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Decentralized Finance (DeFi): A Complete Overview and Its Future

by | Jul 12, 2022 | Industry, Utopia




Why do we need decentralized finance?

There is a lot of uncertainty surrounding cryptocurrency but the disruptive technology behind it has a lot of potential. Blockchain has the potential to revolutionize every industry, especially traditional financial systems. Advocates argue that it has the potential to make the current financial system more efficient, accessible, and faster.

The financial system is the most important pillar of an economy as it establishes trust. The economy is driven by transactions. Every day millions if not billions of transactions are made. Every time money exchanges hand a transaction is made.  However, to transact, trust is needed. We have always relied on central authorities to maintain and manage trust in a transaction.

Central authorities can be banks, lawyers, brokers, intermediaries, and the government. And centralized financial authorities have always controlled the flow of money. The government and the banks control money where they can print more of it, stop you from borrowing, prevent you from having a bank account, or even freeze your asset.

They also control the value of your money based on how the economy is performing. Now, these are not the only problems, the current system has other flaws. Centralized financial authorities act as intermediaries where they manage all transactions in their databases. Which means they control almost everything.

And also their data can still be changed, altered, tampered or even delete. Centralized authority is prone to attack. They can be hacked, corrupt, or even failed. And the process is still carried out by people which means transactions can be slow and susceptible to human errors. A transaction can take days if not weeks for completion and intermediaries charge you for every transaction.

The settlement of stocks, bonds, and other financial instruments takes a lot of time to clear. The financial sector requires a massive amount of human capital in the process. But also key decisions making that impact millions if not billions of people are made behind closed doors by a group of privileged few.

Not to mention that banking scandals can surface months if not years after the fact. There are also a lot of inefficiencies and high costs associated with international banking and remittance services. And also financial services are not given to everyone since billions of people across the globe are still unbanked and thus excluded from the system.

There is also a high barrier to entry or sometimes almost impossible for new players to start a financial company without access to a massive amount of capital. Now, with digitalization, everything is happening so fast. The internet has facilitated international trade and transactions. But while technology facilitates trade, it also raises the complexity of the system and prone to error.

As the world is becoming more and more complex, a lot of companies are trying to lower uncertainty through digital trusted platforms. Hence, technology has the potential to close the trust gap. A growing financial trend backed by blockchain technology is attempting to ramify traditional banking. Decentralized Finance or DeFi has the potential to close these gaps.

DeFi eliminates the need for banks where instead pieces of code run and act as the bank. It is open to anyone in the network and it decentralized trust issues. The technology also promises to bring cryptocurrencies to the masses without the need for middlemen and with almost no barriers to entry. So what does the future hold for decentralized finance?

What is decentralized finance?

Decentralized finance is a financial system without banks. In a sense, it is a system without a middleman executing transactions. DeFi takes the decentralized concept of blockchain and leverages the power of cryptography to build an alternative financial system. It uses smart contracts and computer code that automates the process.

DeFi is a technology that eliminates the need for a central bank or other intermediaries. This permissionless network is fully encrypted, which allows for direct transactions between businesses and individuals. The technology has its roots in the 2008 Bitcoin whitepaper, which set up a decentralized system for digital cash.

Using a network of peer-to-peer computers, the data is verified and cannot be changed without leaving a trace. Some users refer to the platform as virtually unhackable. It allows millions of users in a network to perform financial transactions without permission from an outside institution.

Decentralized finance aims at removing intermediaries’ flaws from transactions while providing common financial services. Services such as payments, lending, borrowing, and trading are made more efficient, fair, and open. On top of that, all operations are settled almost immediately without geographic constrain with low barriers.

DeFi protocols can also operate with minimal or no human involvement. Everything is automated, thus, creating better fairness as all services are completely permissionless and everyone with an internet connection can access them. Nationality or race doesn’t matter as everything is run by code.

On top of that, everything is transparent and visible on the blockchain. Every single transaction can be reliably checked on the blockchain as nothing can tamper with the ledger. Distributed finance has exploded in popularity over the last couple of years. Digital assets lock-in DeFi protocol was around USD 1 billion in 2019, and this number reaches USD 72 billion at the start of 2022.

As blockchain is evolving, the concept is gaining momentum and traction. While decentralized finance is a great step forward, its absence of common legislative principles poses serious risks. For one, everything in DeFi relies on smart contracts and cryptocurrency.

Features of decentralized finance

The idea of decentralized finance is to eliminate third-party intermediaries by utilizing automated protocols on blockchains, and stablecoins for fund transfers. It is a broad term that encompasses a range of financial applications. It draws its inspiration from blockchain technology, which enables multiple entities to store and maintain a history of transactions without a single central source.

DeFi isn’t a single technology, but a collection of innovations that aim to disrupt the traditional financial system. The core technology behind decentralized finance is blockchain, which is a public database of transactions. Blockchain technology is present in virtually every cryptocurrency.

It was first implemented by the inventor of bitcoin and has since been embedded in most of them. By facilitating the alignment of incentives, blockchain technology is becoming a popular choice for businesses and investors. This technology also makes it possible to prevent censorship, remove points of failure, and undue centralization.

Ethereum, or ETH, is a major platform in the blockchain world. It acts as a digital savings vehicle in decentralized finance, which is a hedge against inflation and excessive money printing by global central banks. Ethereum is also widely used in other projects, including the smart contract industry, where users create and execute digital contracts.

ETH is the preferred token for smart contracts. The use of smart contracts has increased exponentially in recent years, making it a popular component in decentralized finance. Smart contracts are codes that are essentially written in if/when…then statements. They are written on a blockchain and executed when certain predetermined conditions are met.

Transactions involving smart contracts are updated on the blockchain and can’t be changed. Only the parties involved in the transaction can view the results. In theory, smart contracts can be used to streamline banking processes and unlock valuable insights for banks. Many technology leaders envision a multitude of applications for Blockchain-based smart contracts.

One of the most promising blockchains in decentralized finance is Fantom. This project offers high speed, throughput, and smart contract functionality. It is already deployed on over 100 DApps, which shows the platform’s market cap momentum. It has also surpassed Binance Smart Chain as the third-largest blockchain in DeFi sector.

In terms of market cap, Fantom has the potential to become one of the largest cryptocurrencies in the world. Using cryptocurrency in DeFi takes the role of fiat money out of the transaction. Users can send cryptocurrency to a secure digital location and receive another asset in return.

This secure digital location then locks the asset until the loan amount is returned. This is the spirit of peer-to-peer lending and technology without a central authority. Wall Street and the Australian Securities Exchange are currently testing Blockchain-based smart contract clearing and settlement systems.

One of the most popular forms of decentralized banking is the lending market. The DeFi lending market connects users with cryptocurrency lenders. The market is algorithmically set, so the higher the demand, the higher the interest rate. The decentralized nature of this system allows users to earn interest instantly and without the need for a middleman.

Depository Trust & Clearing Corporation is working on a Blockchain-based post-trade platform. Blockchain-based smart contracts can also streamline supply chains and trade finance documentation. These smart contracts are more efficient than paper-based systems and decrease processing time.

With increased adoption, decentralized finance platforms are becoming more complex and sophisticated. Now, these platforms are based on the Ethereum blockchain, Which enables bank-like transactions without the use of a bank. As a result, blockchain will play a major role in DeFi in the coming years.

The benefits of decentralized finance

Decentralized finance is an umbrella term for peer-to-peer financial services on public blockchains, primarily Ethereum. It takes the basic thought of cryptocurrency to create an entire digital alternative to banking services, but with more functionality. It creates more open, free, and fair financial markets that are accessible to anyone with an internet connection.

Users typically access DeFI service using decentralized apps (DApp) which are basically software. The main advantage of DeFi is that it allows for the development of new financial services without the interference of central authorities. Blockchain-based smart contracts can streamline trade, clearing, and settlement processes. These activities have traditionally been prone to errors and cost money.

Traditional financial institutions are centralized. They act as a custodian of assets, facilitate transactions, and validate transactions on their own database. With decentralized networks, however, the payments are person-to-person, and assets are held on a distributed network across many computers. The lack of an intermediary means lower costs and faster speeds.

As the technology does not depend on centralized institutions, so there is less room for human error. Because DeFi is literally pieces of code running a program, everything is traceable and verifiable. Decentralized financial systems can also help the unbanked join the economy. In addition, it will open up a whole new world of investment opportunities.

Unlike centralized financial services, DeFi relies on smart contracts, which embed rules in computer code and enforce them automatically. Distributed ledger maintains the data related to transactions. The aim is to eliminate the need for trust and make financial services available to any smart device in the world.

In contrast to the centralized financial services sector that uses centralized software and single points of failure. A distributed system can provide secure, anonymous transactions through a network of computers, thus eliminating the single point of failure issue. The use of decentralized financial systems could reduce the importance of existing entities and allow competition to flourish.

Unlike traditional banking and lending models, decentralized finance can enable easy access to funds and capital. The technology also empowered individuals to aggregate their intellectual and banking firepower, a unique combination in the current world of financial institutions.

By moving power from the center to the edge, blockchain technology can facilitate social decentralization. In addition to decentralizing financial systems, blockchain can also facilitate global collaboration. This is important because it can enable companies to transact with different businesses at the same time without the need for trust.

The decentralization of financial systems can help governments move toward a more democratic society. DeFi platforms enable users to take control of their assets and conduct various transactions on peer-to-peer networks. People can borrow funds, invest in crypto assets, monitor price fluctuations of various blockchain-based assets, and more.

Future of decentralized finance

The future of finance has been shifting towards blockchain technology and decentralized finances. The use of distributed ledger technology in DeFi includes lending, borrowing, insurance, and asset trading. This form of finance seeks to eliminate intermediaries and create a permissionless, transparent financial platform.

This banking ecosystem will be decentralized and will be powered by cryptocurrency. Decentralized finance projects are still in their early stages, and many of them have been plagued by infrastructure failures and scams. Since it is still in its infancy, the risks are unknown. In addition, regulation across the world is lagging.

DeFi needs to be regulated effectively to maintain its integrity and build a clear trajectory. There needs to be a balance between innovation and protecting passive constituencies. Without regulation, DeFi will fail to deliver on its promise. However, the technology holds a lot of potential for the future.

The concept of decentralized finance is often associated with cryptocurrencies, but it’s much bigger than that. The blockchain is the foundation for a wide range of decentralized applications. For example, smart contracts allow individuals to engage in peer-to-peer transactions without involving third parties.

Distributed systems can be applied in both the physical and digital worlds without geographical restraint and with minimal regulation. Blockchain’s decentralized nature also maintains high integrity for the system using it. This is why artists are creating Non-fungible tokens and some people are aiming at decentralizing the internet through web 3.0 backed by the blockchain.

Decentralized finance is a technology that allows users to trade in financial products and services. Traditional institutions suffer from inertia, but the combination of breakneck innovation and the passion for ownership is a powerful force. As a result, this new banking system can help create a new generation of entrepreneurs. The DeFi space covers a range of activities, including trading on decentralized exchanges, liquidity pools, and marketplaces.

Traders who trade cryptocurrencies on decentralized exchanges enjoy a number of benefits, including lower exchange fees, faster transaction settlement, and full custody of their assets. In addition to this, these exchanges allow users to exchange cryptocurrencies without having to go through third-party intermediaries.

Further, DeFi-based applications enable users to engage in pre and post-trade compliance, as well as facilitate the best trade execution. Polygon is a blockchain that is gaining significant attention. It was launched last year and has enjoyed major success over the past year. The ecosystem boasts more than 7000 decentralized applications, including decentralized exchanges such as UniSwap and SushiSwap.

The Polygon ecosystem is poised to take on the banking industry in the future. Maker is another ambitious project built on the Ethereum blockchain with decentralized autonomous organizations (DOA) and stable value functions. It is backed by leading venture capital firms and is designed for ambitious governance.

The Ethereum-based DeFi platform Aave recently introduced undercollateralized lending based on social reputation. Solidly has taken advantage of Ethereum’s weakness and is introducing a new protocol called SOLID, which enables users to access all their assets in a single place. The project is still a work in progress, and it is expected to reach its dynamism within the next few years.

But even if it fails to reach its potential, Solidly’s trial run should be worth watching. Ultimately, the platform may prove to be the future of decentralized finance. If and when DeFi solutions fall into place, the technology will have an even better chance of becoming real products, potentially even going mainstream.

While more and more people are being drawn by DeFI applications, it’s still hard to say where they’ll go. Much of it depends on people’s acceptance of technology and who finds them useful. Many believe various DeFi projects can draw in hordes of new users by making financial applications more inclusive and open to those who don’t have access to a bank.

This financial technology is still at the experimental stage and is not without problems, especially concerning scalability. Developers hope to eventually rectify these problems. Ethereum 2.0 is hoping to tackle scalability concerns with a concept known as sharding. It is a way of splitting the underlying database into smaller manageable pieces for individual users to run.

Until the technology becomes more reliable, it will be a long time before this new financial model can be relied on for everyday financial transactions. Until then, however, it offers an excellent alternative to traditional financial institutions. Despite the uncertainty of the future, it is possible to imagine a world where all of us are financially free and can access the services we need.