Decentralized Finance Technology
Updated: May 18
What Is DeFi?
In the past, when people thought of the crypto industry, many would assume it is just about Bitcoin and other crypto coins. The sector's advancements have birthed a new movement that has democratized financial services beyond a central authority or institution's regulations. This development is broadly known as decentralized finance, DeFi for short.
While Bitcoin has already arguably had a Copernicus effect on our payment and financial system, DeFi also holds the same promise. DeFi essentially provides financial services like savings, loans, trading, insurance, and more to practically anyone with an internet-enabled smartphone. Here, an intermediary's need is greatly diminished as DeFi technically uses "smart contracts" built on blockchain, which automatically looks to enforce any agreements in such contracts.
For want of a definition, let us say that DeFi uses blockchain-powered technologies to provide financial services across various niches without the limitation of central systems or human censorship. DeFi can also be referred to as open finance.
The industry, though still growing, has already recorded massive growth in the last year. The DeFi market cap stands at over $35 billion now, while the total value locked (TVL) in the space is also well over $20 billion. As of January 2020, the figure stood at a paltry $1 billion, which shows that the industry has become more trusted and respected by investors in the crypto space.
Understanding Decentralized Applications (DApps)
In the DeFi space, one prominent component of the system is the idea of decentralized applications. DApps play a very significant role in understanding how the industry operates and the capabilities of the industry.
Most of these decentralized applications are built on Ethereum, the second-largest crypto asset, and it is also straightforward to build other decentralized apps. A developer can quickly deploy a "smart contract" on Ethereum using the Solidity programming language to good effect.
Smart contracts help to carry out transactions automatically, right when certain conditions are met. With blockchain, the requirements of these contracts are set in stone. If the necessary conditions are met, then the transaction goes on seamlessly without any third-party interference.
Generally, most DApps make use of these smart contracts to power their operations. Here is a list of some of the types of DApps:
Decentralized Exchanges (DEX)
A DEX's idea is to provide a platform where users can easily exchange their currencies without a central body's interference. In DEXs, users can either exchange crypto assets for a fiat currency or vice versa, and in some cases, users can also exchange a crypto coin for another. One of the most popular DEX is Binance DEX, which allows its users access to its platform through its native token and other tokens.
We have been told that only conventional financial institutions like banks could provide lending facilities to those who need them. But with the developments made in DeFi, one can easily enjoy these same financial services from DApps that have tailored their functionality to meet these services. To borrow from these platforms, a user would have to fulfill specific criteria that might be in the smart contract, and voila, they have access to loans and so much more. One such top DeFi coin is Compound, which has disrupted the lending space with its protocol.
One issue with cryptocurrencies is the volatility of the market. The crypto market is prone to wild price swings, which is why some investors have remained reluctant to invest in crypto. To battle this, stablecoins were developed. A stablecoin is a crypto asset pegged to a non-crypto asset (although there are several stablecoins with a crypto peg). The majority of the time, a stablecoin's peg is a fiat currency like the dollar or euro. One of the top DeFi tokens is Tether, which is pegged to the U.S. Dollar at a 1-to1 ratio.
"Wrapped" Bitcoin (WBTC)
Wrapped Bitcoin is designed to allow users to use the leading crypto asset on the Ethereum-backed DeFi system. With Wrapped Bitcoin, users enjoy an interest in the amount of BTCs they lend out through the different lending platforms.
Interest in DeFi Is Rising, Here Is Why
Earlier, we spoke of how the crypto industry has grown over time from having a paltry TVL to becoming one of the top mediums where investors stake to profit. There is no denying that the crypto industry presents a new opportunity far beyond the normal that changes everything in the financial sector, but what are the opportunities that DeFi brings?
DeFi Does Not Need Regulators.
The first reason why interest in DeFi keeps rising is that it does not need regulators. In the traditional financial system, regulators sometimes are an "albatross" as they mandate that these conventional institutions implement specific policies that can be limiting.
However, with DeFi, there is no such thing as regulators; instead, the focus is on privacy and bringing the financial system to all, thereby boosting financial inclusivity.
Presence of Institutional Investors
The blockchain-backed crypto industry generally has seen a rise in the interest of mainstream institutional investors. Today, we see Square, PayPal, Grayscale Investment, and a host of others buying and holding Bitcoin because it is now seen as the new gold.
Other institutions that are not buying BTC are making use of blockchain technology to drive their businesses forward. An example is the Office of the Comptroller of Currency in the United States, which recently announced that banks can now issue stablecoins in exchange for fiat currencies.
Plummeting Traditional Financial System Interest Rate
Another top reason why most people are beginning to invest in DeFi tokens lies in the fact that interest rates worldwide are beginning to drop massively, which could be tied to the pandemic's effect and regulatory acts bodies. There is absolutely nothing like that with DeFi.
Top DeFi tokens like Compound offer a higher interest rate than most financial institutions; other assets like Tether also provide their users an opportunity to earn interest, especially when they stake the crypto asset.
While the traditional financial system and its regulators might discourage people from investing in crypto, there is no denying that we are heading towards a more decentralized financial system where privacy is a crucial feature.
It is worth it to note that the DeFi industry poses some level of investment risks. Still, even the conventional system has its risks, which means that investors looking to maximize the DeFi industry need to have a proper understanding of how it operates before diving into it. Nevertheless, DeFi is here to stay, and in little or no time, we could begin to witness more ground-breaking use cases of the industry.
Source: Coin Market Cap, and Lawrence Cummins