There’s zero doubt that blockchain is one of the hottest tech buzzwords in the last few years. It’s likely the next big disruptive innovation and the sector’s seen tremendous growth in recent capital inflow. However, that entire space is far from homogenous in terms of what’s happening inside and what’s driving this growth. With all its promises, blockchain is still in its infancy and people are diligently searching for the perfect use case.
Decentralized finance (DeFi) has taken the lead and seems to be on the right track to create lasting tangible value. Let’s see how decentralized finance works and what to expect in the cryptocurrency and blockchain playgrounds in the near future.
What is Decentralized Finance (DeFi)?
There is no one true textbook definition that can summarize decentralized finance without opening the floor for additional debate. Regardless of that, the principle behind DeFi is quite familiar and not too complex. Decentralized finance is actually an umbrella term that covers many projects exploring new applications and mechanisms in borrowing and lending.
Ages ago, we invented currency to help us exchange goods and services more efficiently. The infrastructure for issuing various types of currencies has converged relatively recently into what we call central banking. However, central monetary authorities and commercial banks have displayed a stubborn tendency to periodically break public trust. They can also sometimes operate against public interest and wield massive influence in the allocation of financial resources in suboptimal ways. Moreover, when people invest through the current financial infrastructure, their assets go through various intermediaries. This increases both the final transaction cost and the associated risk, leading to lower overall yields and high rigidity.
DeFi aims to disrupt traditional finance and create compelling value for its users by cutting out the middleman. It also strives to create new types of unconventional financial and insurance derivatives which would give people increased financial liberty. Make no mistake – for the time being, DeFi is certainly reliant on standard everyday fiat currency (primarily the USD). However, the surge in crypto and blockchain activity is expanding the field of interaction for new financial pioneers. Additionally, one of the biggest promises behind DeFi is its wide accessibility, which will democratize access to capital for individuals. The only technical requirement for conducting a transaction would be a device with internet access, which is already standard practice.
How Does Decentralized Finance Work?
Practical implementation of decentralized finance is heavily reliant on smart contracts, whose nature and mechanisms we’ve mentioned before. The fundamental goal behind it is cutting out the middleman, and DeFi accomplishes this through smart automation. Self-executing contracts with clear triggers represent the primary tool which DeFi utilizes to conduct, verify and record transactions. When two sides engage in any contractual obligation (e.g., the lender-borrower relation), smart contracts can validate mutual fulfillment infrastructure where all of this happens runs on blockchain technology and is leveraging cryptocurrencies to facilitate transactions.
The basic token and blockchain of preference for most DeFi projects is Ethereum, the second largest cryptocurrency by market capitalization. Ethereum itself has become rather well-known in the general discourse even outside the world of crypto-enthusiasts. If Bitcoin is digital gold, Ethereum is digital silver. It is a Layer 1 blockchain (i.e. main blockchain), which stores data in an immutable and cryptographically secured manner. However, the rise in Ethereum’s price has made transactions on the main blockchain quite expensive (the so-called price of “gas”). To solve this, developers have created additional protocols and called them “Layer 2“. Layer 2 represents an “off-chain” solution whose main role is to reduce the burden on the primary layer. This, in turn, allows for a much higher volume of transactions per second and reduces costs.
DeFi also uses tokens known as stablecoins, whose value is fixed to more stable fiat currencies. Their purpose is to integrate security, transparency and rapid execution of cryptocurrencies, while simultaneously reducing everyday price volatility. Combining this should allow people to borrow against cryptocurrencies and enjoy better rates compared to traditional microfinance loans, for example.
DeFi Projects and Trailblazers
A year ago, the estimated sum of all decentralized finance projects was $1 billion. If you compare it to the state of affairs today, you’ll see a 60x growth. Over $60 billion is now dedicated to the development and deployment of a host of Ethereum-based DeFi products. Keep in mind that Ethereum is not the only public blockchain that supports this effort – there’s activity in other realms as well.
Several solutions have rapidly moved to the top of the wave, leading in tech and business use case applications alike. The names you should watch out for are:
- Polygon (formerly MATIC) – decentralized finance apps on this platform have skyrocketed, attracting 75000 new users in just a matter of days. This chain has also seen a huge rise in developers and the trend is ticking upwards.
- Polkadot – enables transfers of any data or asset type between blockchains, effectively taking on the issue of interoperability, which is very relevant for widespread adoption.
- Uniswap – allows automated exchange of decentralized tokens and has gained a name by fixing the liquidity problems for decentralized exchanges.
- EQIFi – a pilot hybrid of the world’s first digital bank (EQIBank) embracing crypto tech, and looking to fuse scalability, trust and security.
If any of these projects succeed in making good on their promises, we’ll undoubtedly see an even bigger subsequent surge. Additionally, the first solution to fully address the issue of volatility in a widely marketable and scalable way will reap massive benefits, but also pave the way for others to explore and compete in this domain.
Pros and Cons of Decentralized Finance
DeFi offers several major benefits – the three main ones being cost, speed and security. Lower costs are a direct result of lower fees compared to banks. The ability to make transactions nearly instantaneously with just a few clicks yields a huge speed boost. You can also see interest rates almost in real time. The cryptographic protection and immutability of the blockchain itself guarantee that your transactions will be securely processed and recorded.
In terms of cons, the fluctuation of market prices takes the cake. Price swings of 20% in a single day are not a rare sight in the crypto world. Also, the Ethereum network still uses a proof-of-work approach. This gives the blockchain limited scalability and represents one of the drivers behind transaction cost spikes. The current trend indicates a shift towards a proof-of-stake, which would contribute to much greater efficiency. However, until that happens, fee volatility and overall scalability will likely remain an issue. Finally, there’s also the issue of how governments process this in terms of taxation and regulation in certain cases.
With all this in mind, decentralized finance will definitely bring many more exciting things in the blockchain world in the near future. We’ll be sure to keep a close eye on how these efforts develop and bring you the latest news.