One of the latest trends in the crypto industry is “DeFi,” which stands for Decentralized Finance. You’ve probably heard of this term, but if it still seems confusing, let’s break down what DeFi is and why it’s gaining momentum.
What is DeFi?
DeFi is short for Decentralized Finance, which refers to financial services provided without human intermediaries and without a central authority in control. Typically, these services are built using blockchain technology, which includes cryptocurrencies, stablecoins, and decision-making ecosystems.
The underlying idea behind DeFi is often referred to as Open Finance. It aims to grant every user full control over their assets and provide financial services to the 1.7 billion people worldwide who lack access to traditional banking.
This can be achieved by creating a new ecosystem of financial applications built on open-source software and utilizing decentralized networks. Such an architecture eliminates the need for any central controlling entity or intermediaries that profit from commissions.
The key difference is that services like currency exchange, transfers, insurance, and lending, which usually involve intermediaries such as exchanges or banks, are conducted directly between parties automatically in DeFi. This is made possible through programmable self-executing agreements known as smart contracts, which are encoded on the blockchain.
The most popular and fully functional DeFi network is Ethereum. It is a scalable open-source software platform that enables anyone to create decentralized applications (“dApps”) using smart contracts.
How DeFi Can Provide Financial Services to the Unbanked?
According to a recent World Bank study, over two-thirds of the world’s unbanked population owns mobile phones. Thanks to their devices, these individuals could gain instant access to DeFi platforms if this blockchain-based financial system becomes widely recognized.
One of the advantages of DeFi is that it can significantly reduce the costs associated with international (cross-border) money transfers. By conducting payments directly without intermediaries, over 50% of the expenses typically incurred in mediator fees can be eliminated. Additionally, DeFi can enable easy and fast access to credit without the need for a credit history.
In the coming years, the DeFi ecosystem may encompass all aspects of finance, not just transactions involving digital currencies, but also any digital assets like commodities or even real estate. This could act as a catalyst for the development of token economies.
What problems hinder the mass adoption of DeFi?
As with any new transformative movement, there are potential issues that need to be addressed before the technology can achieve widespread adoption. One of the challenges is that public blockchains may not be able to process a large number of transactions efficiently, especially in the event of widespread adoption of decentralized financial services.
Additionally, before DeFi can reach global acceptance, it needs to overcome significant developmental hurdles. Existing DeFi organizations currently operate independently in a fragmented market, and each country has its own distinct approaches to regulating operations involving digital currencies and blockchain.
However, once decentralized finance is prepared for mass adoption, it has the potential to resolve issues of financial accessibility and inclusion by giving control of financial assets from banks to users and becoming open to everyone.
What are some examples of DeFi?
DeFi is already a massive market. According to data from the analytical resource DeFi Pulse, the total value of assets locked in DeFi protocols exceeded $11.3 billion in October.
One of the most popular and operational projects in the DeFi ecosystem is MakerDAO. It is a decentralized finance platform governed by a decentralized autonomous organization (DAO) and operates on the Ethereum blockchain. Ethereum itself has over 103 million users, out of which 79,648 are unique users of DeFi services, even though their daily activity does not exceed 8,000 users. The total value of assets used in decentralized financial applications in the second quarter of 2020 surpassed $750 million in ETH.
Daily activity of DeFi users.
Moreover, through DeFi, users can already earn income on their savings in various digital assets. For example, the Compound service allows users to earn interest on deposits in DAI at an annual rate of 2.88%, and in Tether at 4.34%. Both DAI and Tether are stablecoins, with a value pegged to $1. The difference between them is that Tether, with a market capitalization of $16.4 billion, is backed by traditional dollars, while DAI is backed by cryptocurrencies. Currently, its market value is $953 million.
In addition to deposits, thanks to DeFi, people can also borrow dollars, euros, or other traditional currencies against the collateral of digital assets. They can also use DeFi to hedge their currency risks associated with fluctuations in digital currency exchange rates.
With the market already established, the next step is its integration into the traditional financial system. This will allow people to work with programmable payments, instant lending, and offer more opportunities for storing and growing their savings without the risks of bank failures, closures of specific financial institutions, or global financial catastrophes in any particular country.