What is decentralized finance?
decentralized finance , from English Decentralized Finance (DeFi), is an ecosystem that attempts to recreate traditional finance products and services using blockchain technology.
To be more precise, it is an environment in which the usual financial operations are not subordinated by the intervention of any financial institution which would act as a trusted third party.
How is it different from traditional finance?
DeFi differs from traditional finance in two main aspects: technology and human-related properties.
This includes in particular the type of currency, the ownership of the goods, the security authorities and the communication interfaces with these authorities.
- Currency : in the DeFi universe, cryptocurrencies replace FIAT currencies such as the euro or the dollar. In addition, while FIATs are issued by central banks, it is here the blockchain protocols that take over. In the case of Bitcoin (BTC), for example, assets are generated to reward computers that perform financial transactions.
- Goods : in reality, transactions involve goods of the same nature as for traditional finance. However, on the blockchain, these goods take the form of tokens. Through a process of tokenization , a piece of land – for example – becomes a public key whose owner is the only one to have the private key (title deed). This public key is unique, so it can only belong to one person.
- The trusted third party : DeFi eliminates financial institutions in favor of smart contracts (smart contracts). These are computer programs that run automatically when one or more of the conditions they contain are met.
- Interfaces : decentralized applications (dApps) allow you to interact with the blockchain to access financial products and services. They have the particularity of not being hosted on a central server, contrary to what is generally observed. They are installed on peer-to-peer (P2P) computer networks. This makes it possible to regain control of the data from banks and other centralized institutions.
In human terms
DeFi offers consumers the following guarantees:
- control over money : there is no central entity to arbitrate exchanges. This means complete freedom to send as much money as you want to whoever you want. However, this also implies that the responsibility for the management of their funds rests with them. For example, if funds are sent to a certain recipient by mistake, no entity can intervene to allow the funds to be returned.
- transparency : DeFi is a space where there is a climate of trust, because all transactions are visible to everyone. However, there is a minimum of confidentiality which is provided by the establishment of pseudonymous systems. Some cryptocurrencies go further by offering anonymity of transactions, however, they are still not widely used.
- finance for all : banks are essentially in search of profit. For this reason, they only nest in geographic areas where cash flows are important. Thus, places which do not respect this parameter are excluded. DeFi allows everyone to create or use a service of this type as they wish and regardless of their location.
What are the fields of application of traditional finance?
As mentioned above, DeFi is a translation of the existing financial context. However, that does not prevent him from going beyond.
These are cryptocurrencies backed by a fiat currency, such as Tether (USDT) which is backed by the US dollar (USD). Stablecoins retain the programmable aspect of digital currencies while excluding their volatile side.
Some stablecoin projects even aim to become decentralized reserve banks – like Maker (DAI).
Loans and borrowing
Loans are one of the most popular services in the banking industry. Unlike banks, DeFi apps allow borrowers to lend as much money as they want in the form of cryptocurrency.
The only thorny point is that you have to have more than the desired amount so that creditors can have a repayment guarantee.
There is also the notion of interest rate with DeFi, because those who borrow money expect to receive financial compensation.
Decentralized exchanges (DEX)
These are marketplaces where you can exchange cryptocurrencies you own for others.
To keep the market from running out of cash – which happens when a crypto asset is in high demand, but no one has it or wants to convert – DEXs use cash pools.
They are like vaults where cryptocurrency holders deposit the assets they want to get rid of. These are then locked and each time someone wants to make an exchange, the safe of the desired currency is debited and that of the currency to be exchanged is credited. These movements respect a monetary balance balanced in dollars.
Besides the three main uses mentioned above, DeFi has other uses such as synthetic assets, predictive markets, yield farming, insurance, cryptocurrency custody.
What are the challenges of DeFi?
As we can see, decentralized finance is full of opportunities. However, some of these characteristics contain properties within them which can be destructive to it.
The fact that it is accessible to everyone can also be a major obstacle, because all projects, even the most bizarre, find their place there. This usually results in colossal losses for investors.
There is also a slowness issue that is noticeable when using related apps. In addition, the saturation of the ecosystem makes orientation difficult.
For massive DeFi adoption, user comfort is key, but for now we’re a long way from it. It is essential that developers take all these constraints into account so that the processes are optimized.
Decentralized finance is revolutionizing all aspects of conventional finance. However, it must also be vigilant if it intends to compete with the latter on a global scale.
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