What is Decentralized Finance (DeFi) and Why Is It Trending?
A brief guide to decentralized finance (DeFi), its prominent use cases in the financial sector, and why it’s trending.
While cryptocurrencies and blockchain technology applications are rising in popularity and gaining mainstream adoption,one area in particular that is trending: Decentralized Finance (DeFi). The onset of DeFi has completely revolutionized the scope of decentralized applications in the financial ecosystem.
In this article, we take a look at DeFi, use-cases of DeFi in the financial sector, and why DeFi trends are rising with an increasing momentum.
What is Decentralized Finance?
Decentralized Finance, abbreviated as DeFi, aims to disrupt the traditional financial sector by facilitating financial products and services on blockchain-enabled peer to peer networks. DeFi incorporates dApps based on blockchain networks, as well as smart contracts for different financial operations.
Our traditional financial system holds multiple intermediaries for accessing banking and finance services. Middle-men impose limitations on certain groups of people, thereby imposing barriers to acquiring basic financial services. DeFi provides an alternative to approach services like loans, mortgage, insurance, and more through dApps on smartphones without any intermediaries. Instead, financial operations are managed through a network of smart contracts.
Under the current financial sector, nearly 2 billion people across the globe do not have access to services like loans. DeFi provides inclusive access to these services by removing the restrictions imposed by intermediaries like banks. dApps further enable greater efficiency, faster operations, lower costs, and easy accessibility. Furthermore, the blockchain-enabled network of dApps is interoperable with each other. Hence, DeFi integrates a variety of dApps that provide multiple financial services with each other.
Features of Decentralized Finance (DeFi)
In contrast to traditional financial systems, there are certain key aspects and features of DeFi that enable innovation.
Decentralization- he operations of banking and finance are not managed or controlled by a single entity or intermediaries.
Open-Source- dApps developed in DeFi are open-source protocols. Hence, anyone can contribute to the code to understand the contract’s functionality. Additionally, the code is transparent for anyone to audit and find bugs.
Global access- The entire ecosystem of DeFi can be accessed from anywhere across the globe with an internet connection and smartphone.
Asset- In a DeFi infrastructure, the control of an individual’s financial assets remains in their hands and not in the hands of intermediary organizations, i.e.banks.
Permissionless- The access to the DeFi infrastructure is permissionless. In other words, there aren’t regulatory barriers to access the decentralized ecosystem.
Interoperability- DeFi dApps catering to different use-cases can be integrated with each other to promote data interoperability between different applications.
Use-Cases of DeFi
Now that we understand what is DeFi and the value that it adds to the traditional finance system, let’s explore the applications and use-cases of DeFi.
1. DeFi Lending and Borrowing
Lending and borrowing services in DeFi is one of the most prevalent use cases explored today. The current financial system restricts access to borrowing and lending services. Furthermore, the services are largely controlled by a centralized entity that decides on various factors like interest rates and settlement times.
In a DeFi infrastructure, the borrowing and lending services are decentralized. Anyone can access them, irrespective of their geographical locations or economic conditions. The transaction times for settlement of these services are also substantially reduced. Furthermore, smart contracts contain a standardized protocol of operations that promote equality for all.
2. DeFi Stablecoins
Stablecoins are another DeFi use-case explored by multiple central banks across the globe. Stablecoins are digital currencies raised on the blockchain platform and pegged to a fiat currency like the U.S. dollar or Euro.
Stablecoins have the potential to implement innovations like microtransactions and P2P payments. Moreover, blockchain-enabled stablecoins can instantly be transferred anywhere across the globe regardless of geographical location or time, along with minimal transaction fees.
3. Mortgage and Insurance
DeFi facilitates disruption in the centralized infrastructure of services like mortgages and insurance. Within the current financial ecosystem, these services require high fees, pose counterparty risks, and are interlaced with multiple intermediaries.
DeFi integrates these services on blockchain networks that are essentially trustless protocols. Instead of intermediary organizations, terms and conditions of insurance services are encoded within smart contracts. Hence, all operations are automated through smart contracts depending upon pre-defined conditions. This minimizes the human intervention required.
4. Tokenization of Financial Instruments
The concept of tokenization converts real-world assets into their digital counterparts that are represented through tokens on blockchain. Financial instruments like equity, fund, and debt can be tokenized and raised on a blockchain platform.
Furthermore, tokenization enables increased liquidity into illiquid real-world assets. The tangible assets can also be fractionally divided, with ownership of each fraction recorded on a blockchain ledger. Tokenization in DeFi promotes innovation and helps increase liquidity in assets.
DeFi has massive potential in the financial ecosystem, especially when it comes to the various use-cases of DeFi providing financial services/products.
DeFi protocols have experienced exponential growth in 2020. From $60 million in 2018, the DeFi market increased to nearly $1 billion in February 2020. In just six months, the market exponentially increased to more than $7 billion as of August 2020. Moreover, DeFi tokens experienced massive growth in the year 2020 alone. While tokens like Aave have increased more than 200-fold, the LINK token of ChainLink protocol has increased more than 600% since the beginning of the year.
Increasing DeFi trends have been due to a variety of factors, one of which is friendly regulations promoted in the blockchain ecosystem from governments across the globe. Additionally, even prominent players have started to recognize the financial innovation that can be leveraged through DeFi protocols. banks like J.P. Morgan are exploring the concept of introducing their own digital currency, and the central bank of China has already introduced a stablecoin for their fiat currency.
The DeFi space adds innovation and value to the entire financial system. Current trends suggest that we are likely to witness a number of DeFi protocols catering to different use-cases in the upcoming years. While DeFi also has challenges to overcome, it has the potential to liberate and disrupt the finance sector. From the current outlook, one thing is certain: DeFi is here to stay!