Decentralized finance or DeFi is a solution based on blockchain technology that seeks to offer open and flexible solutions as an alternative to the financial system. The main objective is to make conventional financial elements gain in transparency, ease of use and decentralization.
What is DeFi
It is the name given to the ecosystem of financial applications that is being built on the Ethereum blockchain and other cryptocurrencies. DeFi (Decentralized Finance) seeks to create a financial ecosystem radically opposed to the current one, based on open source, free access (permissionless) and totally transparent.
Basically, DeFi is nothing more than smart contracts, lines of code that establish a series of actions and conditions. Smart contracts are executed within the blockchain of a cryptocurrency. Currently, the Ethereum blockchain is the most widely used for creating smart contracts, in general.
DeFi eliminates the need for trusted third parties and intermediaries, eliminates paperwork and generates a secure and agile decentralized finance system.
Origin of DeFi
To find the origin of DeFi we must take a short trip back in time to 1995. It was in this year when Nick Szabo, an American cryptographer and computer scientist, laid the foundations of smart contracts. A solution that later served for the development of Bitcoin and many other things. We could even say that the first DeFi developed is Bitcoin.
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The problem is that Bitcoin smart contracts are difficult to program and have limited capabilities. Ethereum is precisely what comes to solve this problem, allowing the creation of smart contracts in a much simpler and richer way. It is precisely Ethereum’s ability to support more complete smart contracts that has led to the development of different types of solutions, including DeFi.
The first DeFi solutions are liquidity markets, lending systems and decentralized exchanges. These first solutions based on smart contracts start to be developed between 2018 and 2019, with an exponential growth of DeFi solutions in early 2020.
What are the characteristics of DeFi?
Let’s see what the most important features of the decentralized finance ecosystem are:
- Non-manipulable: being integrated within a blockchain ensures that no misuse or manipulation in favor of one of the parties can occur. Once the smart contract is deployed on the blockchain, it cannot be altered, or at most deleted if the function is enabled.
- No third parties: Its operation does not require reliable third parties to verify what is happening. The operation is verified by the blockchain itself, more specifically by the mining nodes and validators.
- Security: cryptography and consensus rules of a blockchain add an additional security element. That all nodes keep a copy of the smart contracts (since they keep a copy of the blockchain) eliminates the possibility of tampering.
- Accessible: One of the characteristics of DeFi is that it is accessible to everyone from anywhere in the world. This allows people who are not allowed or cannot access conventional financial systems to have access to a more flexible and agile economic system.
- Transparency: Any transaction in DeFi is easily audited thanks to the fact that they are based on blockchain technology. All movements can be seen.
- Decentralization: As they are stored in the blockchain, their operation is decentralized, not governed by the rules of countries or governments. The operation of these is autonomous and automated, once deployed.
- Open source: DeFi is based on open source code, which allows anyone to read it and verify that it does not have security problems. Additionally, this code can be downloaded, used and modified for other applications.
Possible DeFi use cases
Within the DeFi ecosystem we find open lending which is quite popular. This mechanism of decentralized borrowing and lending has advantages over conventional credit systems. Instant settlements of transactions, greater ability to collateralize different digital assets, the removal of credit controls and possible future standardization can be added.
As this lending system is based on a public blockchain, the amount of trust required is reduced by relying on cryptographic verification methods. Lending markets embedded in blockchain technology reduce counterparty risks. They also make borrowing and lending cheaper, faster, and more widely available.
Money banking services
One of the solutions that can be developed in DeFi is the issuance of stable coins, mortgages, and insurance. These money banking services are one of the possible uses of these decentralized finances.
Interest in stable coins has grown quite a bit, as these are fixedly matched to the price of a real asset. An example would be the USDC, a stable coin whose unit is worth $1 (1 USDC = 1 US dollar). These currencies protect holders from the abrupt fluctuations that can occur with cryptocurrencies, even being adopted for everyday use as a method of payment.
They can also be used to obtain mortgage loans, which are often complex, expensive, and slow. DeFi can create smart contract solutions that reduce the time, cost, and complexity of obtaining these types of loans.
The creation of decentralized exchanges (DEX) is one of the first DeFi solutions developed and the one with the largest number of developed projects. These platforms allow users to exchange tokens and cryptocurrencies that are operating within the same blockchain. For example, a DEX within the Ethereum blockchain allows to exchange ERC-20 tokens with each other and with ether (cryptocurrency of the Ethereum blockchain).
Typically, DEXs have very low or no commissions when it comes to exchanging between tokens. This is one of the strengths they have over centralized exchanges, which usually charge “high” fees for each transaction.
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