What is Decentralized Finance?

What is Decentralized Finance?

Permissionless and transparent protocols support a new financial ecosystem called DeFi

Decentralized finance (DeFi) is a new approach to financial services using public distributed ledgers that supports autonomy and creates a peer-to-peer financial network. This new system does away with the traditional banking model of relying on a central authority. 

The DeFi ecosystem is made up of decentralized applications (dApps) that operate as permissionless services, meaning the user isn’t relying on an intermediary to process their request. Looking at the economic environment that we’re experiencing today; the flaws and failings within centralized banking systems and an unlimited money supply, financial innovation is needed. Cryptocurrency and DeFi are developing to support that change.

DeFi functionalities: 

  • Permissionless: removal of traditional intermediaries in favor of autonomous self-direction
  • Decentralized governance: autonomous, voting-based management of an asset or protocol 
  • Transparency: verifiable smart contracts on public distributed ledgers
  • Security: open-source code and community-based audits

How the Ethereum blockchain supports DeFi

In a recent blog post we explained that the Ethereum blockchain supports the creation and execution of robust smart contracts, which connect applications, functioning like APIs within traditional systems. The decentralized applications built on Ethereum smart contracts have notably included the rise of decentralized finance (DeFi) services. 

While other public distributed ledgers have been developed for DeFi protocols, the Ethereum blockchain is the primary source for smart contract development. Several core attributes of the Ethereum blockchain support DeFi: programmability (easy smart contract creation), interoperability (exchange of value between protocols), and immutability (the transaction ledger can’t be altered or manipulated). These features make Ethereum attractive for DeFi development because they support financial security, transparency and liquidity. 

dApps within DeFi include: 

  • Stablecoins: tokens that are pegged to the US dollar in order to provide a hedge to cryptocurrency volatility, like USDK and cUSD. Collateralized synthetic assets perform similarly, using approved crypto assets as collateral for a stablecoin with a peg to USD, like MakerDAO’s multi-collateral DAI (MCD) system.
  • Tokenized Bitcoin: protocols that act like stablecoins, bringing the benefits of Bitcoin to the DeFi ecosystem via an Ethereum smart contract and are backed 1:1 with Bitcoin. Tokenized protocols provide enhanced liquidity to the DeFi ecosystem, while expanding a bitcoin holder’s financial options, like wBTC and tBTC.
  • Lending and borrowing: Interest rate protocols enable efficient money markets on the Ethereum blockchain, allowing users to earn interest on deposits for the lending and borrowing of assets, at a guaranteed rate. Tokenized lending protocols include Compound, Aave, and Fulcrum.
  • Insurance: DeFi insurance typically focuses on smart contract, wallet, or even natural disaster insurance, covering the value of the user’s assets in the event of a bug or hack. This cover is provided by way of a token that allows the user to participate in a risk-sharing pool, like with Nexus Mutual or Etherisc.
  • Savings: earn interest on deposits in a blockchain-based savings account that functions like a traditional bank account, but without borders or limits, or needing to sign up with a bank. Supported by a stablecoin backed by USD, savings protocols allow users to easily send and receive value, including Dharma and Linen App.

How does DeFi disrupt traditional finance?

DeFi aims to disrupt traditional finance by removing the barriers that exist within the legacy system, including rules and regulations that favor certain groups and organizations, and global borders. The DeFi ecosystem allows for the disintermediation of finance, meaning that financial services are being developed to operate without need for trusted intermediaries and provide users greater autonomy. Built on decentralized applications, DeFi services prioritize autonomy and transparency when it comes to governance. 

Moving from centralized to decentralized governance means that decision making is based on what’s best for the users of the dApp, rather than the company who built the dApp. Decentralized governance may involve a group of distributed, anonymous voters, or a public, ecosystem-based system, like Compound uses. Compound, a decentralized network of borrowers and lenders, allows users to earn interest on their deposits via the COMP token. Having decentralized governance meant that before users could start earning COMP tokens, a public review and approval of the token distribution plan had to take place.

Utility of stablecoins for traders and investors

Some buyers and sellers of cryptocurrencies use stablecoins for diversification within their portfolio, providing a hedge against the volatility of the crypto markets. Backed 1:1 with USD, cryptocurrency, or an exchange-traded commodity, a stablecoin is intended to do as its name suggests; provide the holder with exposure to a stable asset. In 2019 OKLink launched USDK, a stablecoin pegged to USD that trades on OKCoin

The state of DeFi today 

While the DeFi ecosystem is increasing, the underlying infrastructure needs further development in order to support that growth. The scalability of the Ethereum blockchain will have a significant impact on the future development of DeFi. The Ethereum protocol is slated to undergo an upgrade called Serenity, with the first phase launching this July. Learn more about the Ethereum 2.0 update here.

Additionally, the user experience within DeFi isn’t where it needs to be for greater adoption; it’s a complex process to get onboarded, often requiring multiple stages of setup. While DeFi services pose education barriers and are presently unintuitive to use, these are challenges that are typical of any new, innovative system.

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