With the use of modern technologies such as blockchain and cryptography, the financial world is primed for a complete transformation.
What is decentralized finance?
Among the most groundbreaking moments in history was the change in what could be done in the hands of a human. From starting a fire, to Gutenberg’s printing press that made reading accessible to the masses, to personal computers and smartphones. The purpose of technology is to make it easier to access and help individuals be more innovative, efficient, and productive. Accessibility to the masses facilitates technological change and progress.
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Decentralized finance (DeFi) is here to destroy the functions of traditional finance. Currently, the traditional financial industry is “centralized”. In the United States, the Federal Reserve is the only central authority that controls all monetary policy. Traditional finance is outdated and we have seen several examples of it being heavily manipulated and riddled with inefficiency, fraud and corruption. The system is also isolated and inaccessible to the masses.
DeFi and the dawn of Web 3.0 are modernizing the global financial system for the internet age. By adapting traditional finance to the possibilities of modern technology, we achieve transformative change. DeFi opens up access to a system for all people that is not possible in traditional finance. It is a movement that creates a cheap, fast, efficient, trusted and transparent global financial ecosystem without a central authority. The system is also easily accessible to anyone with a smartphone or the internet.
The term DeFi has become a catch-all for a growing list of financial products and services. Through the use of cryptography, decentralization and blockchain, DeFi is able to provide an open, fully decentralized and transparent financial system. The products and services open up a whole ecosystem of versatile benefits and above all… fun! From names like UniSwap (uni for unicorn), PancakeSwap, BeefyFinance, AlpacaFinance, etc., the potential for memes and fun is endless.
How does DeFi work?
The core technology of DeFi is based on blockchain and cryptocurrency. Blockchain technology is the cornerstone of decentralized finance and enables the decentralization aspect of DeFi. Blockchains like Bitcoin or Ethereum are a collection of transaction data that are strung together in a block chain.
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Blockchains are decentralized, transparent and immutable. The blockchain data is stored in different locations on countless computers worldwide, making the chains decentralized. When it comes to transparency, blockchain data is permanently recorded in a public ledger like BscScan and anyone can check the results. Imagine if the Federal Reserve kept a running book of how each tax dollar was distributed? Finally, cryptography and blockchain technology make every transaction completely immutable. The data cannot be altered, forged or altered and the chains cannot be broken.
Common use cases of DeFi
Bitcoin (BTC), Ethereum and Binance Smart Chain (BSC) are currently the big three of DeFi. Bitcoin is the original and started out as a new digital asset. Satoshi Nakamoto’s Bitcoin white paper was published in 2009. BTC was the first peer-to-peer digital money and the first financial application based on blockchain technology. However, it was Ethereum that changed the world of DeFi and the entire world of cryptocurrencies. While Bitcoin is a store-of-value blockchain, Ethereum is programmable, allowing the creation of new products and services through smart contracts. BSC is more of a newcomer and closely resembles Ethereum and is intended for faster transactions and cheaper fees. While Ethereum is the front runner in the DeFi world, Binance Smart Chain and other chains are growing in size and capability.
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Ethereum allows data and blocks on the chain to contain rules for creating contracts. Smart contracts are an essential feature that replaces the role of a traditional financial institution in all cryptocurrency transactions. The smart contract is recorded on the blockchain and can be used to verify almost any digital asset. Cryptocurrencies and their associated smart contracts provide services that do not require intermediaries. Smart contracts authorize transactions and execute contracts in a trusted environment, eliminating the need for a central authority such as a government, bank, or legal entity.
Web 3.0 is the next generation of applications and protocols that connect users to the decentralized World Wide Web. Below is a list of common use cases for DeFi applications and protocols.
Common dApps and protocols on DeFi
- E-Wallets – Digital or hardware wallets that connect cryptocurrency exchanges and allow assets to be used on third-party platforms and protocols. Examples TrustWallet, MetaMask
- Decentralized Exchanges – Commonly known as DEXes, use blockchain technology and a network of computers to complete and verify transactions. Examples PancakeSwap, UniSwap
- Flash Loans – an unsecured lending option that allows users to borrow instantly and efficiently based on certain rules. Example MakerDAO and Aave
- Yield farming – any blockchain protocol that allows anyone with some holding of crypto tokens to “lock” those holdings with a custodian (the protocol). In return, they give out rewards. Examples: Compound, Beefy.Finance
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Risks and disadvantages of DeFi
Despite all the great benefits of DeFi, the phenomenon is still in its infancy. Due to its early development, it is still prone to various risks and downsides.
First, the industry is still working towards mainstream acceptance and recognition. Currently, there are still few consumer protections for DeFi users. Some exchanges like Coinbase hold their funds in banks backed by the Federal Deposit Insurance Corp. (FDIC) are protected, however there is no protection for crypto assets and no refunds if an exchange fails. In addition, many protocols are vulnerable to hacks and exploits. Codes can be unfinished, leaving gaps for exploitation. With few protections and platforms vulnerable to hacks, there are clear and present dangers in engaging in DeFi.
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Not all blockchains are created with the same level of centralization. While not all DeFi apps are at least the most decentralized, they work with teams that are gradually relinquishing control of their protocols. In the case of BSC, decentralization is negotiable, and the chain proves that users may be willing to trade some centralization for higher speeds and lower fees. Some users have also found strategies like yield farming to be extremely skeptical but also prone to extreme volatility.
Ultimately, DeFi users control their destiny. Under no circumstances should users share a private key. Many victims of an alleged scam are caused by a user unknowingly giving their private key to the wrong person. There is also no way to recover a lost private key. Once it’s lost, it’s lost. This can be a perceived downside of decentralization.
Build a better future
Traditional finance, little updated from the days of analog computers, is ripe for improvement. In today’s world, central governments and financial institutions act as guarantors of transactions. This gives these institutions immense power over the money flowing through them. In a world where bankers and capital leaders call the shots, DeFi products are opening up financial services to anyone with an internet connection. Again, these logs are primarily owned and managed by their users. This is in stark contrast to a world where billions of people cannot even access a bank account.
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To date, tens of billions of dollars worth of cryptocurrencies have flowed through DeFi applications, and the number is growing every day. The platforms are permission-free and open to anyone with an internet connection. It has qualities that can discourage the citizens of the world. DeFi and related projects can become the unsung hero of a brighter financial future. Today you could put your savings in an online savings account and get less than 1% interest on your money. With DeFi, people lend their savings directly to others on a decentralized exchange, cutting out intermediaries and generating higher profits than could ever have been imagined with centralized funding.
Blockchain and DeFi herald the birth of a whole new economy. It creates a path of least resistance to solve the world’s financial problems. After a pandemic that has accelerated the world’s technological literacy, we stand on the cusp of the potential of blockchains and DeFi. Beyond Bitcoin, we have witnessed the tremendous growth of DeFi blockchains such as Ethereum and Binance Smart Chain. DeFi is proving to be the rising wave that capitalist thinkers have championed for decades. The dogmas of traditional finance are not enough for the future of DeFi.
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