What is Decentralized Finance (or DeFi)
Decentralized Finance or DeFi typically refers to the technology trend (including related companies, products and services) where blockchain and DLT powered technology-intensive products and services replace similar services previously offered by traditional banks and traditional financial industry. DeFi introduces new possibilities into Finance markets and fintech thanks to unique features it offers such as direct (peer-to-peer transactioning), self custody of crypto wallets, programmable and transparent financial software (smart contracts or dApps) etc.
Finance is a highly regulated industry with really high entry barriers as it takes serious investment, time and effort to obtain licenses, infrastructure and other necessary components to establish a banking or financial institution.
This has resulted in historically slow progress in terms of technology disruption in the financial sector.
However the above is rapidly changing over the last few years with the adoption of DLT and blockchain technology. Cryptocurrencies such as Bitcoin and Ethereum, and especially the introduction of smart contracts by Ethereum and other blockchains have unlocked the possibility for Decentralized Finance. With the help of dApps (decentralized apps) also known as smart contracts and thanks to decentralized immutable ledger technology anybody can become a “financial institution” of some sort.
To give just a few examples:
(1) It is now possible to create an escrow smart contract which will release the funds based on some specific external conditions – without having to rely on any 3rd party services, lawyers or escrow providers. The smart contract effectively replaces both a written contract and a financial institution behind it;
(2) Anybody can issue a “currency” by way of crypto coin, anybody can tokenize an asset or create a financial instrument using blockchain and DLT technologies. Major differentiator here again is the distributed ledger technology, which is sometimes called “trustless”. I (TF) prefer to call it the concept of “verifiable trust”. You don’t have to trust someone or rely on a centralized authority such as a bank or a financial regulator to ensure your funds are safe. The way the system is designed the funds can be transacted and financial instruments can be operated in a trustless peer-to-peer environment. All systems have security holes in them and DLT / DeFi systems are not prone to failure. We are just saying that blockchain has made decentralized finance possible.
(3) Yield Farming – another trendy phrase lately which shows how money can be made in DeFi by any participant. The way it works is user purchases some cryptocurrency, such as Ether, and commits it into a DeFi application of certain fintech organization, for example a company that uses DeFi and DLT to offer microcredits / business loans. The interest earned from this activity is automatically distributed by the smart contract to all contributors in proportion to their stake. This is similar to how traditional banks use customers deposits to lend funds to other customers, however with DeFi technology this works faster, with less overheads and provides new possibilities for financial instruments previously unseen. If set up correctly, this is a decentralized financial service because there is no bank or other organization who is a gatekeeper or holder of the funds – the funds are held automatically by smart contracts in the blockchain.
Read more about Decentralized Finance from Dappros Blog: https://www.dappros.com/category/defi-finance/