Decentralized finance (DeFi) refers to an ecosystem of financial products that do not rely on traditional financial intermediaries such as banks and exchanges. Central to the success of decentralized finance is smart contracts, which are deployed on Ethereum (contracts that two parties can deploy without an intermediary). DeFi also gave rise to dApps (decentralized apps), giving developers the ability to build applications on top of the Ethereum blockchain.
Understanding decentralized finance
Decentralized finance is as much a philosophy as it is a way of doing business. Indeed, DeFi advocates a transparent financial ecosystem that is open-source, available to everyone, and operates without a central authority.
Central to the success of decentralized finance is the use of smart contracts, which are deployed on Ethereum. Smart contracts avoid the need to involve traditional intermediaries, who often charge exorbitant fees to facilitate financial transactions. Decentralized finance provides these same services in a faster and cheaper way that is also more secure.
Smart contracts also give developers increased functionality. Instead of simply building programs that send or receive cryptocurrency, smart contracts can be used to build programs on the blockchain that execute when certain conditions are met.
These programs are now commonly referred to as decentralized apps, or dApps. Collectively, dApps comprise a DeFi ecosystem.
The core components and criteria of dApps
To understand DeFi it is important to first understand dApps.
Structurally, a dApp consists of:
- A front-end interface – such as an app or website.
- A smart contract – or a program that facilitates online transactions autonomously according to programmed rules. Smart contract code can be audited to verify that it is bug-free and non-malicious.
- The Ethereum blockchain – which ensures that the smart contract cannot be hacked or otherwise tampered with. It’s also important to note that a fee (calculated in ETH) is charged to the user every time a smart contract is utilized.
The dApp architecture is also characterized by four criteria:
- It must be entirely open-source. No entity must own the majority of tokens and protocol changes must be decided via network user consensus.
- Data must be stored on a decentralized blockchain.
- Each dApp must generate tokens acting as proof of value.
- Tokens must be distributed as rewards on the network.
Potential applications of decentralized finance
In theory, the applications of decentralized finance are limitless.
Having said that, here are a few of the most salient:
Monetary banking services
Monetary banking is an obvious use, but one that is maturing through the creation of stablecoins. These coins are a type of crypto-asset, usually pegged to a real-world asset such as fiat money or exchange-traded commodities.
Decentralized stablecoins help mitigate the volatility seen in cryptocurrencies, allowing them to be used as a form of cash without the need for a central authority. Stablecoins might also be beneficial in processes that require many intermediaries, such as mortgage or insurance applications.
Borrowing and lending
DeFi has several advantages over the traditional credit system of borrowing and lending. These include the ability to collateralize digital assets and provide instantaneous settlement. DeFi also negates the need for credit checks and through standardization, can make the process more efficient.
For the lender, blockchain reduces the risk of default. Lenders can also offer cheap and fast services to a broader audience of borrowers.
Some argue that decentralized marketplaces offer the most room for DeFi innovation.
This is most applicable to decentralized exchanges (DEXes), which allow users to trade digital assets without requiring the exchange to hold their funds.
Platforms that issue security tokens, for example, may give users the tools and resources necessary to launch tokenized securities on the blockchain. The same might also be possible for derivative, futures, and synthetic asset markets.
- Decentralized finance is a suite of financial products and services that operate without a traditional intermediary such as a bank or exchange.
- Decentralized finance is based on decentralized apps, or dApps. Each dApp has a user interface and smart contract based on the Ethereum blockchain.
- Decentralized finance has the potential to revolutionize monetary banking services, borrowing and lending, and traditional, centralized marketplaces.
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