Decentralized Finance (Defi). Defi can be defined as all known financial services done in a decentralized manner with blockchain technology. It gets rid of intermediaries in financial services and makes them more secure, faster, cheaper and more accessible to the general public.
Users use DeFi through decentralized applications, they are similar to traditional web apps but the backend is running on blockchain technology.
In comparison to traditional banking, using DeFi dApps do not require fulfilling time-consuming forms and paperwork. All transactions are made instantly and on user demand. The most important factor in DeFi is the lack of intermediaries which impacts transaction time, simplicity, composability and control over funds.
Long story short – thanks to DeFi every person with access to the internet can use financial services which are a vital part of economic development
Decentralised Finance, or DeFi for short. We can describe DeFi as all known financial services, implemented in a decentralised manner, via blockchain technology. This makes financial services in the digital world safer, without intermediaries, faster and publicly accessible, and is also intended to be significantly cheaper than traditional finance.
In 2021 the whole sector grew by 900% and the total value of money and assets located in all DeFi protocols has reached over 170 billion US dollars.
Users use DeFi via dApps, decentralised applications These are similar to traditional apps, but are based on blockchain technology. What benefits does this bring?
Unlike traditional banking, when using dApps within DeFi, we do not have to fill out time-consuming applications to use financial services and transactions are made almost instantly. The most important feature of DeFi is the absence of centralised intermediaries, which translates into the speed of transactions, no bureaucracy and full control over funds. With DeFi, any person with access to the internet can use financial services.
DeFi currently offers three main applications: loans against assets, decentralised exchanges and applications offering trading in derivatives, namely futures and options. However, work is underway to develop other financial services within DeFi, such as unsecured loans, bond issuance platforms and insurance. The future of the world of decentralised finance, therefore, seems to be heading in the right direction.
Going back, let’s take a look at how DeFi currently works, and we’ll start by exploring what decentralised exchanges are.
DEXes
Decentralized Exchanges (DEXes) are applications that allow an exchange of one asset for another without intermediaries in form of market-making institutions, trading houses, investment banks and other market makers.
Decentralised exchanges, or so-called DEXs. These are applications that allow you to swap one asset for another, without the need to register or share personal data, and without intermediaries in the form of market makers or brokerages, i.e. market makers.
Nowadays, in order to buy shares in any company, we have to use a brokerage house or bank, as well as a stock exchange. These are centralised intermediaries that charge fees for their services and require the sharing of personal data in a complex registration process. In addition, and worth noting, often the firms offering this type of service effectively become the owners of their client’s funds. On more than one occasion, there have been situations in which these funds have been frozen or confiscated from their rightful owners, for various reasons that are not always justified. In addition, the hours of operation of the companies mediating such financial transactions, are limited.
DEXs, or decentralised exchanges, are actually applications and programmes that take orders to sell an asset on the one hand and buy orders on the other. These programmes, based on smart contracts, manage liquidity within their markets and automatically connect both sides of a buy or sell transaction, of different types of assets.
DEXs allow trading 24 hours a day, 7 days a week. Trading on DEXes also takes place without intermediaries, but this does not mean that there are no commissions for transactions on this type of exchange at all, but more on that later.
One example of a DEX is the Uniswap exchange, which is currently the largest exchange of its kind in the global market. Uniswap already reaches 10% of the daily volume of the New York Stock Exchange (NYSE). This result is impressive, especially given the relatively short market presence of the Uniswap exchange, which has only been in operation for 4 years.
The advantage of DEX is its simplicity and user-friendly interface. Interaction with the application is limited to a single mouse click on a regular website’s buy or sell button. Trading on DEXs is 100% automated.
DEXes are revolutionary not only from the perspective of investors but also for individuals and entities looking to raise capital.
To raise capital on a traditional exchange by issuing shares or bonds, companies are forced to go through time-consuming and very expensive legal and financial processes. These barriers mean that only large companies choose to issue shares.
In the case of Uniswap or other DEXs going public, raising capital, from a technical perspective, is much simpler and less costly. All you have to do is create your own token using code and then list it on an exchange where investors can purchase it.
Lending Protocols
Another example of DeFi applications are lending protocols. Nowadays, they allow you to take instant loans against assets and lend surplus funds to other investors for a suitable percentage.
This solution is different from traditional banking because we skip the bank as an intermediary and borrow funds directly from another person who has free capital to invest and is willing to lend it to us in exchange for an appropriate interest rate. Currently, most lending protocols, offer loans only against the collateral made of digital assets, reflected on the blockchain. Ultimately, these protocols will allow us to take a loan without collateral, based on a credit rating, similar to that known from traditional banking. Such solutions are already being tested and it is only a matter of time before they will be rolled out to the general public.
All procedures within the loan applications, as with DEX, are automated. With just a click of the mouse, funds are sent to the address of the corresponding cryptocurrency wallet – the equivalent of a bank account on the blockchain.
DeFi in today’s economy
The main problems with implementing DeFi technology in today’s companies are hard UX, a lack of consumer knowledge about blockchain technology and a lack of proper regulation.
Many FinTech companies could use DeFi today as a backend platform for their services as blockchain allows faster, cheaper and more composable financial operations than the traditional banking sector.
However, on the other hand, regulations may complicate the introduction of new technology. There is a risk of not meeting compliance standards and being suited by the government.
Currently, DeFi is unregulated, it operates in a quasi-shadow environment where no founder knows what is illegal.
Many propose a full ban on blockchain financial services, like the government of the People’s Republic of China or Pakistan. Yes, there are scams (2 billion USD stolen in total in 2021), and there are some cases of money laundering, but I don’t see it as the best path to stimulate economic development. The potential benefits for the economy are too big to ban it. So what to do?
Too much intervention will slow down sector growth, and not enough will not allow it to flourish. Currently, most of the DeFi applications operate in an “in-house manner” this means that blockchain solutions serve mostly blockchain solutions. This is due to the fact that there is no legal bridge connecting the blockchain economy and the real economy. Many courts do not recognize buying agreements made on blockchain even if in technical and real terms it was the most trustworthy form of signing a deal.
Also, individuals’ control over their funds means no control of the banking authorities. There is a popular opinion that blockchain, cryptocurrencies and Defi empower money laundering and tax avoidance. I believe this is a misconception. Why?
Blockchain means full transparency – every transaction is public. If you sent money from account A to account B, everyone can check it. Furthermore, a new European Union directive called AML6 will enforce on every cryptocurrency exchange identifying and tracking wallets thus mitigating totally the possibility of easy money laundering
Outlook for the future
DeFi is one of the most promising technologies of the early 21st century, but its growth is dependent on multiple factors. Most importantly, regulations.
If DeFi finds itself in a well-suited legal environment, then the sector will flourish empowering finance accessible with only an internet device.
Sources:
- https://www.youtube.com/c/Finematics
- https://defillama.com/
- https://docs.aave.com/hub/
- https://docs.uniswap.org/
- https://www.coinbase.com/pl/learn/crypto-basics/what-is-defi
- https://www.electronicid.eu/en/blog/post/aml6-sixth-anti-money-laundering-directive/en
- https://www.investopedia.com/cryptocurrency-regulations-around-the-world-5202122
- https://www.msn.com/en-xl/news/other/mainland-chinese-banks-banned-from-crypto-assets-at-home-weigh-services-in-hong-kong-after-policy-change/ar-AA13FCIu