Why Decentralized Finance (DeFi) is Revolutionary
Decentralized finance (DeFi) is one of the areas in crypto that has received notable traction. At a high level, DeFi aims to re-create the financial system that we use today but in a way that removes the need for intermediaries like banks. Bitcoin, which most readers will probably be familiar with, laid the foundation for this movement by creating a censorship-resistant currency that can be transacted between users without the need for an intermediary.
Ethereum: More than a currency
Ethereum, which came a bit later extended these trust properties to a broader range of use cases by introducing so called “smart-contracts”, which allow developers to create new tokens and currencies on top of its network, as well as building applications that move these tokens according to pre-specified rules.
The main building block of this network is the Ethereum Virtual Machine (EVM). Each computer participating in the Ethereum network runs this Virtual Machine, which ensures that the code of these smart contracts gets executed correctly. This makes these applications extremely resilient compared to traditional web applications where the code only runs on the web servers of a single company.
Smart contract applications can be accessed by anyone in the world and even though they are not managed by a company in the traditional sense, users can trust that these applications will do and behave exactly like they promise. For developers, Ethereum is a magic playground because existing smart contracts residing on the chain can be re-used as building blocks for their own application. Imagine you could use Facebook’s codebase, extend it with some extra features and build your own social media network interface without having to go from scratch. That’s Ethereum in a nutshell. Lastly, once these contracts are deployed to the Ethereum Blockchain, they are ‘immutable’ meaning that they can’t be arbitrarily taken down or censored because they live on thousands of computers simultaneously.
So what is Decentralized Finance?
The promise of the DeFi space is that, using these financial primitives a new kind of financial system can emerge. One that will be global, transparent, fair and open for anyone to use and build upon. A shared infrastructure like the internet but for value- instead of information exchange.
Let’s look at a few examples of services traditionally offered by banks being replicated on crypto networks.
- Stablecoins & Payments
Stablecoins are Blockchain tokens whose value is pegged to a fiat currency most commonly the US Dollar. Because of the strong worldwide demand for US Dollars, the Ethereum network is increasingly used as a payment rails to send dollar tokens to anywhere in the world. Unlike bank accounts, crypto wallets, to store and receive these tokens, can be downloaded by anyone. The monetary base of all stablecoins has increased to over $11 billion dollars in the last couple of months. The most popular stablecoins are Tether, USDC and DAI and they are used for a broad range of use cases from e-commerce payments to remittances and trading.
- Borrowing & Lending
Lending and borrowing cryptocurrencies is becoming an increasingly important sub-sector of the crypto industry. Users can deposit their crypto into a crypto savings account and earn interest like in a traditional bank account. However, these crypto saving accounts work very differently than bank accounts. Compound, the most popular peer-to-peer lending protocol, is effectively a liquidity pool consisting of a set of smart contracts. Users can either deposit cryptocurrencies into the liquidity pool and earn interest or borrow from it and pay interest for the borrowed funds. To borrow, users must deposit a sufficient amount of cryptocurrency as security in order to minimize the credit risk for the lenders. Once borrowers decide to close their loan, they receive their posted collateral back.
Interest rates for borrowing and lending are set algorithmically by the protocol according to supply and demand. The whole process of borrowing and lending is made extremely easy by wallets such as Argent or Dharma who have integrated Compound and unlike bank accounts these services are available to anyone in the world.
- Decentralized Exchanges
You may know cryptocurrency exchanges such as Coinbase and Kraken or stock exchanges like Nasdaq or NYSE. These exchanges operate order books which allow users to trade. However, to do so users first need to sign-up for a brokerage account (if you live in the right country) and leave their funds in the brokers custody with no direct control over them. Moreover, it’s very hard for new assets to get listed on these exchanges. Decentralized exchanges such as Kyber Network or Uniswap allow users to swap cryptocurrency assets by using smart contracts to eliminate the need for an intermediary. Users can for example trade USDC tokens for Ether from within their crypto wallet while keeping full ownership of their funds. Because these exchanges are decentralized, developers can submit new assets without any paperwork. Decentralized exchanges are perfectly suited for trading crypto native assets and will become important infrastructure as securities and bonds issuance will increasingly shift to crypto networks.
Conclusion
The magic with decentralized finance is that it is global by definition and it can be used by anyone in the world with a smartphone – even by the 1.7B people without a bank account. DeFi applications are powered by open-source code which is auditable for anyone.
While it might not be obvious to every Western reader our current financial system is far from being perfect. Decentralized finance brings access to stable currencies and sound investment opportunities to every corner of the world. Even in countries which try to enforce capital controls, such as Venezuela or Argentina, users can easily use crypto to circumvent controls. Crypto allows financial sovereignty and that’s why the crypto community is excited about DeFi.
Emanuel Coen, Founder Cryptotesters.com
Twitter: https://twitter.com/litocoen
LinkedIn: https://www.linkedin.com/in/emanuelcoen/