A closer look at decentralized finance (DeFi)
Central to cryptocurrency’s rise throughout the past year has been the growth of decentralized finance – or DeFi for short – which has helped increase the popularity of the Ethereum network while introducing a host of new innovations to the financial space.
Money flowing through DeFi platforms has already increased from $1 billion in June of 2020 to almost $90 billion in May of 2021, indicating a meteoric rise and adoption that could further shift the way financial transactions take place.
Here is a closer look at what DeFi is, how it works, and what it could mean for the future of finance.
What is DeFi?
Technically all forms of cryptocurrency could be referred to as decentralized finance, as all crypto is decentralized in nature – which has long served as one of its key advantages. But the term DeFi is a bit more specific.
DeFi specifically refers to a variety of blockchain-based financial applications aimed at disrupting the traditional financial system, which many view as being too outdated and overly controlled to serve an optimally effective purpose on a modern global scale.
The current financial system is largely defined by intermediaries – centralized, third-party middlemen that can limit the efficiency and sophistication of transactions by offering users less direct control over their money.
DeFi aims to buck this age-old system by taking the concept of blockchain and applying it to more complex financial issues, giving users more control and visibility over their money in a way that is safer and that is founded in code anyone can inspect.
Removing the middleman
A core aspect of digital assets is the lack of an intermediary. Even on the Bitcoin platform, institutions like banks are removed from the transaction equation to allow two parties to transact directly with one another.
DeFi takes this a step further, removing centralized middlemen from more complex transactions such as loans, insurance, crowdfunding, and more. The DeFi markets are always open, and there are no centralized authorities capable of blocking payments or denying access.
DeFi is essentially open to anyone with an internet connection and eliminates the need to have your money held by another entity that can take days to process transactions and that has access to your identity and other personal information.
The building blocks of the DeFi space are its applications, most of which are built on the Ethereum platform – the second-largest blockchain network in the world behind Bitcoin. Ethereum differs from Bitcoin in that it can be used to create decentralized applications in addition to performing simple peer-to-peer transactions.
Smart contracts are the primary basis of many DeFi apps, enabling transactions to automatically execute once certain conditions are met (e.g. your portfolio’s asset allocation adjusts if a particular metric surpasses or falls below a certain threshold).
Popular examples of DeFi applications and practices include:
- Decentralized exchanges (DEXes), which are non-custodial, automated exchange platforms that allow users to exchange currencies for other currencies. DEXes connect users directly so they can trade without an intermediary.
- Uniswap (UNI) is one example that lets you trade any Ethereum-based token or earn money on it if you add liquidity to its market.
- Stablecoins, which are forms of cryptocurrency tied to a non-cryptocurrency asset such as gold or the U.S. dollar. Tying crypto to a fiat asset helps stabilize price over time.
- Tether (USDT) is the first stablecoin that came to market and is also the most used and adopted stablecoin with the largest market capitalization. Tether is backed one-to-one on the U.S. dollar.
- Lending platforms, which use smart contracts to replace intermediaries that manage lending in the middle. Many of the largest DeFi apps are lending platforms.
- Maker (MKR) is one of the most popular DeFi lending platforms, built on the Ethereum network with the goal of minimizing the price volatility of its own stablecoin, Dai, against the U.S. dollar.
- Yield farming, which is a term for users scanning through DeFi tokens in search of opportunities for larger returns.
What’s next for DeFi?
Much like crypto, the specifics of the future of DeFi remain largely unknown, but a few distinct possibilities have been pinpointed for investors and developers to anticipate, including:
- Cross-blockchain compatibility, which would allow more and more crypto to be used on other networks, rather than just their own.
- Expansion beyond Ethereum to platforms such as Binance and Huobi.
- Integration with centralized finance to allow compatibilities such as linking credit scores to DeFi lending protocols, staking properties as collateral for a crypto loan, and more.
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