Blockchain-powered cryptocurrency, with the emergence of bitcoin, is causing a boom. However, some years later, the need was felt to extend the functionality of blockchains beyond mere making transactions.
Blockchains like Ethereum took the initiative in this direction, making possible an array of financial operations – lending, borrowing, data analytics, asset management- through the P2P network.
And this led to a new dimension of finance.
Decentralized Finance, DeFi.
Origin of DeFi
While bitcoin started a decentralized way of making transactions, the first innovative application came with the launch of MakerDAO in 2017. MakerDAO is an Ethereum-based protocol that enables users to use a cryptocurrency that is pegged 1:1 with USD. This enabled users to borrow Dai stablecoin for Ether and engineered a way to take loans without any central authority. MakerDAO and Dai were the first building blocks of a permissionless financial system that paved the way for the DeFi ecosystem.
What is DeFi?
Decentralized Finance, DeFi operates on a decentralized peer-to-peer network, as in blockchain technology. It eliminates the need for any central or regulatory authority or intermediaries to conduct financial transactions. Instead, all the financial transactions are conducted over the blockchain platform, which records and maintains them in a distributed public ledger or databases. The members of that blockchain network can view all the records anytime from anywhere.
All that is needed is an internet connection to connect to the blockchain; that would help you lend, borrow or transact from anywhere. Besides, DeFi empowers you by offering wallets and trading services, thereby making you gain better control over your money.
How does it work?
Decentralized finance uses blockchain technology that powers cryptocurrency. For example, most DeFi applications operate on the Ethereum blockchain and use a feature called Decentralized applications – Dapps, which run on Smart Contracts.
Smart contracts execute automatically when certain predetermined conditions are met, and are composed of a set of statements or codes.
In a blockchain, transactions are grouped to form a ‘block’. Each block is verified by the nodes in the blockchain using a method called the consensus mechanism. Nodes must agree on the validity of a block; once a majority of them confirm, the block is closed and encrypted.
A new block is tagged in a chronological sequence with the information of all preceding blocks, forming what is called a “Blockchain”. The blocks are linked or chained in the process.
It is not possible to alter or edit the block without impacting the information in the previous blocks. This feature of blockchains makes them highly safe and secure.
DeFi applications carry out all operations, including lending, borrowing, and payments, in the above manner, ensuring high security.
Benefits of DeFi
As compared to the traditional fiat-currency system, DeFi offers several benefits. Some of these are discussed below:
- DeFi is permissionless. Anyone with a crypto wallet and access to an internet connection can use DeFi applications from anywhere. There’s no need to involve a bank or any intermediaries.
- Most DeFi rests on Ethereum, which is open source. As a result, anyone can view, audit, and develop code. Developers can connect multiple DeFi applications and design newer financial products. There’s no permission required.
- DeFi offers a high degree of security and transparency. Operating on blockchains, all transactions are recorded and maintained in a public distributed ledger, which cannot be altered by anyone. These records can be viewed by anyone in the network, adding transparency to the system.
- DeFi works on smart contracts which are highly programmable and allow including multiple conditions using an infinite number of variables.
- DeFi transactions take place in real-time. The underlying blockchain instantly updates as transactions occur, and also updates interest rates multiple times. These aspects make the experience hassle-free for the users.
Applications Of DeFi
DeFi offers a plethora of useful applications, some of which include—
- DeFi’s P2P lending and borrowing operate on blockchain, eliminating the need for intermediaries to build trust. Smart contracts enable parties to directly agree upon conditions.
- Decentralized Autonomous Organizations (DAO): DAOs are a key application of DeFi and smart contracts. As the name suggests, these are autonomous bodies, not controlled by a leader or hierarchy. Their operations, asset management, administration, and governance are all managed by decentralized apps and smart contracts.
- Asset Management: With DeFi, it has become easier for users to handle their assets. Buying, selling, and transferring assets digitally is possible. Moreover, users can also earn interest on their digital assets. In addition, blockchain uses only encrypted addresses, allowing users to avoid disclosing their personal information.
- Data Analytics: With decentralization and the emergence of blockchains, users are able to access data easily, well in advance. These data can be used to create meaningful datasets and draw actionable insights. DeFi projects like DeFi Pulse are tapping the potential of data analytics to use it to identify financial opportunities and enhance risk management strategies.
- Derivatives: One of the most amazing applications of DeFi is the tokenization of derivatives. Tokenization refers to assessing the value of a contract based on the assets underlying it. Since the value of the assets supporting it fluctuates, it is considered a secondary security.
Why is it important?
The primary objective of DeFi is to build an open, trustless, and permissionless financial market. Significant advancements are taking place, and DeFi space is still evolving. DeFi technology focuses on improving the efficiency of various financial operations, primarily in the trade finance domain. As DeFi matures and evolves, we must prepare ourselves to develop a reliance on its applications.
DeFi financial products
Peer-to-Peer (P2P) transactions are the central aspect of DeFi applications. Let’s take the example of loans. Say you need to borrow a loan. In a usual scenario, you would approach a bank or a lending agency, present your documents, check your validity, and so on.
On the flip side, in DeFi, you would use a Dapp and key in your loan requirements. Next, an algorithm would match your needs and find a lender for you. You would need to agree with the lender on the terms and conditions, which happens via smart contracts.
The blockchain would then record and maintain all of these transactions. You receive the loan amount once the consensus mechanism verifies. Finally, you make repayments in installments at intervals agreed between you and the lender.
Each time you use the Dapp to make payments, it goes through the same steps discussed earlier on the blockchain. This way, the lender receives the transferred funds.
This is just one basic example of DeFi application; however, this technology is also used for more complex financial operations.
DeFi technology uses cryptocurrencies to carry out transactions. However, it is still nascent; research work is going on to understand the dynamics deeper. One proposal is to prioritize the use of stablecoins for DeFi transactions.
Future of DeFi
DeFi is nascent; there are many aspects to investigate before it becomes fully functional. Laws are currently based on separate jurisdictions. However, with DeFi’s borderless capabilities, there arise several questions to ponder. Like, in cases of financial fraud across borders, who will investigate? Who will oversee the enforcement of regulations, and which governing bodies will enact them? Besides, there are concerns about system updates, hardware failure, energy consumption, and more. Despite its potential, DeFi still requires further development and attention to several aspects before it is ready for widespread use.
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