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 are a set of statements or codes that are executed automatically when certain predetermined conditions are met.
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. This means the nodes have to reach an agreement on the validity of a block, and when the majority of them confirm, the block is closed and encrypted.
A new block is then tagged in a chronological sequence with the information of all the blocks preceding it. Thus, the blocks are ‘chained’ or linked in the process, forming what is called a ‘Blockchain’.
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.
In DeFi applications, all operations – lending, borrowing, and payments- are carried out in the above manner, thus making them very secure.
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. As it operates on blockchains, the records of all transactions are maintained in a public distributed ledger and cannot be altered by anyone. Furthermore, these records can be viewed by anyone in the network, thereby imparting transparency to it.
- 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 blockchain underlying it is instantly updated as and when a transaction happens 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—
- P2P Lending and Borrowing: While the traditional financial system requires borrowers and lenders to involve a bank or third party to build trust, DeFi being decentralized and operating on blockchain obviates this need. Through smart contracts, the conditions can be agreed upon between the parties.
- 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. Apart from that, users are no longer required to disclose their personal details, etc., as blockchain uses only encrypted addresses.
- 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. It is regarded as secondary security as the value fluctuates based on the assets supporting it.
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.
Next, all these transactions would be recorded and maintained on a blockchain. 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. And this way, your funds are transferred to the lender.
This is just an example of a basic application of DeFi, while there is a multitude of complicated financial operations conducted using this.
DeFi technology uses cryptocurrencies to carry out transactions. However, it is still nascent; research work is going on to understand the dynamics deeper. A suggestion that’s been put forward is to focus on the use of stablecoins for DeFi transactions.
Future of DeFi
DeFi is nascent; there are many aspects to investigate before it becomes fully functional. At present, the laws are formulated 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? What regulations will be followed, and who will regulate them? Besides, there are concerns about system updates, hardware failure, energy consumption, and more. That said, DeFi is not ready for use, and several aspects have to be looked into before we embark on this journey.
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