What is Decentralized Finance and What’s It Good For?
“We can imagine a financial industry with an entirely new infrastructure running on smart contract-based protocols.” Current users will for the moment need to be careful when using DeFi.
DeFi, or decentralized finance, is one of the biggest things in the blockchain and cryptocurrency industry right now, and it does pretty much what its name suggests. That is, it uses blockchains, smart contracts and/or cryptocurrencies to deliver financial services to customers, be these loans, payments, remittances, derivatives, or investments.
But even with the growing number of real-world examples, decentralized finance still has a long way to go before it will reach the scale of legacy financial systems. Meanwhile, current users will for the moment need to be careful when using DeFi platforms and services, since much of the technology involved is can be fairly unforgiving for the uninitiated user.
What is DeFi and what’s it for?
“DeFi” might sound a little opaque to newbies, but good examples of decentralized finance will already be familiar to most people who follow crypto.
For one, there’s decentralized lending. MakerDAO provides perhaps the most well-known example of this, with users able to receive loans of its DAI stablecoin if they deposit enough Ethereum. Other examples include Dharma, which lets users borrow and lend Ethereum without needing a bank account or credit score, and also SALT, which lets people receive loans in fiat by using their crypto assets as leverage.
Next, there are also decentralized payment services. Ink Protocol and its payment and reputation system for P2P marketplaces provide one example of this, while Request and its open network for transaction requests provides another.
Then there are a variety of decentralized exchanges and liquidity providers. The Bancor Network is one of these, given that it lets users trade cryptocurrencies directly with each other, while the Kyber Network provides a similar trading service via token swaps.
Related to this, there are also decentralized prediction markets and decentralized investment platforms, such as Allinfra, which lets people invest in infrastructure and environmental assets. Another is Melonport, which is building an autonomous system for crypto-asset management.
And as Melonport CEO and co-founder Mona El Isa tells Cryptonews.com, decentralized financial systems and services offer a number of advantages over their centralized counterparts.
She adds, “Some of these include: secure self-custody financial solutions (the Binance hack was a great reminder of why it’s important to control your own crypto assets), almost-immediate settlement, full transparency, non-disputable property rights, easy issuance and distribution of assets, and peer-to-peer tradability.”
In other words, decentralized finance creates the possibility to transfer power away from centralized institutions and to individual users, who thanks to the use of DeFi platforms will have more control over their own wealth, as well as a heightened ability to dispose of this wealth as they see fit.
As El Isa elaborates, DeFi effectively does the same thing for finance that Bitcoin does for currency: cuts out the middlemen. And in the context of finance, the ability to provide infrastructure and services without people in the middle should yield massive savings and efficiencies.
“The financial services industry typically encompasses several financial intermediaries to ensure price correctness, fairness, finality, settlement, regulatory, operational and administrative reporting duties around trading assets,” she says.
“With crypto, you get a digital asset universe that introduces the possibility to code all of these ‘services’ into smart contracts with the enforceability guarantees of decentralized blockchains like Ethereum. This means that we can imagine a financial industry with an entirely new infrastructure running on smart contract-based protocols such as Melon, Ethfinex, Kyber Network, MakerDAO, dYdX, and others.”
Challenges and the future
But while DeFi has already made considerable progress and already shows much promise, it’s still very much in an early stage of development as a sector of the wider crypto economy.
For example, the recently launched DeFi.Review website tracks the biggest decentralized finance projects and platforms. In terms of assets locked up in the corresponding system, MakerDAO is the biggest DeFi platform, with approximately USD 346 million locked up, while EOSREX – a platform for EOS lending – is the second biggest, with roughly USD 296 million in assets.
However, after these two platforms there’s a substantial drop in the amount of money locked up by the next biggest service, which is Compound (an Ethereum lending platform) with USD 32 million in assets.
What this shows is that the DeFi sector is still decidedly underdeveloped, and one consequence of this is that users need to exercise a heightened degree of caution when using certain platforms.
“If you lose your key, that’s it and the DeFi system is unforgiving to innocent mistakes with its lack of reversibility,” says Mona El Isa.
“The danger is entering a DeFi system at this still very early and experimental stage without fully understanding the risks or the technology and suffering a loss as a consequence. Technology is still user-unfriendly and prone to vulnerabilities, until security tools are improved and protocols are more battle-tested.”
Despite this warning, El Isa is, like many other people within the DeFi sector, confident that it will “continue to expand.” That said, she expects that “it will take several years before it gathers any real traction and market share as a proportion of total global assets.”
The reasons for this delay are all familiar, relating to the need to sort out scalability, regulation, privacy and liquidity. But crypto and the wider world can expect that, once these challenges are all resolved, DeFi will deliver on its promise of making finance more accessible – and more empowering – for more people.