Financial services have always provided some of the most compelling use cases for blockchain technology. From online payments and remittances to cryptocurrency storage and trading, blockchain has initially challenged traditional finance. After the recent emergence of the decentralized finance (DeFi) movement, the case for blockchain in finance has become substantially more compelling.
DeFi, an abbreviation for decentralized finance, refers to various blockchain-powered applications that aim to create peer-to-peer alternatives to conventional financial services and institutions. Decentralized finance has continued to advance, attracting impressive amounts of capital and meeting expectations that it will be one of the 2020’s most prominent trends.
According to DeFi Pulse, the leading data aggregator for decentralized finance, the total value of DeFi protocols is just under $11.5 billion, up from less than $1 billion a year ago. While this is insignificant compared to traditional financial markets, the most important takeaway is that DeFi has increased by more than tenfold in the past year. This is a clear indication of the increasing popularity of decentralized finance. The most encouraging aspect is that DeFi’s rapid expansion reflects the strength of its value proposition. Let’s investigate what makes decentralized finance so attractive to investors.
The benefits of decentralized finance
The DeFi movement promises to deliver numerous benefits to customers and investors, including the elimination of intermediaries and centralized oversight, the democratization of financial markets for retail investors, and the creation of new investment opportunities. DeFi developers rely on blockchain technology’s fundamental characteristics to achieve their lofty goals.
The term “decentralized finance” already indicates what the DeFi movement considers its characteristic. Decentralization is central to the value proposition of blockchain. Blockchain networks accomplish this by ensuring that all members share the transaction history.
The decentralized approach can contribute to the democratization of banking and finance by facilitating everyone’s access to financial services.
Ethereum, the second-largest blockchain protocol after Bitcoin, powers most DeFi applications. As a permissionless (public) blockchain, Ethereum is highly decentralized and accessible to anyone interested in developing or utilizing a DeFi application. In addition, the permissionless nature of the blockchain and the interoperability it enables allow for a wide variety of third-party integrations.
It is essential to note that these characteristics are common to Ethereum. However, Ethereum’s position as the leading network for smart contract development has made it the platform of choice for developing not only DeFi applications but also other decentralized applications.
Additionally, with decentralization comes increased transparency. Since everyone has access to the distributed ledger containing information about all activities on a blockchain network, the network’s data is available for public inspection. In addition, the blockchain’s cryptographic principles ensure that data is only recorded after its authenticity has been confirmed.
The transparency provided by DeFi applications can be a game-changer for customers. It can enhance due diligence and assist individuals in identifying and avoiding possible financial scams and harmful business practices.
Blockchain technology achieves true immutability by ingeniously employing cryptography and consensus algorithms, such as proof-of-work. This ensures that it is nearly impossible to manipulate records stored on a blockchain network. Combined with the features we’ve already discussed, this creates a level of security that is difficult, if not impossible, to attain through conventional means.
DeFi applications bring blockchain’s inherent benefits to the financial sector while also striving to create user-friendly interfaces to ensure a seamless user experience. Moreover, using smart contracts, such as dApps, protects against malicious actors and fraudulent transactions.
How can DeFi help the financial services sector?
DeFi has the potential to improve traditional finance, based on what we’ve observed so far. However, as with any transformative technology, DeFi’s potential is not limited to merely enhancing the status quo. Rather, its true strength lies in its ability to disrupt the market by facilitating the creation of new financial products and services. Even at this early stage, the technology demonstrates great potential. It alters how individuals manage their assets, borrow and lend funds, and conduct online transactions. Here are some of the most common applications of DeFi:
Lending and borrowing
DeFi has enabled the creation of peer-to-peer lending and borrowing solutions that offer substantial advantages to the end user. These services include cryptographic verification mechanisms and the integration of smart contracts, which eliminate the need for intermediaries such as banks to verify and process lending and borrowing transactions. This makes the process significantly cheaper and quicker while protecting the counterparties involved in a transaction. Other benefits include immediate transaction settlement and increased accessibility.
Lending and borrowing Decentralized app Development (dApps) are among the most popular DeFi applications. The compound has become a popular platform in this category. Lenders can contribute crypto assets to lending pools. They are entitled to a portion of the interest paid back to borrowers. The interest rate depends on their contribution to the collection and liquidity of crypto assets.
The increasing popularity of DeFi lending platforms has enabled individuals to manage their savings in novel ways. As stated previously, when users lock their crypto assets in lending protocols such as Compound, they begin to earn interest on those assets. This has resulted in the emergence of DeFi saving applications that can connect to various lending protocols to maximize their users’ interest earnings potential. The term ‘yield farming’ has been coined to describe the practice of users moving their idle crypto assets between various lending protocols to earn higher returns.
A few years ago, the Ethereum boom led to the emergence of one of blockchain’s most significant trends: tokenization. The robust smart contract capabilities of the protocol enabled the issuance of crypto tokens, digital assets that exist on the blockchain and can have various properties and uses. These include utility tokens that are native to a particular dApp, security tokens that are analogous to digital shares, real estate tokens that enable fractional ownership of physical properties, and others.
Tokens can also provide exposure to other assets, including oil, gold, fiat currencies, and cryptocurrencies. These so-called crypto synthetic assets are secured by tokens locked within smart contracts based on Ethereum. Synthetix, one of the most popular platforms for synthetic assets, currently has nearly $600 million locked in smart contracts.
Stablecoins are crypto tokens pegged to a stable asset or asset basket. They are closely related to synthetic crypto assets. Stablecoins are typically pegged to fiat currencies such as the US dollar, but tokens can also be pegged to commodities and cryptocurrencies. Stablecoins seek to reduce the price volatility of cryptocurrencies and bolster the case for blockchain-based payment solutions.
We can categorize stablecoins into three categories based on the method used to maintain their value. The issuer of collateralized stablecoin must hold assets against their coin. Other coins are pegged to cryptocurrencies, with over-collateralization and stability mechanisms maintaining their weight. Lastly, non-collateralized tokens with algorithmically sustained fixed prices.
In many ways, stablecoins are what fuels the DeFi engine. They are utilized extensively throughout the industry to facilitate remittances, lending and borrowing, and other DeFi services.
DeFi is also beginning to influence the online exchange of goods and services. The recent emergence of decentralized exchanges (DEXs) that facilitate peer-to-peer trading of digital assets is an illustration of this. Uniswap is one of the leading companies in this industry.
The concept is easily extensible to include traditional financial instruments, tangible goods, and services. One of Our clients is using smart contracts and other blockchain features to create a new marketplace for purchasing, selling, renting, and exchanging luxury goods. Learn how We have helped Idoneus to reinvent the luxury asset market.
Given DeFi’s stellar growth in 2020, it is difficult to be pessimistic about the space’s future. There will likely be new obstacles in the coming year, but as interest in DeFi grows, there will also be new opportunities.