What is DeFi? The Complete Guide to Decentralized Finance

About 1.7 billion people remain unbanked, globally, according to the World Bank. The current financial ecosystem experiences a lot of barriers in the ease of accessibility to financial services, due to several reasons, with the presence of intermediaries, such as banks, being a major hindrance. Imagine a world where more people can easily gain access to financial services without the limitations posed by financial institutions or any other third-party. That world is what Decentralised Finance (DeFi) seeks to create.

The question is, what exactly is DeFi?

DeFi, also known, as Decentralised Finance or Open Finance, is a financial ecosystem comprising financial applications built on top of a blockchain network to enable permissionless  access to financial services. In other words, with DeFi, anyone from any part of the world can maintain absolute control over their financial assets and be able to make transparent interactions within the DeFi ecosystem via peer-to-peer networks operating without a central authority, in contrast to the traditional financial system. 

How does DeFi work?

DeFi aims to create a decentralised financial ecosystem by leveraging an overlap between decentralised applications (DAPPs) and smart contracts which are built on Ethereum. Via smart contracts, financial transactions can be made between two or more concerned parties without the involvement of third parties. This leaves the users with absolute control over their assets.

If you are wondering what smart contracts are, they are simply self-executing contracts made of computer protocols that digitally validate or enforce the negotiation and execution of a contract. As a user within the DeFi network, you can sell your assets to another user you have never met, or carry out any other financial exchange, without the risk of a breach of contract. Your assets are automatically transferred to the buyer, legally, only when payment has been validated, and vice versa. You do not need a bank, a lawyer or any other intermediary to do this. With just your smartphone, you can access this and many more leverages DeFi provides.

Benefits of DeFi

With just a brief overview of what the buzz about DeFi is all about, one may be curious to explore several benefits that this innovative system provides. Below are some of the advantages of DeFi.

  • Easy access to financial services

The unrestricted ability to participate in DeFi is perhaps its biggest advantage. With DeFi, all of the 1.7 billion people excluded from the financial ecosystem can have easy access to financial services. DeFi empowers anyone to participate in financial transactions, without the need for an intermediary. The absence of these intermediaries also reduces the cost associated with access to various financial services since there are no longer middlemen that profit from these services. With DeFi, low-income communities and families around the world, can have increased access to financial services . Not only can anyone participate in the financial ecosystem via DeFi, but anyone can also easily create DeFi products since most of the protocols, like Ethereum, are open source.

  • Interoperability

It is extremely easy to leverage the potentials of existing DeFi services in the creation of new DeFi applications. Stable coins, decentralised exchange, and other DeFi services can be easily combined by anyone to create a new DeFi product. Multiple DeFi services can be leveraged to complement the features of another DeFi product.

  • Access to alternative forms of capital

In countries like Venezuela and Argentina where inflation and financial instability are gradually crippling the national economy, DeFi could provide a solution to facilitate economic stability. By providing a wider access to capital, DeFi provides a cushioning effect to citizens of nations where decisions made by central authorities, like the government, negatively affect economic stability. Venezuelans, for example, could store their wealth in Dai, a stable decentralised cryptocurrency. Dai reflects the value of the USD. Dai is always overcollateralized with forms of collaterals like ETH. Hence, Dai provides a better alternative to the Venezuelan domestic currency and can save the country from the bad economic decisions made by the government or any other central authority.

Decentralised Finance (DeFi) vs Traditional Finance

Traditional financial systems require the presence of intermediaries such as banks, in the provision of financial services. DeFi, however, requires no need for intermediaries. The existence of smart contracts in DeFi provides an easier and cost-free alternative to courts and legal systems for arbitrations and validation of asset exchange and financial transactions. The absence of intermediaries in DeFi also removes the extra cost of financial services associated with the profits these intermediaries generate from offering access to these services. This can speedily facilitate financial inclusion and low-cost access to financial services for people in poor and low-income regions.

Existing DeFi Products

Each day, the DeFi ecosystem continues to experience robust progress and the birth of new innovative products constantly increases. There are quite a number of DeFi products available in the market today. Here are a few of them and a short description of the services they provide.

  • Maker DAO

This is significantly one of the most dominant decentralised finance applications. With MakerDAO, the application offers Dai, a stable, decentralised digital currency which can be used to make payments, trade or invest.

  • Compound.finance

Compound is a decentralised platform that facilitates the borrowing and lending of digital assets against collateral, on liquidity mining.

  • dydx

This is an Ethereum-powered decentralised non-custodial margin trading platform that allows users to lend, borrow or trade supported digital assets on margin.

  • bZx

bZx is a decentralised finance application platform that facilitates the borrowing, lending, or trading of supported digital assets with margin and leverage.

Current Challenges of DeFi

  • Security

Since DeFi applications rely heavily on smart contracts, the system is vulnerable to cyber hacks. Over $25 million was lost from the DeFi ecosystem on April 19, 2020. The vulnerability of this open source system to hacks and program bugs, is a major challenge of decentralised finance.

  • Speed

The current speed of processing transactions on blockchain networks is not very impressive. The current blockchain infrastructures that make up DeFi applications are unable to process very large numbers of transactions per second, compared to traditional finance counterparts. 

The Future of DeFi

Decentralised Finance (DeFi) is still in its infancy phase and has a lot of promising potential to transform the financial ecosystem. Innovations in DeFi are constantly evolving with new developments like the Lighting Network that can significantly increase the speed of processing transactions and address the scalability issues of DeFi. With the innovative potentials of DeFi, it is set to disrupt the entire financial ecosystem and will significantly empower everyone on the globe to access financial services irregardless of their location or status. It is, therefore, safe to say that the future of finance will experience a paradigm shift with the massive leverage which DeFi offers.

List of DeFi Projects in the Cryptocurrency Market/ DeFi Pulse

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