What is DeFi (Decentralized Finance)?
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The world of cryptocurrencies is expanding at such a rapid rate. Who would have thought the merging of cryptography and distributed ledger technology would give birth to an industry that revolutionized the way we perceive money, store value, and transact. Since the birth of Bitcoin, the crypto market has continually evolved. Not only did we witness the hype of Initial Coin offerings, followed by Stablecoins, we also saw waves of newer cryptocurrencies joining the ecosystem. Each cryptocurrency brings with it newer blockchain technologies, an improved means of transacting with cryptocurrencies, or a more efficient way to apply crypto at a wider scale. With that said, a discussion about cryptocurrency would not be complete without talking about the main concept that drives the crypto market in the first place, and that is the decentralization of currency and finances. Which begs the question, what is decentralized finance?
I am a late bloomer when it comes to learning about decentralized finance, or more commonly referred to as DeFi. It was only when I came across Pantera Capital’s CEO, Dan Morehead’s explanation of why DeFi has more chances to grow 100x in the next five years than Bitcoin when I made it a point to dive deep into the DeFi rabbit hole.
In his interview with Cointelegraph, Morehead argued that despite the relatively weak performance of Pantera’s Altcoin funds in the previous year, the situation had flipped for them by mid-2020 due to the explosive growth of decentralized finance’s protocols and tokens.
In fact, by the end of August 2020, despite the effects of the pandemic, Pantera’s digital assets fund was in a surplus of up to 123%. As Morehead pointed out gleefully: “The world has woken up to DeFi and capital has flowed into the space.”
So, what is decentralized finance?
To put things simply, DeFi is basically a union between traditional banking services with decentralized technologies such as cryptocurrencies and decentralized applications (DApps).
If we have to be a little more technical, decentralized finance (DeFi) refers to a merger of all the decentralized products and services. For example, crypto assets, smart contracts, protocols and applications.
In order to get a better understanding of what is decentralized finance, I’ll try to break this down a little further by comparing this to traditional financial systems. At the moment in the conventional economic system, we have a central authority that is at the core of our financial system (e.g. the government or central bank).
The current financial system requires its users to rely on a middleman to maintain the value of their currency, to take care of the deposited money and even intervenes in how transactions are carried out. But with DeFi, this does not have to be the case.
DeFi can also be seen as an Open Finance Movement that enables money and payments to be universally accessible – to anyone in the world, no matter where they are.
This is even more possible with the recent launch of space internet (ie. Star Link). Imagine a global, open, alternative to every financial service you’re currently engaging in – savings, loans, insurances and more. All you need is to be connected to the internet, and DeFi is powering ahead to materialize this.
Difference between DeFi and traditional financial services
DeFi honors the principle of decentralization. This means that DeFi protocols or apps require for its code to be transparent on the blockchain so that anyone is able to carry out an audit.
This paves the way for a different kind of trust with participants because anyone has the opportunity to understand how a contract works or even to find potential bugs.
Transaction activities are open for the public’s review – yes, that includes you and me. Although some people are concerned about privacy issues, rest assured as transactions are anonymous.
DeFi protocols or applications are not fully managed by a single entity, its developer, or its employees. Instead, rules are typically written in code or smart contracts.
Once the contract is enacted to the blockchain, the DApps are able to run on their own with further intervention required. The only time when developers are involved is when upgrades are needed or to carry out maintenance such as bug fixes.
What are the benefits of DeFi?
- DeFi apps are designed for a global audience. Anyone from around the world can participate in DeFi platforms. All you really need is a smartphone with internet access. DeFi also offers programmability. Perhaps the most exciting potential of the DeFi movement is its ability to provide financial services for those who do not have access to traditional banking facilities. The current banking system leaves around 40 percent of the global population without any form of banking.
- Immutability. This means that data coordination across the blockchain is tamper-proof and this increases security and auditability.
- Interoperability. Since Ethereum’s software stack is composable, DeFi protocols and applications are built to be integrative and complementary to one another. This means that those involved in DeFi have the flexibility to build on top of other existing protocols, or to integrate other third-party applications. Think about DeFi as some sort of “money legos”.
To be honest, the list goes on and on when it comes to DeFi’s benefit. And other perks include DeFi being permissionless, and enabling self-custody.
Should you invest in DeFi?
Well, like any other investment, DeFi too, has its risks. In fact, because it is such a young market, the DeFi market does perhaps have a larger degree of risks. However, many believe that DeFi is the future of finance and DeFi has a lot to offer in how we make purchases and settlements.
Perhaps the biggest risk is that most newcomers to the DeFi space are unable to differentiate between a good project from a bad one. Not all DeFi projects succeed, in fact, many do fail. And there are plenty of bad ones.
Remember when YAM crashed and burned where its USD 60 million market capitalization went to zero dollars in the short span of 35 minutes. Other DeFi projects that led investors to bleed include Hotdog and Pizza. Yes, the risk is real.
But to be fair, there are also successful DeFi tokens, such as ChainLink and Polka dot. What appears to be a trend is that as technology disrupts how we do our banking, there is a growing prominence of the role DeFi can play. And it would not be too crazy to imagine a world where the decentralized application will set the new standard for future financial services.
What are my thoughts on DeFi?
To conclude, we come back to the question of what is decentralized finance, and what can we expect in the future? One thing for sure is that DeFi is spearheading the way we perceive and interact with day to day financial services.
It has the potential to pave the way for a more open financial system; one that could be inclusive. Despite the financial havoc resulting from Covid-19, many DeFi token values have surged in value, with some of the stronger projects surging by 200 percent since the beginning of the year.
Personally, I am interested in what the DeFi movement proposes – to give economic power back to the people by creating a financial system that is inclusive, accessible, and transparent.
Maybe DeFi is just the catalyst we need to give birth to a truly global financial revolution. In any case, what are your thoughts on decentralized finance?
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Last updated March 2nd, 2021.