Almost every aspect of banking, lending and trading is managed by centralized system, operated by governing bodies and gatekeepers. Consumers have to deal with a number of financial middlemen to get access to everything from auto loans, mortgages and stocks and bonds.
Decentralized finance challenges this centralized financial system by removing middleman or intermediaries entirely, thus allowing peer-to-peer financial transactions. We take a deeper look how decentralized finance has evolved and its role in the future.
Decentralized Finance Explained
Decentralized finance, commonly referred to as DeFi, is a rapidly emerging sector that promises to disrupt the traditional financial industry with blockchain-based tools and services. DeFi is a collective term for financial products and services that can access a public blockchain, such as Ethereum, for performing all kinds of financial activities.
With decentralized finance, there are no centralized authorities who can block or deny you access to anything any the markets are always open. As with any blockchain application related to crypto, decentralization means there is no centralized company we trust to provide customer service or protect our data/accounts. The responsibility rests on our own hands.The core purpose of DeFi is to offer a viable alternative solution to the centralized middleman-focused system.
How Does Distributed Ledger Technology Work?
Distributed Ledger Technology is able to cut out financial institutions and intermediaries by utilizing smart contracts on blockchains. The process looks like the following:
- A user initiates a transaction and signs it with its private key
- A block representing the transaction is created on the platform
- The transaction is broadcasted to the peers within the network based on any present criteria
- The peer users then validate the transaction
- After validation, it’s included in the block. At this point, the transaction is confirmed.
- The block gets added to the ledger and links itself to the previous block
Common Defi Use Cases
- Open Lending Platforms: simple decentralized applications that allow you to either lend your digital assets out to other users to earn interest or borrow digital assets from other users paying interest on top.
- Stablecoins: a stablecoin is a special type of cryptocurrency that is asset-backed. It allows users to peg the value of a digital asset to another asset in order to reduce volatility and keep the price as stable as possible.
- Decentralized Exchanges: a decentralized exchange is a peer-to-peer marketplace that connects cryptocurrency buyers and sellers
- Decentralized Insurance: decentralized insurance utilizes the power of blockchain technology and smart contracts to provide automated insurance claims, secured audits, and reduced paperwork
- Yield Farming: yield farming is a process that allows cryptocurrency holders to earn rewards on their holdings. An investor deposits units of a cryptocurrency into a lending protocol to earn interest from trading fees.
- Staking: This is the process of helping to participate in the network governance of Proof-of-Stake (POS) blockchains, by either delegating digital assets to a validator node or by simply holding these digital assets in a compatible wallet
- Wallets & Asset Management: Wallets and asset management applications allow individuals and businesses to safely secure their assets. ERC-20 compatible wallets are required so they can be connected to the wider DeFi ecosystem through a variety of asset management tools.
- Payments: Payment providers allow for the secure, scalable and instant transactions for individuals and institutions on decentralized networks.
Centralized Finance vs Decentralized Finance
One of the best ways to understand the benefits and potential of DeFi is to understand the problems that exist in traditional finance and compare it to the benefits of decentralized finance.
You hold your own money
Your money is held by companies
You control where your money goes and how its spent
Put trust in companies not to mismanage your money or lend to risky borrowers
Transfers of funds happen in minutes
Payments can take days due to manual processes
Transaction activity is pseudonymous
Financial activity is tightly coupled with your identity
DeFi is open to anyone
You must apply to use financial services
Is Decentralized Finance Secure?
Well, DeFi applications aren’t completely secure. In reality, no system can offer you 100% security. However, DeFi ensures that it offers a far more advanced security system compared to traditional monetary systems.
In reality, hacking these applications is highly difficult and quite tricky. As the system is distributed, cyber-criminals have to hack every single device using the application. This takes up a lot of resources and, in the end, not worth the effort.
The Potential Risks and Downsides of DeFi
Although there are numerous benefits to DeFi, it is also still an emerging phenomenon that comes with potential risks. Since it is a recent innovation, it has not been tested by long or widespread use. Additionally, national authorities are taking a harder look into the systems with consideration of implementing regulations. Some potential risks of DeFi include:
- No Consumer Protections: DeFi has been thriving in the absence of rules and regulations. This means users have little recourse should a transaction go foul. In a centralized finance system, banks are require by law t 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 Potential Threat: Although blockchain may be nearly impossible to alter, other aspects of DeFi are at large risk of being hacked, which can lead to funds theft or loss.
- Collateralization: Collateral refers to an asset that a lender accepts as security for a loan. For example, when you get a mortgage the loan is collateralized by the home you are buying. Nearly all DeFi lending transactions require collateral equal to at least 100% of the value of the loan. These requirements vastly restrict who is eligible for many types of DeFi loans.
- Private Key Requirements: With DeFi you must secure the wallets used to store your cryptocurrency assets. Wallets are secured with private keys, which are long and unique codes known only to the owner of the wallet. If you lose a private key, you are at risk of losing access to your funds as there is no way to recover a lost private key
Exemplar Blockchain and Decentralized Finance Experts
Exemplar Companies blockchain and decentralized finance experts can assist in the following areas
- Smart contract auditing and formal verification services: To ensure there are no code vulnerabilities and its hack proof.
- CeFi (Centralized) crypto services currently outnumber DeFi due to true consumer protection and insurance – Exemplar can be a domain expert of CeFi services, however as DeFi tech matures, can aid existing CeFi companies/services and new projects to replicate CeFi processes in a decentralized fashion.
- Successful DeFi apps need expertise in traditional banking and financial institutions to aid developers to replicate functionalities (i.e. compliance processes, collateralized lending design and risk management, financial modeling, fund management fiat/multi-currency etc.)
- Design public policy, education, and legal advocacy for DeFi
- Provide professional/expert review of DeFi Lending Platform designs – how are they collateralized, risk of run-on’s give them rating like bonds etc.
- Promote DeFi passive income opportunities such as yield farming and lending and help clients with tax strategy from such income. And using these opportunities as a safe low risk on-ramp to get into crypto.
CEO, Exemplar Companies, Pbc.
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