Decentralized Finance (DeFi): Disrupting the World of Finance Using Blockchain Technology
- The meaning of blockchain technology and its mechanism.
- How DeFi challenges the centralized financial system.
- How dApps and smart contracts are currently being used.
- A rising number of DeFi applications built on Ethereum and growing institutional interest in the technology could be behind its rapid price rise.
- Some risks and concerns to be aware of.
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Blockchain Technology Explained
A blockchain is a decentralized ledger of all transactions across a peer-to-peer network. Using this technology, participants can confirm transactions without a need for a central clearing authority.
The blockchain is a constantly growing list of information. That information is in blocks, and all these blocks are linked together. Each block matches the preceding and following, and the information that the middle block contains is encrypted by an algorithm using a cryptographic function called a hash. This makes this information inviolable. It is a secure, open and public database.
To illustrate how the blockchain works, the metaphor of a ledger distributed among many people is often used. Think of it as a book where digital events are recorded and the information is made publicly available. The fundamental thing here is that this book is "distributed", that is, shared between many different parts (nodes). It can only be updated from the consensus of the majority of the system participants and, once entered, the information can never be deleted. The Bitcoin blockchain, for example, contains an accurate and verifiable record of all the transactions that have been made in its history.
In other words, the authenticity of the Blockchain is not verified by a third party, but by the consensus of the whole: it is the same network of users that participates in it. Once entered, the information is recorded in multiple backups and cannot be deleted or modified. The only thing that can be done is to add new information, since the blocks are connected to each other, as if it were a path of Lego blocks. This gives the system great reliability: as it is unalterable, the information is inviolable.
What is Cryptocurrency?
Cryptocurrency is decentralized digital money, based on blockchain technology. While Bitcoin and Ethereum are the most popular versions, there are more than 9,000 different cryptocurrencies in circulation, according to CoinLore.
The Future of Finance: Decentralized Finance (DeFi)
DeFi challenges the centralized financial system by disempowering middlemen and gatekeepers and empowering everyday people via peer-to-peer exchanges.
“Decentralized finance is an unbundling of traditional finance,” says Rafael Cosman, CEO and co-founder of TrustToken. “DeFi takes the key elements of the work done by banks, exchanges and insurers today—like lending, borrowing and trading—and puts it in the hands of regular people.”
Here’s how that might play out. Today, you could put your savings in an online savings account and earn a 0.50% interest rate on your money. The bank then turns around and lends that money to another customer at 3% interest and pockets the 2.5% profit. With DeFi, people lend their savings directly to others, cutting out that 2.5% profit loss and earn the full 3% return on their money, by using smart contracts on blockchain.
Removing the middleman (like a bank), which can incur onerous expenses, take up unnecessary time, halt or reverse transactions or even cause clients to lose everything in bankruptcy or fraud, is an essential hallmark of DeFi.
So conventional transactions can be done in this unconventional manner. Direct purchases, loans, derivatives, crowdfunding, insurance and other contracts can all be utilized with DeFi as well.
When you make a transaction in your conventional checking account, it is recorded in a private ledger—your banking transaction history—which is owned and managed by a large financial institution. Blockchain is a decentralized, distributed public ledger where financial transactions are recorded in computer code.
When we say that blockchain is distributed, that means all parties using a DeFi application have an identical copy of the public ledger, which records each and every transaction in encrypted code. That secures the system by providing users with anonymity, plus verification of payments and a record of asset ownership that’s (nearly) impossible to alter by fraudulent activity.
When we say blockchain is decentralized, that means there is no middleman or gatekeeper managing the system. Transactions are verified and recorded by parties who use the same blockchain, through a process of solving complex math problems and adding new blocks of transactions to the chain.
Advocates of DeFi assert that the decentralized blockchain makes financial transactions secure and more transparent than the private, opaque systems employed in centralized finance.
How is DeFi Related to Ethereum? What are Smart Contracts and dApps?
DeFi is closely related to Ethereum and the cryptocurrency that incentivizes its use, Ether, which is second only to Bitcoin in market capitalization. That's because Ethereum was designed more as an infrastructure that enables developers to build decentralized applications, or dApps, on top of it, with these self-regulating "smart contracts" being coded to work on the Ethereum network. “Smart contracts” are programs running on the blockchain that can execute automatically when certain conditions are met. These smart contracts enable developers to build far more sophisticated functionality than simply sending and receiving cryptocurrency. These contracts self-execute when specific outcomes come to fruition. For example, you could create a contract with someone else that pays you one bitcoin if the Charlotte Hornets beat the Los Angeles Lakers, as revealed by the ESPN website. If the Lakers win, you would pay out one bitcoin.
The Bitcoin network, which was the first blockchain and emerged in 2009, was not built to facilitate smart contracts, although smart contracts that direct Bitcoin transactions can be coded. Ethereum, for its part, was specifically designed to include smart contract functionality. Since going live in 2015, it has become the most widely used blockchain in the world for precisely that reason.
How dApps and Protocols Are Currently Being Used
Traditional financial transactions: Anything from making payments, to trading securities and insurance, to lending and borrowing are already happening with DeFi.
Decentralized exchanges (DEXs): Right now, most cryptocurrency investors use centralized exchanges like Coinbase or Gemini. DEXs facilitate peer-to-peer financial transactions and let users retain control over their money.
E-wallets: DeFi developers are creating digital wallets that can operate independently of the largest cryptocurrency exchanges and give investors access to everything from cryptocurrency to blockchain-based games.
Stable coins: While cryptocurrencies are notoriously volatile, stable coins attempt to stabilize their values by tying them to non-cryptocurrencies, like the U.S. dollar.
Yield harvesting: Dubbed the “rocket fuel” of crypto, DeFi makes it possible for speculative investors to lend crypto and potentially reap big rewards when the proprietary coins DeFi borrowing platforms pay them for agreeing to have the loan appreciate rapidly.
Non-fungible tokens (NFTs): NFTs create digital assets out of typically non-tradable assets, like videos of slam dunks or the first tweet on Twitter. NFTs commodify the previously uncommodifiable.
Flash loans: These are cryptocurrency loans that borrow and repay funds in the same transaction. Here’s how it works: Borrowers have the potential to make money by entering into a contract encoded on the Ethereum blockchain—no lawyers needed—that borrows funds, executes a transaction, then repays the loan instantly. If the transaction fails to execute, or if the flash loan will result in a loss, the funds automatically go back to the lender. If you do make a profit, you can pocket it, minus any interest charges or fees. Think of flash loans as decentralized arbitrage.
Bitcoin Vs ETH: Ethereum is Booming
The price of Ether crossed the $3,000 milestone for the first time a few weeks ago, driven by the explosion of NFTs, or nonfungible tokens, and the DeFi market. A year ago, it traded at just $210.
The gains in Ether, the second-largest cryptocurrency by market value behind bitcoin, have accelerated even as bitcoin’s momentum has slowed. Ether gained more than 40% in April, while bitcoin fell about 2.4%.
Ethereum, launched in 2015 on the same concepts as bitcoin, is a platform for developers to build and operate apps, much like Android or iOS. Unlike those operating systems, which are owned by and controlled by Alphabet Inc. and Apple Inc., respectively, Ethereum is an open-source software project, which means no central party has control.
A rising number of DeFi applications built on Ethereum and growing institutional interest in the technology could be behind the rapid price rise.
“Thousands of developers are building applications that recreate traditional financial products in decentralized ways on top of Ethereum, and as more and more users pour in to interact with these apps, they require ETH (Ether) to conduct any transaction,” Sergey Nazarov, co-founder of smart contract network Chainlink, said.
“Second, there seems to be growing institutional interest in the public Ethereum blockchain, as stakeholders play around with ways to leverage the public network.”
The total amount of crypto held in DeFi protocols on Ethereum—a number referred to as “total value locked”—has skyrocketed to $68 billion, according to the website DeFi Pulse, from about $900 million a year ago.
Risks of DeFi
DeFi is an emerging phenomenon that comes with many risks. As a recent innovation, decentralized finance has not been stress-tested by long or widespread use. In addition, national authorities are taking a harder look at the systems it’s putting in place, with an eye toward regulation. Some of the other risks of DeFi include:
No consumer protections. DeFi has thrived in the absence of rules and regulations. But this also means users may have little recourse should a transaction go foul. In centralized finance, for instance, the Federal Deposit Insurance Corp. (FDIC) reimburses deposit account holders up to $250,000 per account, per institution if a bank fails. Moreover, banks are required by law to hold a certain amount of their capital as reserves, to maintain stability and cash you out of your account any time you need. No similar protections exist in DeFi.
Hackers are a threat. While a blockchain may be nearly impossible to alter, other aspects of DeFi are at large risk of being hacked, which can lead to theft or loss of funds. All of decentralized finance’s potential use cases rely on software systems that are vulnerable to hackers.
Collateralization. Collateral is a thing of value used to secure a loan. When you take out a mortgage, for instance, the loan is collateralized by the home you’re buying. Nearly all DeFi lending transactions require collateral equal to at least 100% of the value of the loan, if not more. These requirements vastly restrict who is eligible for many types of DeFi loans.
Private key requirements. With DeFi and cryptocurrency, you must secure the wallets used to store your cryptocurrency assets. Wallets are secured with private keys, which are long, unique codes known only to the owner of the wallet. If you lose a private key, you lose access to your funds—there is no way to recover a lost private key.
Transactions Costs. High transaction fees associated with smart contracts may impact the value of an investment adversely.
Environmental Impact. Like Bitcoin, Ethereum requires computers to handle the computations, known as "mining," and those computers require a lot of energy. An analysis from Cambridge University found mining for Bitcoin consumed more energy than the entire country of Argentina. Ethereum is second to Bitcoin in popularity, and its power consumption is on the rise and comparable to the amount of energy used by Libya.