The promise of cryptocurrencies is to make money and payments universally and democratically accessible to everyone, no matter where you are in the world.
Decentralized Finance (DeFi) or the Open Finance movement aims to take this promise exactly one step further. That is, imagine a global and open infrastructure where all the traditional financial services you use today – deposits, loans, trading, insurance and much more – are accessible worldwide by anyone with a smartphone and internet connection.
Over the past 2-3 years, Decentralized Finance has become one of the fastest growing areas in the blockchain and cryptocurrency world, both in terms of number of users and monetary value invested. Much of this growth has been built on the Ethereum blockchain.
DeFi is not a new concept; it was coined by individuals and institutions that have spent years analyzing the traditional financial structures of today to identify problems in traditional systems and then take steps to solve them.
We can summarize the main problems in traditional financial systems as follows:
- Low “Fault Tolerance” of centralized structures (Need for Decentralization)
- High barriers to access to National and International Alternative Financial Instruments (Technology & Need for Personal Finance)
- Eternal control of intermediaries and third-party institutions over our financial assets is risky (The Need for Financial Freedom)
Since 2016-2017, DeFi products make economic and financial instruments publicly available outside central authorities and without corporate governance systems. First, without going into more detail about DeFi, we would like to dispel a few common misconceptions here.
DeFi does not represent any cryptocurrency or value. DeFi represents a movement just like “Open Banking” or “Open-Source Code”. Projects or platforms built on centralized blockchains can market themselves as DeFi applications. They can access financial instruments offered on DeFi, such as earning interest or borrowing money. However, the fact that they offer these services is in no way a guarantee that they belong to the DeFi space or that they are secure. Centralized Finance = CeFi (Celcius, Nexo, Blockfi, etc.)
What is DeFi?
For an apt to be considered “DeFi”, ideally you should be able to answer “yes” to most or all the following questions:
- Does the app provide a financial service, as we can see in traditional markets (swaps, interest, loans, funds, etc.)? Does the service benefit us?
- Do I need a non-custodial wallet to connect to the app (Metamask, Argent, Trust, etc.)?
- Do I have 100% control of my funds using this wallet (Personal Finance)?
- When connecting to the app, do I avoid contact with any intermediary person/institution by trading only through smart contracts (Financial Freedom)?
- Can I use the app without having to do KYC (Know Your Customer) procedures?
- There are no regional restrictions for use, right?
DeFi Protocols and Applications
The biggest differences of Decentralized Apps (DApps) from centralized apps:
- Our funds are always under our control and we ask for permission to invest in any app via a non-custodial wallet.
- One of the biggest differences from centralized apps is that the app (platform/protocol) runs on a completely decentralized blockchain, meaning that it is not controlled by any central entity. In this case, the administrative tasks that we call managers in traditional finance are delegated to smart contracts, i.e. code.
- All transactions are finalized, meaning they cannot be changed by anyone, and can be transparently tracked by everyone.
Apps, in the DeFi whirled, allow us, the users, to invest in financial instruments (earning returns, lending, insurance) that are completely under our control and without the need for any intermediaries.
Decentralized Finance aims to offer financial democracy and freedom by eliminating the risks of intermediaries and centralized systems that we are used to, as well as providing advantages such as drastically reduced costs.
DeFi Use Cases:
The prices of cryptocurrencies can jump as much as 10% per day, and stable cryptocurrencies based on fiat currencies have emerged to prevent these fluctuations. For example, USDT is a stable coin indexed to the Dollar, and there is always 1 Dollar behind 1 USDT. In general, stable cryptocurrencies make DeFi protocols and dApps more accessible to individuals by providing a stable unit of financial value.
Example: USDC, Dai
Decentralized Borrowing and Lending:
In traditional financial markets, individuals must apply to financial institutions and obtain approval through various procedures to borrow money or receive passive income. In the world of decentralized finance, users can start earning passive income or borrow money by pledging their digital assets as collateral, completely person-to-person and without the need to trust any intermediary institution. And they can do all this in a matter of minutes over the internet, without any minimum amount or maturity period.
Example: Aave, Compound, Maker
Decentralized Exchanges (DEX):
People need exchanges to trade their cryptocurrencies. Although cryptocurrencies are often thought of as a decentralized system, the largest crypto exchanges in the world are centralized. In addition to contradicting DeFi’s starting point, this centralization puts users’ crypto assets at risk. However, with intermediary-free DEXs like Uniswap, users have full control over the exchange of their crypto assets.
Example: Uniswap, Balancer, Kyber Network, Venice Swap.
Fund management is the process of managing cash flow to ensure control of the return on your investments. There are two main types of fund management: active and passive fund management. Active fund management has a management team that makes investment decisions to deliver returns above a specific index, such as the S&P 500. A passive fund does not have a management team but is designed to mimic the performance of a particular benchmark as closely as possible.
In DeFi protocols, some projects have started to allow active and passive fund management to be done in a decentralized way. The transparency of decentralized finance makes it easier for users to monitor how their funds are managed and understand the cost they will pay.
Example: TokenSets, Idle Finance, Yearn Finance
One of the greatest value propositions of cryptocurrencies is the ability to make payments between two people completely decentralized and without the need for trust. With DeFi protocols, hourly, daily, weekly or monthly payments can be made transparently and securely through smart contracts.
Example: Sablier, xDai, Yearn Finance
Insurance is a risk management strategy whereby a person receives financial protection or reimbursement against losses from an insurance company in the event of an unfortunate event. It is common for individuals to purchase car, home, health and life insurance.
All cryptocurrencies locked in smart contracts are potentially vulnerable to smart contract vulnerabilities. While the code of most projects has been audited, we never know if smart contracts are truly secure and there is always the possibility of a hack that could result in a loss. The need to purchase decentralized insurance is an important consideration due to the risks involved, especially if there are large amounts of funds in DeFi protocols.
Example: Nexus Mutual, Opyn
The DeFi movement represents the finance of the future. While this may seem controversial, we have summarized why we think this is the case in this article. At the beginning of 2020, the total value locked in DeFi apps was $1 billion, but before the end of this year, this important milestone had risen to $10 billion. In other words, this total amount locked on the internet is now the building blocks of an entirely new decentralized financial system of programmable money stored in smart contracts.
Perhaps most importantly, this future is accessible to everyone. If people are connected to the internet, they can benefit from this ecosystem anywhere and anytime. This is DeFi’s strength in accessibility and scalability.