DeFi is a simplified term for Decentralized Finance that refers to financial services offered via decentralized networks. By this very broad definition, there are numerous cryptocurrencies that would qualify as “DeFi” in that they’re (1) created, stored, & transferred across blockchain-based decentralized networks and (2) possess a store of value or medium of exchange characteristic.
However, decentralized finance is most often used to refer to the emerging financial ecosystem on the blockchain that is powered by smart contracts and decentralized applications. Leveraging the unique benefits of blockchain technology, specifically security and accessibility, new products and services have been introduced that have the potential to solve key challenges that exist in our current global financial system.
Bitcoin: The Original DeFi
Bitcoin deserves to be highlighted in this article due to its nature as the world’s first DeFi product. In 2008 it emerged as an idea in a whitepaper called “Bitcoin: A Peer-to-Peer Electronic Cash System” by an author using the pen name Satoshi Nakamoto. Bitcoin’s key features were: decentralization, blockchain-based, peer-to-peer, and a fixed monetary supply that would never exceed twenty-one million coins.
Many believe that, due to the timing of Bitcoin’s emergence, it was created in response to the financial collapse of 2008, which many attributes to banks being irresponsible with their customers’ money. Bitcoin would cut banks out of the equation and circumvent the Federal Reserve which continuously inflates the dollar and devalues peoples’ hard-earned savings. By capping the total supply, Bitcoin would be seen as a store of value due to its scarcity, with many drawing comparisons between Bitcoin and traditional stores of value such as Gold and Silver – assets that also have fixed supplies. But where Gold and Silver are stores of value, Bitcoin adds its blockchain-based security and decentralized nature.
Ethereum: Introducing a Foundation for the Decentralized Future
Building on the foundation set by Bitcoin, Ethereum was introduced in 2015 with the vision of increasing the utility of the underlying blockchain technology by creating a foundation for decentralized applications and smart contracts to be built upon – similar to the value that Apple’s App Store offers to developers in creating new applications, Ethereum evolved rapidly into the destination for an industry that was ripe for disruption: finance.
How DeFi Works
Decentralized finance consists of applications that are hosted on a blockchain and enable individuals to facilitate a financial transaction by fulfilling predetermined terms and conditions, which are also known as “smart contracts.” Throughout the process of accessing the decentralized finance application, the financial transaction can be achieved without the intervention of a middleman or other intermediaries, such as a banker, lawyer, or accountant.
In fact, the individual has historically only needed to own a cryptocurrency wallet to access the DeFi platform and facilitate financial transactions. The cryptocurrency wallet provides the secure gateway between an individual’s public blockchain address, which is where the digital assets are stored, and the DeFi platform to facilitate lending, borrowing, staking, yield farming, and voting.
Similar to how mixing ingredients in a recipe produces a dish that’s tastier than the “sum of individual parts,” the utility of DeFi platforms is enhanced through partnerships with other DeFi platforms to create new financial products and services. With the malleability of DeFi platforms to integrate with other services referred to as “composability,” many investors are gaining access to wealth-generating investment opportunities that have historically been reserved for accredited investors and high net worth individuals.
The Pros and Cons of DeFi
Since the start of 2020, there have been three key advantages of decentralized finance that have ultimately led to its rapid adoption and evolution: accessibility, revenue generation, and efficiency.
Whether it’s access to a checking account or student loan, the current financial system has become a staple of our daily lives. While the emergence of DeFi can reshape our relationship with financial institutions, the most profound impact may be experienced by the 2 billion individuals globally who do not have access to basic banking services. Due to political or economic factors, these “unbanked” individuals are left to find alternative options to store wealth and exchange of value such as livestock, perishable food supply, or loosely-owned land titles.
However, there is a technology that can easily fuel the growth and access to decentralized finance to these 2 billion individuals: mobile phones. According to a Gallup World Poll in 2018, 83% of adults in the developing world have a mobile phone. With connected devices readily available and affordable, decentralized finance can provide a stable financial system – a gateway to the global economy – for billions of people around the world.
One of the most prominent differentiators between decentralized finance and traditional banking services is revenue-generating opportunities made available to customers. Compared to the 0.5% interest rate for high-yield savings accounts, it’s often eye-opening for many new DeFi savings account customers to find that they can receive interest rates at 4%+. They’re often even more excited to find that they can compound that interest by utilizing DeFi platforms that offer complementary staking and lending services.
Throughout the DeFi landscape, smart contracts and decentralized applications have created a transparent, auditable, and efficient system to facilitate a wide range of financial services. Despite the advances in technology that have made our lives more digital and connected, our global financial system has remained in an analog era. From costly wire transfers to time limitations when the NYSE is open for trades, the automated and permissionless nature of DeFi delivers a tremendous opportunity to disrupt the current financial system.
While there are significant advantages to decentralized finance, it’s important to be mindful of risks and challenges that exist in the maturing market:
While blockchains, such as Ethereum, have provided an opportunity for DeFi to flourish, it’s important to note that investors are subject to transaction fees – otherwise known as “gas fees.” These fees are attributed to the cost of executing and adding a transaction onto a blockchain. With increased activity and congestion on Ethereum, there have been instances where investors have been presented with gas fees in excess of $200-$300 per DeFi transaction. But there is always an alternative, for example, Fantom Blockchain. Fantom boasts higher scalability, lower transaction cost, and extremely fast transaction confirmation times than Ethereum. You can read more about the Fantom blockchain in this article.
Ease of Use
While DeFi provides unparalleled access to financial products and services, many new investors find the steps required to get started and participate can be both daunting and complex. New investors are often required to learn new concepts while navigating a litany of sites, Chrome extensions, and technical requirements to reap the benefits of DeFi.
Similar to other markets that draw investor interest, there are bad actors in cryptocurrency who attempt to deceive and defraud investors. It’s imperative to do sufficient research on your investments, secure your digital assets offline on hardware wallets, and avoid sharing sensitive information with others online.
Within a few years, decentralized finance has arguably achieved more to disrupt the financial industry than the preceding twenty years. From large financial institutions to retail investors, the excitement continues to build around how decentralization can deliver more value for more people around the world. From citizens in developing countries to small business owners in the United States, decentralized finance is well-positioned to change a cornerstone of our daily lives for the better.