliver loans. Somewhat unfortunately, however, lenders are neither universally fair nor inclusive. Furthermore, the process of getting a loan approved involves navigating a complex web of documentation and human oversight. Obtaining a loan isn’t as simple as proving your ability to pay it back these days.