The advent of fintech has brought a lot of ease to the financial world, allowing people to navigate the cumbersome space of banking, lending, and trading. At the moment, most of the transactions and financial operations are still handled by centralized networks, yet a new dawn is upon us with the industry being more and more invested in decentralized finance (DeFi).
Unlike the centralized finance (CeFi) system, decentralization promises to remove third parties, save costs, and empower participants rather than having them rely on a trusted entity to do what is best for them. DeFi allows customers to perform the same operations as with any traditional bank or insurance company, except this time the paperwork, validation process and high costs are no longer factored in. As a result, more people can access financial services at lower costs or receive better interest rates than those offered by traditional financial institutions.
DeFi – a short history
The need for a decentralized financial system came after the trust people were required to have in traditional financial institutions was constantly broken and they started to question the central authority. The industry saw the potential for an open protocol that was easily accessible to anyone and could remove the trust issue from the equation.
Blockchain technology, with its first worldwide practical implementation through Bitcoin in 2009, made it possible for everyone to understand there could be different ways of doing financial transactions. Capitalizing on smart contracts that appeared a few years later, DeFi allows multiple parties to interact with each other without a centralized intermediary.
How does it work
DeFi applications are known as dApps (or dapps) and most of them are nowadays built using the Ethereum network, allowing any person with an internet connection to access them to perform financial transactions. These transactions are executed automatically without any human intervention and they are accessible to all participants in the chain who can verify that everything is executed accordingly. At the same time, transaction data is visible on the blockchain and can be checked by anyone.
Some of today’s use cases for DeFi include:
- Traditional financial transactions such as payments, loans, lending, trading, buying derivatives.
- Decentralized exchanges (DEXs) – allow each participant total control over their cryptocurrencies rather than adding them into a wallet that might be prone to risks due to its centralized characteristics.
- E-wallets – can operate independently of the largest cryptocurrency exchanges and give investors access to everything from cryptocurrency to blockchain-based games.
- NFTs – can be traded and exchanged for money, cryptocurrencies, or other NFTs.
- Stablecoins – are less volatile than other cryptocurrencies, making them more reliable to use for ordinary transactions.
- Healthcare – to store and track healthcare records, and to enable communication and collaboration between healthcare professionals.
- Education – to create decentralized learning platforms, allowing students and teachers to interact and collaborate directly without intermediaries.
The main benefit of DeFi relies upon eliminating the challenging need for trust in third parties and legacy institutions that are reluctant or unable to change. Transparency and lack of restrictions make DeFi (and blockchain) pivotal in moving towards an open financial infrastructure. This will enable companies, people, financial institutions and regulators to contribute to the development of protocols, analyze transactions, identify and compute risks in real time.
DeFi – where to next
There is still a long way to a fully decentralized financial space, not only due to technological or regulatory challenges that still need to be overcome but also because of skeptics who continue to believe in the power of a central institution making all decisions.
No rules challenge – Blockchain and DeFi are fueled by fewer rules and common standards which allow for a lot of freedom and accessibility, yet this also means that people have less – or not at all – means to protect themselves in case of transactional issues.
Hacking vulnerability – even though blockchain transactions are proven to be more secure, certain aspects of DeFi networks are still at risk when it comes to hackers.
Collateral value – DeFi might not be restrictive regarding being part of a blockchain, but it can reduce the number of people who are eligible for loans by requiring collateral equal to at least 100% of the value of the loan – in some cases even more.
These are only some of the challenges brought along by DeFi, however, they are by far surpassed by the potential and value it adds to the financial industry. DeFi, along with web 3.0 and crypto, can reduce costs, increase speed and improve functionality in financial transactions by eliminating friction in terms of technology, contracting and coordinating multiple parties. According to Forbes, in 2021 DeFi’s market capitalization was worth USD 74.8 billion, which shows that the industry is growing. This means conventional financial institutions cannot ignore the trend and need to prepare for shifting to DeFi platforms as soon as possible.
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