What is Decentralized Finance (DeFi)?
Some of the initial mainstream conceptions of decentralized finance (DeFi) took hold following the 2007-2008 Global Financial Crisis as skepticism and eroding trust regarding intermediaries and financial institutions spread like contagion. With such a sentiment and awareness in place as kindling, the explosion in popularity of blockchain technology and cryptocurrencies served as fuel for the DeFi fire. Today, the industry continues to garner support from investors, particularly venture capitalists, as well as consumers and enterprises through growing application adoption and development.
DeFi represents the technologies and services that enable and facilitate financial transactions and decentralized exchanges without the need or use of an intermediary or third-party, such as a bank or financial institution used in traditional finance. DeFi technology provides entities with the ability to conduct secure, independent, and efficient peer-to-peer (P2P) transactions and payments through the use of blockchain and related technology. The suite of products and services falling within the DeFi umbrella is designed to operate in a trustless and open manner, providing not only transparency but also an immutable ledger that securely records all activities.
Why is DeFi important?
The supplantation of traditional centralized finance by DeFi carries significant and meaningful implications for both enterprises and consumers, given many of the underlying characteristics and features of such technologies and DeFi platforms.
By virtue of being decentralized, DeFi products, services, and activities are controlled by a network of multiple users, rather than by a single centralized entity. This structure serves to produce secure and transparent financial activities, given the lack of a single managing entity and the lack of a single point of attack or compromise that can be present in traditional financial systems.
The absence of an intermediary for a decentralized exchange can also contribute to enhanced transactional speed and greater personal data ownership. In a peer-to-peer payments environment, there is no third party to facilitate or collect data on any of the engaging parties and, as a result, there is no subsequent third-party fee associated with transacting; yielding a more efficient and private process for consumers and organizations.
Another benefit conferred by DeFi is the improved accessibility and reach afforded by such financial technology. Entities can engage in transactions and activities with one another without the need for a bank account at a local bank or any other authority permission from centralized financial institutions. The accessibility of DeFi and blockchain technologies allow anyone with a smartphone or computer to transact, serving to simultaneously expand the reach of enterprises and have financial services directly.
Control and flexibility are two important characteristics associated with DeFi solutions. Not only can individuals and entities structure transactions more freely when compared to transactions involving centralized institutions, but they can also leverage smart contracts to fulfill a variety of functions and decentralized exchanges. DeFi's smart contracts can be programmed to execute a wide array of actions automatically – such as transferring funds or executing a purchase once certain conditions have been met – without any additional involvement or action from centralized financial institutions beyond the engaged parties.
What are some of the current and tangible DeFi approaches and applications?
Although still relatively nascent, many of the most adopted and employed DeFi projects and solutions are designed to accomplish and run in parallel to traditional financial activities, engagements, and transactions. Some of the more prominent technologies that come together to form the basic functions and infrastructure for the DeFi ecosystem have been outlined below:
Digital wallets enable the storing and accessing of digital assets, such as digital currency. They allow individuals and businesses to connect to various applications and marketplaces to participate in activities, engage other parties, and conduct financial transactions.
Marketplaces and decentralized Exchanges
These platforms are operated as DeFi hubs, in which users can engage in peer-to-peer payments involving funds, digital assets, collectibles, or any other good or service without the need for a centralized financial system. Marketplaces and exchanges can also incorporate smart contract functionality, allowing for the automatic completion of certain actions and complex financial transactions once stipulated conditions have been satisfied.
Smart contracts are self-executing contracts with the terms of the agreement between buyer and seller being directly written into lines of code. They are considered "smart" because they can automatically execute the terms of the contract when certain conditions are met, without the need for intermediaries.
In the context of DeFi, smart contracts are used to automate and enforce the rules of financial transactions on a blockchain network. They can be used to create decentralized versions of traditional financial products, such as loans, derivatives, and insurance, without the need for a traditional financial institution as intermediary.
Payments & financial transactions
DeFi payment systems serve as the infrastructure that facilitates decentralized transactions across systems, blockchains, and decentralized applications. They allow for communication between technologies and provide the means for building and enabling scalable transaction capabilities, efficient settlement, and payment conversion.
Tokenization represents the process of securitizing digital assets or services for representation on a blockchain. With tokenization technologies, entities can transform tangible and intangible assets into representative digital tokens that can be traded or transacted. Goods and services that have been tokenized also provide an immutable record of ownership that is securely documented on the blockchain.
DeFi banking utilizes blockchain technology and digital ledger systems to decentralize financial services, such as lending, borrowing, and investing. These peer-to-peer banking solutions are aimed at providing greater transparency, security, control, and ownership over financial assets.
Although DeFi technologies have enjoyed largely strong investor support and growing adoption, the industry has experienced some souring as of late due to the volatility, uncertainty, and concerns taking root in the cryptocurrency market. Despite the promises of increased transactional efficiency, security, flexibility, and transparency, the industry will need to overcome contagion and headline concerns, as well as practical concerns such as reliability, feasibility, and integration.
In the face of such headwinds, in order to maintain growing scale, application, and enterprise adoption, DeFi actors and segments will need to demonstrate the ability to create DeFi protocols and to reliably replace traditional financial activities and transactions while consistently delivering relatively more efficient, economical, and aligned solutions.