DeFi: What You Need to Know About Decentralized Finance

Decentralized finance DeFi (decentralization finance) is an economic and financial paradigm that has breathed new life into the cryptocurrency industry. DeFi blockchain technologies are financial ecosystems devoid of central control and intermediaries, in which users interact through peer-to-peer networks and DAPPs.

The main role of decentralized finance is to enable absolutely everyone to use payment systems and financial products, like those of classical banks, regardless of citizenship or financial situation. In addition, a significant advantage of DeFi is their modular structure and interoperability between blockchains, which will allow the creation of entire financial services markets.

Схематическое изображение принципов работы банков и DeFi
Schematic representation of how banks and DeFi work

In this material, we will examine in detail the advantages and disadvantages of the most ambitious direction of blockchain technology development, which seeks to become a full-fledged alternative to classical banking systems.

What is the difference between cryptocurrencies and DeFi?

From the classic description of DeFi, which defines them as financial instruments based on decentralized systems, the question may follow: how are they different from conventional cryptocurrencies? And this will be logical, because Bitcoin and Ethereum are also assets that represent a certain financial value and are built on an exclusively decentralized blockchain technology.

Популярность блокчейн-платформ для запуска децентрализованных приложений
The popularity of blockchain platforms for launching decentralized applications

Despite this, there is a fundamental difference between the classic cryptocurrency and DeFi. The fact is that, although a cryptocurrency is a token written on a blockchain, its purpose, often, has to be invented independently, if this is not provided in advance by the developer. And in this case, most crypto-coins become just a speculative instrument for traders, or a high-risk investment for investors.

In turn, decentralized finance offers full-fledged banking products and is being developed to replace the traditional financial system, fully implementing its capabilities on the blockchain. Of course, the first cryptocurrencies are not capable of this, and this is the main difference.

DeFi Benefits Over Traditional Finance

Given the fact that most modern DeFi runs on the Ethereum blockchain, their technological advantages also come from Ethereum's capabilities, including Smart Contracts. There are three main advantages of decentralized finance:

Programmability. The use of smart contracts working on the Ethereum blockchain allows you to program the fulfillment of any transaction conditions, creating new financial instruments and valuable assets.

Security. The decentralized structure of the application, in which data is stored on hundreds and thousands of different nodes, makes it technically impossible for a hacker attack or hacking in order to take control or change data on the network. No node on its own can harm the entire network, which evenly distributes the storage and confirmation of information across all nodes.

Compatibility. The shared use of Ethereum protocols allows different DeFi to interact with each other, creating opportunities for the existence of a full-fledged financial ecosystem.

But the main and fundamental difference from traditional financial systems is the complete absence of intermediaries. Each dispute is automatically resolved by code, ensuring that the original terms of the contract are met and absolutely unbiased. This significantly reduces the cost of any transactions that no longer require the mandatory involvement of third parties.

DeFi also has a significant social advantage over the classic banking system. Since the latter function only thanks to commissions, fees and interest, respectively, they do not enter potentially disadvantageous markets. Decentralized financial systems, on the other hand, are available to people from any country and social class, since they do not need large commissions and additional fees

Application of decentralized finance

According to the information service DeFi Pulse, the market for decentralized applications is constantly growing. In the last year alone, the capitalization of assets blocked in Defi has increased 5 times, and currently exceeds 2.5 billion US dollars.

Стоимость активов, заблокированных в DeFi приложениях
The value of assets locked in DeFi applications

All existing decentralized applications can be divided into 3 broad categories:

DeFi lending

Open and transparent lending services are very popular due to their clear advantages over traditional lending institutions. DeFi does not require mandatory checks, and the use of blockchain and smart contracts solves the issue of trust when concluding a contract. Decentralized lending is more profitable due to the absence of intermediaries, has a high speed of decision-making and is available to almost everyone.

Decentralized financial services

DeFi allows the creation of stablecoins - digital tokens backed by a real physical asset. This is a new type of cryptocurrency, which is devoid of their main drawback - high volatility. Indeed, a more logical use of a volatile asset would be trading and investing, but definitely not monetary settlements on an ongoing basis.

Unlike classic cryptocurrencies, the value of stablecoins is tightly tied to fiat currencies, precious metals, or other assets that are locked into DeFi accounts. Thus, to issue one dollar stablecoin USDT, you need to block 1 USD, backing the coin with the value of a real asset. Thanks to this, stablecoins are an alternative payment instrument that is not controlled by government agencies.

Decentralized Exchanges DEX

One of the most significant technologies that came out of DeFi. Decentralized exchanges are gaining popularity every year and this is easy to explain. The fact is that trading on DEX is conducted without the participation of a broker, as on classical exchanges. The transaction takes place directly between the wallets of the two parties using smart contracts. Thus, it is possible to avoid unnecessary trading commissions, and the exchanges themselves do not require complex maintenance, unlike their centralized counterparts.

In addition, DeFi can be used to issue security tokens, create derivatives, forecast, track transactions (KYT), launch asset management funds, mortgages, and insurance.

The most famous DeFi projects

Статистика капитализации самых популярных DeFi согласно Defi.review
Capitalization statistics of the most popular DeFi according to Defi.review

Compound. A project on the Ethereum blockchain that allows you to invest in lending and take out loans. Each Compound member can transfer their assets to a liquidity pool and earn interest by issuing these funds as loans. Compound was launched in September 2018 and updated to v2 in May 2019. The protocol supports BAT, DAI, SAI, ETH, REP, USDC, WBTC, and ZRX. Compound is managed by the project community. The owners of the COMP token and their delegates vote on all decisions and changes within the project.

MarerDAO. Operating since 2017 and the most famous decentralized financial system, which for a long time held the leading position in terms of capitalization among other DeFi.

The DAO blockchain platform also works on the Ethereum protocol, and allows you to issue loans in DAI stablecoins after collateral in ETH or BTC. In addition to lending, backed by other assets, DAI can be used for gambling, financial markets, international trade and for accounting.

Lightning Network - One of the few DeFi projects to use the Bitcoin blockchain. The goal of the LN protocol is to increase the scalability of the bitcoin network. The Lightning Network consists of a network of interconnected payment channels. A channel opens when two or more participants enter a transaction on the public blockchain. While the channel is open, participants can conduct any number of transactions between themselves.

Curve Finance. Decentralized exchange for trading stablecoins, which has been operating since January 2020. This DEX does not yet have its own token, but allows traders to trade using special algorithms with a reduced commission, which are designed specifically for stable tokens.

DeFi Perspective

Of course, like any technology, decentralized financial systems are not without some disadvantages. The main one is the low performance of the blockchain. According to one of the famous financiers of our time, “The Ethereum blockchain is slower than a calculator thirty years ago,” which is partly true. The low bandwidth of many blockchain networks significantly limits the use of DeFi. Until this problem is resolved, it is too early to talk about superiority over traditional financial systems, which are dozens of times faster.

But it should be borne in mind that the DeFi sector is currently the most active direction in the development of blockchain technologies, which gives hope for the resolution of the "childhood diseases" of decentralized networks in the near future. The main thing is that we have the opportunity to observe and take part in the development of a real alternative financial sector, which will not be controlled by states and will be able to provide services to all segments of the world's population.