The Decentralized Finance concept (also known by the acronym DeFi) designates an ecosystem of financial applications built on blockchain networks.
To be more specific, the term Decentralized Finance can be used to refer to a movement that aims to create an open source, permissionless and transparent ecosystem of financial services that is accessible to everyone and operates without any central authority. . Users would maintain full control over their assets and interact with said ecosystem through peer-to-peer (P2P) decentralized applications (dapps).
Traditional finance depends on intermediary institutions such as banks, and others such as courts that provide arbitration.
DeFi-type applications do not require intermediaries or arbitrators. The code specifies the resolution of any potential disputes, while users maintain control over their funds at all times. This reduces the cost associated with providing and using such products, while enabling a frictionless financial system.
Another significant advantage of such an open ecosystem is the ease of access for individuals who would otherwise be deprived of any financial services. Because the traditional financial system relies on intermediaries seeking to generate profits, their services are traditionally not available in places with low-income communities. However, with DeFi, costs are significantly reduced, and low-income individuals can also benefit from a wide range of financial services.
Open lending protocols are one of the most popular types of applications in the DeFi ecosystem. Taking and granting loans in an open and decentralized manner has many advantages over the traditional credit system. Among these, we can include instant settlement of transactions, the ability to collateralize digital assets, the absence of credit controls and potential standardization in the future.
Since these lending services are built on public blockchains, they minimize the amount of trust required and come with the guarantee of cryptographic verification methods. Blockchain lending marketplaces reduce counterparty risk; and they cheapen, expedite and make the taking and granting of loans available to more people.
Since DeFi-type applications are by definition financial applications, money banking services are an obvious use case for them. These include the issuance of stablecoins, mortgages, and insurance.
As the blockchain industry is maturing, there is increasing interest in creating stablecoins. They are a className of crypto assets that are usually priced at real-world assets, but can be digitally transferred with relative ease. Since the price of cryptocurrencies can fluctuate wildly at times, decentralized stablecoins could be adopted for everyday use as a form of digital cash that is not issued and monitored by a central authority.
Largely as a result of the number of intermediaries that must be involved, the process of obtaining a mortgage is expensive and time consuming. Thanks to the use of smart contracts, subscription and legal fees can be significantly reduced.
Blockchain-based insurance could eliminate the need for intermediaries and allow risk sharing among many participants. This could result in lower premiums with the same quality of service.
This category of applications can be difficult to assess, since it is the DeFi segment that gives the most space for financial innovation.
Arguably some of the most crucial DeFi applications are decentralized exchanges (DEXs). These platforms allow users to trade digital assets without the need for a trusted intermediary (the exchange) to hold your funds. Exchanges are made directly between user wallets with the help of smart contracts.
Because they require much less maintenance work, decentralized exchanges typically have lower trading fees than centralized exchanges.
Blockchain technology can also be used to issue and allow ownership of a wide range of mainstream financial instruments. These applications would work in a decentralized manner, eliminating custodians and eliminating single points of failure.
Security token issuance platforms, for example, can provide the tools and resources for issuers to launch tokenized securities on the blockchain with customizable parameters.
Other projects may allow the creation of derivatives, synthetic assets, decentralized prediction markets and many more.
1) Poor performance: Blockchains are inherently slower than their centralized counterparts, and this translates to applications built on top of them. DeFi application developers need to be aware of these limitations and optimize their products accordingly.
2) High risk of user error: DeFi applications transfer responsibility from intermediaries to the user. This can be a negative for many. Designing products that minimize the risk of user error is a particularly difficult challenge when products are implemented on immutable blockchains.
Currently, using DeFi applications requires additional effort from the user. For DeFi applications to be a core element of the global financial system, they must provide a tangible benefit that incentivizes users to switch from the traditional system.
It can be a daunting task to find the most suitable app for a specific use case, and users need to be empowered to find the best options. The challenge is not just building the apps, but also thinking about how they fit into the broader DeFi ecosystem.
Decentralized Finance focuses on building financial services separate from the traditional financial and political system. This would allow for a more open financial system and could prevent precedents of censorship and discrimination around the world.
Although it is a tempting idea, not everything benefits from decentralization. Finding the most suitable use cases for blockchain features is crucial to building a useful stack of open financial products.
If successful, DeFi will take power from large, centralized organizations and place it in the hands of the open source community and the individual. Whether this will create a more efficient financial system will be decided once DeFi is ready for mainstream adoption.