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Published in · 6 min read · Nov 1, 2019
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Understand Decentralized Finance (DeFi) and how it works via these 5 commonly asked questions.
Decentralized Finance aims to provide the same financial services as traditional banking without any central authority or intermediaries. Without a central authority, DeFi allows everyone to engage with financial services like payments, lending, borrowing or investing with high autonomy and fewer barriers.
In such a financial system, individuals will have access to applications that use public blockchains to participate in new open global markets. The question is, how would this shape the global financial system for the better?
This article strives to give you answers to questions about decentralized finance and essential things around this fast-evolving space.
Decentralized finance, or DeFi, refers to a new decentralized financial system that is built on public blockchains such as Bitcoin and Ethereum.
There are six primary elements that differentiate public blockchains from the private networks managed by governments and traditional financial institutions:
- Permissionless: Anyone in the world can connect to the network and create applications regardless of central authorities.
- Decentralized: Records are kept simultaneously across a cluster of thousands of computers distributed around the network.
- Transparent: All transactions are always verifiable on the blockchain.
- Trustless: There is no central party required in a DeFi product.
- Censorship Resistant: A central party cannot alter and invalidate token custody, transfer, and exchange.
- Programmable: Developers can program applications into low-cost financial services. Assets that are handled on the product have all the native attributes of conventional tokens on a decentralized network.
DeFi enables wider global access to financial services. Aforementioned, anyone with an internet connection and a smartphone can access financial services in decentralized finance. Conversely, there are plenty of barriers that prevent access in the traditional system, mostly revolving around status, location and wealth.
In DeFi, cross-border payments become affordable. Let’s take a look at the remittances market, in which overseas workers send billions of dollars across borders to support their families every year. Think of how much of transaction fees they face for doing this. Indeed, they are excessively high which eats into their modest income, not to mention it’s a time-consuming process. By cutting down intermediaries, DeFi services have the potential to slash these costs by more than 50%. This not only allows an employee to save more and be more productive, but it will also help support small businesses and economies on the other side of the world.
Loans are another pain that can be addressed, thanks to DeFi. At present, it’s virtually impossible for the unbanked to borrow money, often because they lack credit records and history with a banking institution. DeFi platforms connect borrowers and lenders directly, eliminate credit checks, and enable digital assets to be collateralized.
The structure of decentralized finance includes stablecoins, a type of digital currency that stands to shield consumers against the volatility of crypto by being pegged to another asset such as dollars or gold.
Within the constraints of the definition of decentralized finance given above, stablecoins that do not require a centralized, banking entity are the only tokens that are genuinely “decentralized”. If a stable token’s issuer such as Tether (USDC) can dictate the terms upon which a dollar redemption is made, it is not accurate to suggest that it is decentralized. Although ERC-20 tokens that are backed by fiat currency can be used for the purpose of creating DeFi applications, the centralized nature of the custody of the assets backing those currencies makes it highly risky. In the scenario of Basis being stumbled and shut down abruptly due to regulatory concerns with its non-collateralized model, MakerDAO’s Dai has been able to capture the bulk of the markets and addressed the issues.
Backed by Ether, Dai uses game theory and balanced economic incentives to sustain its value of $1, allowing the ability to transfer USD in any amount, instantly, across borders, without fees, without any interference. Most decentralized exchanges and DeFi-oriented products in the market are now built on Dai.
The volume in DeFi has been growing fast over the last two years. According to DApp Total, the total value participating in this space as of Sep 30, 2019 is $997 million up from $219 million one year ago. The yield that can be earned in this new market can reach levels as high as 5% per month even without taking a market risk toward the new field of cryptocurrencies.
MakerDAO is one of the largest DeFi platforms. The platform allows users to lock Ether into smart contracts as collateral in order to secure loans in Dai. Since Dai is pegged to USD, investors can prevent market risks. (See more about Dai and its incentives’ mechanism)
There are several platforms such as Compound that added support for Dai. The way a platform like Compound works is that a user locks up a portion of their digital assets as collateral in order to take out a loan in the form of a different cryptocurrency. Even though this practice has some similarities to MakerDAO, one key difference is that CDP creation on MakerDAO creates new tokens, whereas Compound users borrow existing tokens instead. The Compound protocol currently has $39,504,817 of DAI earning 6.19% interest.
Another stream of income can include mining activities of blockchains. The role of miners is to secure the network and to process transactions. For example on the Bitcoin blockchain, buying a Bitmain Antminer S17e (64TH) generates 4.87% per month on the invested capital.
In addition, individuals can generate value in the DeFi space by participating in pools at decentralized exchanges like Uniswap or participating in auctions for derivative or asset platforms like Setprotocol.
There are some challenges that lie ahead for DeFi’s proliferation.
Even though DeFi solutions could transform the lives of millions of people, it’s an inevitable fact that they haven’t gained the public awareness that they deserve. Adoption in the crypto world has been modest, to say the least.
It’s also worth considering that even if DeFi applications manage to welcome hundreds of millions of people to its platforms, the public blockchains they rely on may lack the capacity to accommodate their demands. Scalability concerns have also been a long-running thorn in the side of Ethereum, with its co-founder, Vitalik Buterin has recently admitted that the blockchain is almost full, leading to the creation of Ethereum 2.0.
Volatility is yet another concern in the cryptocurrency space. Even though stablecoins have been seeking to remedy this, the hurdle of regulatory compliance continues to loom large.
It can be seen as a big backdraw in achieving consensus due to how DeFi organizations are working independently of one another, creating a fragmented market. Adding up to the problem, there remains conflicting attitudes and criticisms from certain governments toward crypto and blockchain in general. Some countries have banned digital currencies in their entirety, with the likes of India threatening to send those caught dealing in crypto to jail for 10 years.
Opening new partnerships between DeFi platforms, and engaging in conversations with decision-makers is nothing short of crucial if crypto and blockchain are going to become a compelling alternative to the current status. Unless governments and central banks suddenly cease to exist, there’s no possibility for decentralized finance to completely replace these centralized models. But what if they can co-exist? Will we allow it? The answer is yet a matter of time.
