The term DeFi dates back to 2018, when a movement to automate financial services built on blockchain infrastructure aimed to remove banks as “middlemen” from transactions between individuals . Three years later, DeFi which aims to recreate traditional banking services using cryptocurrency, has turned into a multimillion industry in an of itself.
DeFi is an abbreviation for decentralized finance , which is an umbrella term for a variety of financial services that replace the function of banks through distributed ledger technology, more commonly known as blockchain. DeFi is useful because it expands the use of the blockchain from simple currency transfer to more complex, financial applications like loans and investments. Through DeFi protocols users, can lend out cryptocurrency and earn interest. However the technology allows for increasingly more complex forms of services like liquidity provision for decentralized exchanges.
In contrast to the decentralization of money through Bitcoin , DeFi aims to generally decentralize the traditional financial industry. The core of the initiative is to open up traditional financial services to all, by providing an unlicensed financial services ecosystem accessible to anyone with an internet connection. DeFi services like payments, loans and insurance are enabled by the new type of decentralized applications (dApps) that enable peer to peer interactions between individuals wishing to transact with each other. The clever accomplishment of the technology behind DeFi is that while in the traditional financial service, the bank would act as the guarantor of trust, in DeFi, trust is enacted by sophisticated bits of code known as smart contracts. Through a smart contract individuals who do not know or trust each other, can transact freely knowing that the terms of the agreement are irrevocable, immutable and executed by code.
Take for example travel insurance. A policy that offers traveler’s compensation for delayed flights, could be automatically executed as long as a set of conditions are met. If a flight is delayed by more than 2 hours. Compensation could immediately be credited to an insured customer’s account without the need to log in a claim or a dispute.
Interest rates in DeFi are typically higher than what’s expected from traditional banks, but as anyone with basic knowledge of economics will know, higher risk is the price to pay for higher yields
Since DeFi is based on the blockchain, it inherits many of the advantages offered by the technology:
Fast and cheap transactions: The use of the blockchain as a technical infrastructure enables fast and cheap transactions. The transactions take place instantly and you avoid extra costs because third parties are not required.
Democratization: DeFi services are available to anyone regardless of social status or location. Many of the limitations imposed by centralised organisations in order to secure the safety of the transacting environment, vanishes as the system is kept functional and secure through technology.
Transparency: Decentralization improves transparency as transactions and digital wallet identifiers are available for everyone to see on the blockchain. The cryptographic principles of the blockchain ensure documentation of information only after verification of a transactin. At the same time, DeFi applications can help people avoid possible scams.
Accesibility: Defi users do not require a bank account and are therefore exempt from going through the process of confirming and validating their eligibility for one. One’s assets are one’s own to manage at any time of the day.
Privacy: while DeFi transactions are visible to anyone within a blockchain, the identity of the parties transacting remain anonymous. This stands in stark contrast to the traditional financial system that requires all participating individuals to identify themselves before being allowed to transact.
While the benefits of DeFi are many, it it’s necessary to highlight some of the downsides of decentralization. The removal of a central intermediary means that full accountability of transactions falls back on the individual and no longer on a central body. Having the freedom and responsibility over one’s own decisions means owning up to the consequences without the possibility to recourse. The transfer of funds made by mistake to an unintended account, would be practically impossible to reverse, and there would be no one to turn to for help.
Another issue that can be seen as as a disadvantage is the uncertainty of the crypto market and the volatility of crypto tokens, the preferred currency of choice in DeFi services. The fasts fluctuations in the crypto-market pose a risk that many participants may find uncomfortable to absorb. While its is unlikely that a given cryptocurrency could tank to zero overnight, incidents like the collapse of Titan, a DeFi token from Iron Finance, show that no one is exempt from the risk.
All innovation goes to unstable periods en route to mainstream adoption. As innovation strives to find market and regulatory fit, it is likely to generate divisive camps of support and deterrence. What we are witnessing with the rise in popularity of DeFI services, is the evolution of a powerful technology underpinned by a revolutionary ideal, put control of finances back on people’s hands. Whether the future of decentralisation will resemble the current version of DeFi is hard to tell, but what’s certain is that the strong appeal and momentum of its original thesis is too strong to be reversed.