With DeFi, a regular financial consumer can do most of the things banks support: earn interest, borrow money, lend money, buy insurance, trade derivatives, trade assets, and so on; with the benefit that it is faster and does not require paperwork or a third party.
What is DeFi
It is the name given to the ecosystem of financial applications that are being built on the blockchain of Ethereum and other cryptocurrencies. With DeFi (Decentralized Finance), the aim is to create a financial ecosystem radically opposed to the current one, based on open source, free access (permissionless), and transparency.
DeFi is nothing more than smart contracts, lines of code that establish a series of actions and conditions. Smart contracts run within the blockchain of a cryptocurrency. Currently, the Ethereum blockchain is the most used to create smart contracts, in general.
In DeFi, the need for trusted third parties and intermediaries is eliminated, paperwork is eliminated and a secure and agile decentralized finance system is generated.
Origin of DeFi
To find the origin of DeFi we must take a short trip back in time and we must go to the year 1995. It was in this year that Nick Szabo, an American cryptographer, and computer scientist, laid the foundations for smart contracts. A solution that has subsequently served for the development of Bitcoin and many other things. We could even say that the first DeFi developed is Bitcoin.
The problem is that smart contracts in Bitcoin are difficult to program and have limited capabilities. Ethereum is precisely what it comes to solve, allowing the creation of smart contracts in a much simpler and richer way. Ethereum precisely can support more complete smart contracts that have led to the development of different types of solutions, including DeFi.
The first DeFi solutions are liquidity markets, lending systems, and decentralized exchanges. These first solutions based on smart contracts began to be developed between 2018 and 2019, being at the beginning of 2020 when there is an exponential growth of DeFi solutions.
What are the characteristics of DeFi
Let’s see what are the most important characteristics of the decentralized finance ecosystem:
- Non-manipulating: By being integrated into a blockchain, it is guaranteed that they cannot be misused or manipulated in favor of one of the parties. Once the smart contract is deployed to the blockchain it cannot be altered, at most deleted if the function is enabled.
- No third parties: Its operation does not require reliable third parties to verify what is happening. The operation is verified by the blockchain itself, more specifically by the mining nodes and the validators.
- Security: The cryptography and consensus rules of a blockchain add elements of security. That all nodes keep a copy of the smart contracts (since they keep a copy of the blockchain) eliminates the possibility of alteration.
- Accessible: One of the characteristics of DeFi is that they are accessible to everyone from anywhere in the world. This allows people who are not allowed or cannot access conventional financial systems to have access to a more flexible and agile economic system.
- Transparency: Any transaction in DeFi is easily auditable thanks to the fact that they are based on blockchain technology. You can see all the movements made.
- Decentralization: As they are stored in the blockchain, their operation is decentralized, not governed by the rules of countries or governments. The operation of these is autonomous and automated, once it is deployed.
- Open source: DeFi is based on open source, which allows anyone to read it and verify that it has no security issues. Additionally, you can download, use and modify this code for other applications.
Uses of DeFi
Within the DeFi ecosystem, we find open lending (open loans) which are quite popular. This mechanism for taking and granting loans in a decentralized manner provided advantages over conventional credit systems. They can add instant settlement of transactions, increased ability to collateralize different digital assets, the removal of credit checks, and possible future standardization.
As this lending system is based on a public blockchain, the amount of trust required is reduced by relying on cryptographic verification methods. Loan markets built on blockchain technology reduce counterparty risks. Likewise, they cheapen, speed up, and make the taking and granting of loans available to a greater number of people.
2. Money banking services
One of the solutions that can be developed in DeFi is the issuance of stablecoins, mortgages, and insurance. These money banking services are one of the possible uses of these decentralized finances.
Interest in stablecoins has grown quite a bit as they are pegged in a fixed way to the price of a real asset. An example would be USDC, a stablecoin whose unit is worth 1 dollar (1 USDC = 1 US dollar). These currencies protect holders from the abrupt fluctuations that can occur with cryptocurrencies, even being adopted for daily use as a payment method.
They can also be used to obtain mortgage loans, which are usually complex, expensive, and slow. DeFi can create solutions through smart contracts that reduce the time, costs, and complexity when obtaining this type of loan.
3. Decentralized exchange
The creation of decentralized exchanges (DEX) is one of the first DeFi solutions developed and the one with the largest projects developed. These platforms allow users to exchange tokens and cryptocurrencies that are working within the same blockchain. For example, a DEX within the Ethereum blockchain allows ERC-20 tokens to be exchanged with each other and with ether (cryptocurrency of the Ethereum blockchain).
Normally DEXs have very low or zero commissions regarding the exchange between tokens. This is one of the strengths they have compared to centralized exchanges, which usually charge “high” fees for each transaction.
What are the challenges to be solved by DeFi
Although the proposal is interesting and seems promising, it currently has the following problems:
- Low processing capacity: Cryptocurrencies currently have a limited transaction processing capacity, something that is being corrected. Bitcoin supports between 5-8 transactions per second (tx/s) and Ethereum supports between 12-20 tx/s, much less than services like Visa, which would support around 40,000 tx/s. For DeFi to work, cryptocurrencies need to scale in the number of transactions per second they support
- Risks for the user: DeFi eliminates intermediaries, just like cryptocurrencies, so the user is solely responsible for everything that happens. It is necessary to create DeFi structures that minimize risks in the face of possible errors or ignorance of what is being done
- Not very intuitive: Currently DeFi applications are complex and require the user to make a lot of effort to understand what they are doing . If these types of solutions want to be a real alternative to the financial system, they must offer a benefit to the user, which is to make them simple, intuitive and easy to handle
- Chaotic ecosystem: One of the main current problems lies in finding a mechanism that adapts to each need. The user has the task of diving into this complex ecosystem to find the solution that best suits him. The need to build broad DeFi solutions is one of the challenges facing this ecosystem.
Strengths and weaknesses of DeFi
Currently DeFi is an ecosystem that is in an early stage of development aspects must be corrected to make it accessible to all users.
- It facilitates access to financial services for people who are currently unbanked. It is a great opportunity for people’s financial freedom
- The financing process for companies and different types of projects is simplified. Through DeFi, development and financing can be offered in areas or for companies that otherwise could have it very complicated
- They offer security to all parties since once the operation is validated, it can no longer be modified. This ensures that clauses are not added or some aspects are modified at will or in favor of one of the parties.
- Smart contracts offer great versatility and ease in creating different solutions. Anyone can write a smart contract or simply access the code of a smart contract and adapt it to their needs.
- Interestingly, smart contracts, which are a strength of DeFi, are also a weakness. In the end, a smart contract is nothing more than a code written by a programmer and may contain errors. It is important to properly audit a smart contract before deploying it to avoid problems like the one that happened with The DAO.
- If a financial system needs something, it is stability and that is something difficult in the cryptocurrency segment. The current mechanisms for creating a stablecoin are not perfect and may not protect against fluctuations at times. MakerDAO and DAI, whose correction variations have shown that there may be weaknesses due to protocols that are not mature.
- The transaction processing capacity of blockchains today. Ethereum has suffered from congestion on its blockchain on several occasions due to the high volume of DeFi transactions. For this, an emergency mechanism has been devised that has yet to be implemented and we do not know how it will work. An increase in transaction processing capabilities is required for DeFi to be viable.
Alternative to FinTech
Financial Technologies (FinTech) is an attempt to update the conventional financial system. The aim is to develop a digital financial system that can reach a greater number f people while offering a fast, efficient, cheap, simple-to-use-to-use system. An attempt that has its beginnings in the last years of the 20th century, which pointed ways, but has ended up falling by the wayside.
In 2008, a certain Satoshi Nakamoto with his proposal for a peer-to-peer digital currency based on cryptography made FinTech practically obsolete. The launch of Ethereum and the start of the development of DeFi systems have already been the last straw for FinTech. Creating a safer, decentralized financial system that has no borders and, above all, that does not require reliable third parties.
FinTech vs. DeFi
|Management and control||governments and banks||decentralized|
|Trust||Banks and “reliable” third parties||Community|
|Economy||Fiat||Cryptocurrencies, tokens, stablecoins|
|loans||Banks and other lenders||tokenized debt|
|Regulation||States and regulated bodies||Consensus|
|Requires permissions to use||Yes||No|
|auditable||Transactions and code are not public||Transactions and code are public|
Current best DeFi solutions
Many projects have been developed to offer DeFi solutions accessible to all users. Some of the most important are:
- Bisq: P2P exchange protocol that has been developed for Bitcoin and is completely decentralized.
- Bancor: Decentralized Token Exchange Based on Ethereum
- 0x: Protocol to create P2P-type DEXs that works on the Ethereum blockchain
- Kyber: Exchange protocol for the integration of variations functions between applications with cross-chain operations (between different blockchains)
- Curve: Decentralized exchange specialized in stablecoins
- RSK: Set of services and protocols for the development of a complete platform. Includes smart contracts, digital identity, instant payments, cross-chain bridges, creation of decentralized markets, and other elements
- SushiSwap: It is a DEX for the creation of an automated market created in the Ethereum blockchain that has its token
- Shiba Inu (SHIB): Is an ecosystem of solutions under development that includes several types of fungible tokens, an NFT platform, and a DEX that is under development
Final words on DeFi
Cryptocurrencies have brought about a change in the functioning of money, as we knew it. It goes from the need for trusted third parties that determine the prices and what can be done with the money to a decentralized system where the community determines the price and can do what it wants with the money.
DeFi is now proposing to take this one step further and bring the different elements of the conventional banking system into a fully digital and decentralized environment. They seek to offer disruptive solutions that simplify traditional banking processes. All this eliminating the need for trusted third parties eliminates the additional costs of the conventional banking system, reduces management times, and reduces tedious bureaucracy.
All this practically idyllic environment of DeFi has the great problem of the scalability of the different blockchains. Until mechanisms are found to increase the number of transactions per second supported, without putting the security of the network at risk, DeFi has a somewhat complex future.