What is Decentralized Finance?
Updated: Sep 22, 2023
Decentralized finance is gradually gaining traction as a more secure, transparent, and efficient alternative to traditional banking. We establish a more transparent and trustworthy financial system that is also considerably more accessible by eliminating centralized financial institutions.
Decentralized finance, protected by blockchain technology, reduces the danger of fraud, corruption, and mismanagement of your assets. It will also make managing finances significantly more cost-effective and efficient. For example, there will be no overdraft fees, no wire transfer fees, and no need to wait for a transaction to be validated during banking hours.
These are just a few of the ways DeFi is improving technology solutions. So let’s dig deeper into what Decentralized Finance is all about.
In this article, we will explore What is Decentralized Finance?
What is decentralized finance?
Decentralized finance, or DeFi, refers to a financial system without traditional, centralized intermediaries.
We're accustomed to everything passing through a bank or other financial organizations, such as a global exchange, but DeFi establishes a self-contained system. Online transactions using DeFi coins are perhaps the most well-known application of decentralized finance. Still, it also allows us to handle various financial applications like investing, insurance, trading, borrowing, and lending more efficiently and transparently.
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The beginning of decentralized finance
How can investors entrust more than two billion dollars to decentralized applications, many less than three years old and against which they have no legal recourse? What is the source of this trust?
Blockchain technology is where the answer can be found. In the case of DeFi, this level of confidence is usually provided by the Ethereum blockchain. Let’s have a quick refresher on bitcoin and Ethereum.
1. Bitcoin: Bitcoin is the first blockchain in the world. Bitcoin became well-known to a broader audience after a dramatic price spike in 2017. Bitcoin's two main characteristics are scarcity and security.
2. Scarcity: It is rare because more than 21 million Bitcoins will never be issued. Bitcoin was the first and only restricted digital resource that could not be replicated as much as desired when it was created in 2009 instead a digital picture or text. Bitcoin is now referred to as digital gold in the investment world. It is primarily regarded as an alternative and uncorrelated investment instrument.
3. Security: The security aspect is a little trickier. Blockchain technology underpins Bitcoin. But, first and foremost, what is a blockchain? The ledger, or transaction list, contains the whole history of Bitcoin transactions. Each new transaction is added to this ledger and related to it. However, this is done in blocks rather than as a single transaction. The word blockchain comes from this sequence of blocks. If this blockchain is stored in a data center that is successfully attacked, the entire network's security could be jeopardized. One successful attack would be enough to delegitimize the blockchain and its recorded blocks and transactions. As a result, the ledger is saved on several decentralized computers. Approximately 10,000 active full nodes (computers that store a complete copy of the blockchain) are now estimated to be spread across the globe. Attacking Bitcoin would necessitate simultaneous attacks on all machines storing the blockchain (or many of these computers). This and cryptography are the most crucial factor in Bitcoin's security.
Bitcoin fulfills a fundamental and relatively simple use case by storing value over time and, if necessary, transmitting value. The user's only options are receiving, storing, and transmitting Bitcoins. Bitcoin's relatively constrained programming language, incapable of embedding extensive computational logic into Bitcoin transactions, is one of its fundamental weaknesses (or strengths, depending on your perspective). As a result, while Bitcoin lacks functionality, precisely this limitation serves the security attribute.
Ethereum and smart contracts
When enabling more use cases than just receiving, storing, and transmitting, off-chain processing was impossible for the blockchain community that is just getting started. As a result, in 2013, five years after Bitcoin's inception, a group of people came together to form the Bitcoin Foundation. Ethereum was founded by a group of visionaries led by Vitalik Buterin. Ethereum is a blockchain, just like Bitcoin. Its digital currency native to you, Ether, is likewise rare. Still, it provides a lot more freedom in terms of development. Ethereum is the most popular programmable blockchain globally, with over 500,000 users in 2021. Ethereum's primary programming language, Solidity, is a Turing-complete language, which means it can implement any computational logic. Ethereum presents the idea of "smart contracts." Smart contracts are computer applications that automate specific tasks like executing transactions on the blockchain following agreed-upon terms and conditions. Self-evaluation of smart contract code Users, much as in the conventional banking system, usually put their faith in particular institutions or individuals, such as auditors or specialists. When one considers the evolution of blockchain technology from Bitcoin to Ethereum, one might conclude that Ethereum took some of the best features of Bitcoin and expanded on them by allowing computers to communicate with each other. If Bitcoin lacks features, Ethereum has a plethora of them.
How are Smart Contracts used in Financial Services?
Financial primitives are the primary financial functions that are programmed into smart contracts. Smart contracts are highly adaptable and may be used in various industries, including energy, logistics, health care, and the financial sector. In this case, smart contracts can make things a lot easier. Payment (stablecoin) and credit (lending/borrowing) functions, as well as more complicated functionalities such as Derivatives (leverage, swaps) and crypto-asset trading (decentralized), which are entirely automated and decentralized, with no middlemen.
The dangers of DeFi
Decentralized finance has solved problems and holds a promising future. However, there are some dangers attached to it, some of which include:
Technical Hazards
On the blockchain, false or fraudulent transactions are irreversible by design. Smart contracts and the underlying blockchain system are critical to DeFi's success. Any flaw in the programming could result in a hack and significant losses for decentralized app users. It's nearly hard to code without making mistakes, especially when considering future bitcoin protocol advancements. Furthermore, detecting vulnerabilities in smart contracts is difficult due to the technology's novelty and the lack of DeFi protocols. As a result, there have been reports of DeFi hacks, with several million dollars in value taken and lost in various projects.
Aside from smart contract errors and inaccuracies, technological risks are associated with the underlying blockchain technology. Almost every relevant DeFi project is based on the Ethereum blockchain. Ethereum's blockchain has had a few congestion difficulties during excessive usage. A transaction can remain pending if the network becomes overloaded, resulting in market inefficiency and information delays. Liquidity hazards are inextricably linked to these technical scaling issues. Given the existing throughput limitations, it is highly doubtful that DeFi will be sustainable on Ethereum, especially if Ethereum's user base continues to grow.
In short, DeFi is highly reliant on a successful Ethereum 2.0 update, which could resolve these technical difficulties but will take at least another few years. Other smart contracts that provide blockchain platforms (such as EOS, Tezos, and others) have the potential to overtake Ethereum's dominance in the DeFi space. Still, they face insufficient decentralization and a lack of developer/community support. The fact that Ethereum is now the most popular platform is due in part to its enormous usage.
Risk of regulation
In most jurisdictions, decentralized projects run without a license, regardless of the end user. In most jurisdictions, the treatment of DeFi assets is likewise not clearly defined in terms of taxation. DeFi activity accounts for roughly 2% of total crypto market activity, little compared to global financial markets. DeFi assets and products will undoubtedly face increased regulatory scrutiny, similar to how regulators worldwide address regulatory questions regarding crypto-assets, such as establishing new license regimes for crypto custody. Financial regulation will inevitably need the presence of a responsible counterpart, making completely decentralized governance and the decision-making process for DeFi products unthinkable.
DeFi projects that strive to fully satisfy financial supervisors by constructing responsible counterparts, on the other hand, go against the primary DeFi idea of true decentralization and disintermediation. One possible solution to this problem is the Bank for International Settlements, a novel means of supervising and regulating financial risks. This regulatory paradigm change would allow financial authorities to automatically monitor compliance with regulatory aims by reading the market's ledger as an active DeFi infrastructure player, potentially intervening or shutting down a project. This would eliminate the need for DeFi projects to collect, validate actively, and deliver data and intervene in compliance events (KYC, AML, and so on). Such a paradigm shift in the future would fundamentally flip financial regulation on its head, and it is unlikely to happen in the near or medium term.
Risk of usability
The usability or user experience of DeFi protocols, which are typically tricky, unintuitive, and built for crypto-native users, is a danger, or better put, a central weak point intimately tied to the technical implementation. Beyond individuals already familiar with Ethereum, DeFi projects have struggled to acquire popularity. Many products need users to manage multiple tokens in non-custodial wallets independently. Realistically, it is still far too early for the general public to put their money on the line in this unstable and uncharted environment. The user experience of DeFi products will undoubtedly be one of the top goals for developers after the technical and regulatory risks have been resolved. When compared to today's social media platforms or specific trading services, the early uses of the internet were anything but easy to use. This is also the same for DeFi In the future, we will see more user-friendly DeFi products.
DeFi Projects' Top 4
1. Avalanche
Avalanche (AVAX) bills itself as the "fastest smart contracts platform in the blockchain industry" while also cementing its position in the burgeoning NFT area and establishing connections with other blockchain initiatives like SushiSwap (SUSHI), Chainlink (LINK), and the Graph (GRT). Furthermore, due to its ability to enable cheaper transactions a fraction of the time, the project sees itself as a direct competitor to Ethereum. In addition, Avalanche just received $230 million in financing to assist its DeFi activities, making it an attractive location for DeFi projects to establish themselves.
2. Cardano
Because of its excellent energy utilization data and proof of stake protocol, Cardano (ADA), one of the world's most significant blockchain projects, is called the "Green Blockchain." Cardano revealed this month that its recent $100 million investment in decentralized finance, NFTs, and blockchain education is boosting the ecosystem.
4. Polygon
Polygon (MATIC) is a decentralized application ecosystem and Ethereum Layer 2 scaling solution that is widely used and growing. It has interoperability, scalability, and security characteristics. Polygon adds a few traffic lanes to Ethereum's heavily used Layer 1 freeway. The Ethereum blockchain now houses the bulk of DeFi initiatives. As a result, lower Ethereum congestion implies faster speeds and more benefits for the DeFi ecosystem.
5. Uniswap
Uniswap (UNI) is a decentralized exchange that lets users buy and sell cryptocurrency directly from their wallets for a cheap fee. Its AMM (automatic market maker) provides enough liquidity on its platform, allowing for high traffic and quick trading. Uniswap's native token, UNI, can be available on investing platforms outside of the DeFi network, such as Voyager, because of its popularity.
In conclusion, DeFi platforms have great moments, and they're getting much love from customers and investors.
DeFi funds raise millions daily to support initiatives, enhance and build platforms, and expand the already robust network. These improvements pave the way toward financial equality by making critical and previously inaccessible financial instruments more accessible. DeFi bridges the gap, removing the previously limited economic development barriers to the privileged few. DeFi's future has already arrived, and it's for everyone.
Edith Lagunas
All Things Blockchain and Defi, crypto enthusiast, and CRE Investor. #mujerinvestor #finance #investor #investing
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