What Is Decentralized Finance (DeFi)?

On Sep 18, 2019 at 5:45 am UTC by Adedamola Bada · 6 min read
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Photo: Shutterstock
Photo: Shutterstock

There are a lot of talks that today the traditional centralized finance system can’t satisfy all the currently existing demands. But are there any other options? In this guide, we will tell you about DeFi, its decentralized counterpart.

The traditional centralized finance system works in a way that doesn’t allow consumers to have total control over their finances but rather holds them in place for safekeeping and investments.

In this light, many business experts have predicted that Decentralized finance (DeFi) could be the next step in achieving a future utopia of finances where poor governance and administration control over transactions can be bypassed or severely limited. Let’s have a look at DeFi is.

What Is DeFi and Why do We Need It?

Decentralized finance is an open-source system built on the blockchain technology focused on offering traditional financial services, like depositing, loaning, and trading, to consumers on a censorship-resistant and transparent platform.

DeFi grants individuals complete access and total control over their assets, which deviates from the existing financial system. DeFi operates on a decentralized principle of peer-to-peer transactions without the need for an intermediary like a bank or financial institution in place to oversee the operations.

The open-source feature of DeFi allows for innovation and technological advancements towards the cause of decentralization of the financial system. DeFi grants full accessibility over services without restrictions that exist in the traditional financial system with improved privacy in transactions.

Financial structures, which are operated and managed by individuals, are susceptible to the risks of errors which could, in turn, affect the interests of the consumers.

How Does Centralized Finance Work?

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Centralized finance is a system with financial intermediaries that perform regulatory, operational, and administrative functions for assets procured by consumers with the prospect of a return.

Such a system operates with so-called ‘middlemen’, banks or financial institutions, that hold control of all the assets and oversee all the commercial operations made by the consumers. The intermediaries tend to incur their own costs and fees on all transactions made by the consumers.

All the financial solutions are provided by the intermediaries with all practices moderated or constrained by an official government body. Government corporations and regulators have an unmatched power over how all the decisions are made by financial institutions.

Centralized finance has barriers restricting consumers from participating like the lack of status, funds, and a suitable location. Also, centralized finance is mainly controlled and steered by those with financial literacy and connections.

How Does Decentralized Finance Work?

Decentralized finance works with applications that offer consumers access to global markets for trading and other financial solutions. These applications operate on the blockchain with underlying layers of system architecture, with each layer serving a diverse set of functions, and protocols serving the system.

These applications are specifically targeted at those restricted from participating in the traditional financial systems. DeFi offers a system with a decentralized process of obtaining diverse cryptocurrency and financial services which is transparent and accessible to all interested parties.

What Are Decentralized Applications and Services?

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The applications which can be used to access the decentralized finance services include:

  • Open Lending Protocols
  • Issuance Platforms
  • Decentralized Prediction Markets
  • Exchanges and Open Marketplaces
  • Asset-backed Stablecoins and Decentralized Stablecoins

The open lending protocol is a system which provides an interested party with the tools to access borrowing/lending of digital assets. There are several open-source protocols already in existence that offer such services like MakerDAO, Compound, and Dharma implemented on the blockchain which offers peer-to-peer transactions.

MakerDAO, a decentralized protocol built on the Ethereum blockchain, offers lending services with the cryptocurrency, stablecoin DAI. DAI maintains a 1:1 ratio with the USD, meaning 1 DAI is equal to $1, which opens it up to trust because the price is well-adjusted and not inflated. DAI makes 2% of the total volume of Ether with its smart contract.

Compound is an open-source protocol, also built on Ethereum, it provides consumers access to decentralized money markets on which they can borrow and lend with the providence of collateral. The collateral helps in assuring the users of its security. The Compound protocol uses an algorithm to calculate the interest rates, which is based on supply and demand. Compound favors companies as well as crypto funds because of their size of investments as Compound has low market money returns rates. Ethereum (ETH), stable coin DAI, Ox (ZRX), Basic Attention Token (BAT), and Augur (REP) are supported on the Compound platform.

Dharma is a protocol which offers borrowing and lending contracts launched on Ethereum on which ‘creditors’ offer up some of their digital assets up to the ‘debtor’ and get rewarded with interests. The protocol employs the use of ‘underwriters’ which are trusted to ascertain the chances of a ‘debtor’ returning the assets back to the ‘creditor.’ The ‘underwriters’ are backed by law processes which makes sure the debts are redeemed.

Issuance Platforms

Issuance platforms are systems based on blockchain, which utilizes security tokens in raising funds, and the security tokens require the proper build of platforms and exchanges for them to be tokenized.

The top blockchains platforms involved in security token issuances are Polymath, Swarm, Securitize, and Securrency, to name a few. Each has its own unique set of services and functionalities but still following the same principle.

Decentralized Prediction Markets

These are markets where you can buy and sell shares in predictions which are of two types, Yes (long) and No (short). These predictions determine the payout of the shares acquired, the price of which is determined by the amount the buyers are willing to pay and the sellers – to get. The perceived probability of an event determines the price of the shares, which means the higher the shares, the higher the probability.

Prediction markets offer insights into the general opinion of the public but are restricted by the Closed, Controlled, and Costly constraints.

Exchanges and Open Marketplaces

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Photo: Unsplash

In this list, it’s also worth mentioning exchanges and open marketplaces that allow trading and transactions using cryptocurrencies as a medium of exchange between digital and traditional currencies. Professional trades are done using designated tools on such platforms and offer better security and transparency in transactions.

There are numerous platforms that offer such services like Coinbase, CEX IO, BitMex, Bitfinex, and many others.

Asset-backed Stablecoins and Decentralized Stablecoins

Asset-based stablecoins are tokens backed by real assets in which consumers can redeem assets at the conversion rate set to own real-world assets. There is better stability of the price of commodities which portrays an effective advantage for the stablecoins.

Decentralized stablecoins are frequently used in cryptocurrency markets for trading against other cryptocurrencies like Ethereum (ETH), Bitcoin (BTC), and others. These are preferred due to the perceived sense that cryptocurrency prices could be easily affected and the sense of security that stablecoins assures consumers.

Conclusion

The benefits of DeFi far outweighs the limited risks of its financial solutions. DeFi is the next step for the financial community with its several applications and functions for a wide range of services for the general public.

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