DeFi: What Is It and What Does It Mean for The Future of Finance
When Satoshi Nakamoto published his white paper on Bitcoin in 2009, heralding the introduction of blockchain technology, it instantly changed the world. To what extent? Not even he could have known at the time. For years, the blockchain space consisted only of cryptocurrencies, wallets, exchanges, and related platforms. But, 12 years later, it is evolving into something called “DeFi”, or decentralized finance.
That name defines it as opposed to the current system of world finance, centralized/traditional finance, or CeFi. A revolutionary new model to change how finance has been run for the past hundreds of years. But what really is it? I have written this article to explain what both DeFi and CeFi are, and to draw whatever parallels and opposites exist between them.
Traditional finance is referred to as centralized because of the presence of intermediaries and regulatory bodies. For example, when you shop on Amazon and pay using your credit card, the funds do not go directly to Amazon, even though they appear to. They go from your bank through your card provider, through their point-of-sale terminal provider to their bank, which then credits it to their account. And all levels of this transaction are subject to government regulation and scrutiny.
However, the finance sector is not concerned only with payment transactions. In fact, the oldest and most important service in finance is banking, which is essentially taking deposits from savers and loaning the same funds to borrowers for interest. But it has long widened to include other services like insurance, financial advisory, and asset management.
DeFi offers all of these financial services utilizing blockchain networks, allowing people to send and receive payments directly, without any intermediaries. As much as Satoshi Nakamoto might hate to admit it, regular cryptocurrencies and exchanges are centralized as payments still pass through centralized intermediaries.
Decentralized finance operates entirely differently, by replacing intermediaries with smart contracts, which is essentially a computer program that automatically executes a transaction based on a predetermined contract. These smart contracts are usually based on open-source software built by several independent developers in the crypto community.
Already, there are DeFi services, like AAVE and Compound, that allow people to save their assets in exchange for substantial interest rates, just like traditional banks. The system also allows people to borrow from the fund, with collaterals.
There are also so-called flash loans, where people can borrow any amount and pay them back without collateral, in a single block transaction. Also, the algorithm changes interest rates based on market demand, just like traditional banks.
Other services available in the DeFi ecosystem are asset management and insurance. Yearn Finance, for example, is an algorithm built to automatically search for and invest in the best performing tokens in the cryptocurrency market, to grow its users’ portfolios. Also, protocols, like Nexus mutual, provide insurance cover for any vulnerabilities in smart contracts.
What Is the Future Like?
All of these DeFi services are still nascent. Regular cryptocurrency wallets and exchanges have been around for a while and have reached near perfection. But, most of the protocols offering savings and lending services, insurance, and asset management among others, have only been around for about a year.
The sector has attracted a lot of funds from venture capitalists and has generated sufficient buzz among software developers and thus has a lot of potentials. But it has also inevitably attracted attention from regulatory agencies who are still unsure what steps to take, especially in the light of few incidents of system failure. So, it’s left to be seen how much progress will be made, and how soon.