DeFi, or decentralized finance, is undoubtedly one of the hottest topics in recent months in the blockchain space. Dozens of projects compete in various segments, including loans, payment solutions, decentralized commerce, or insurance, and their size has grown from one billion dollars at the end of 2019 to more than 100 billion till now. In this first article, we will define the concept and give examples.
DeFi can be defined as an experimental form of financial praxis that moves away from the dependence on centralized financial intermediaries. As such, DeFi aims to disintermediate financial activity and does so through the surrogate use of blockchain architecture. Often the most used platform in DeFi applications is Ethereum, which has become the main tool for blockchain-based innovations in the last five years. DeFi approaches allow users to exchange capital flows for various purposes, be it lending-borrowing, asset swapping, portfolio diversification, insurance, or fixed-income and variable-income instruments.
The decentralized architecture of DeFi emanates from DApps (decentralized applications) that are programmed to execute financial functionalities on the blockchain. Using DApps allows users to not only bypass traditional financial institutions but also bypass cryptocurrency structures like exchangers, which have become the new crypto brokerage hubs. DApp solutions allow DeFi users to transact directly through mechanisms mediated by smart contract technologies (Smart Contracts).
These smart contracts automate processes and enable the development of highly complex mechanisms through the sum of multiple DApps. For example, they can adjust interest rates on the liquidity exchange in an automated and dynamic way, allowing multiple users to transact at constantly adjusted rates with supply and demand.
Examples of DeFi Protocols
To better illustrate what decentralized finance consists of, let us think of one of the simplest use cases, the lender-borrower relationship, that is, the supply and demand of liquidity. In DeFi protocols, stablecoin owners can choose to pool these stable value cryptocurrencies into a smart contract so that other users can borrow them after posting collateral. This guarantee also consists of a crypto active that is deposited in the smart contract. Automatically, a DApp protocol adjusts interest rates in real-time based on supply and demand. Unlike traditional structures, in this case there is no institution that manages and guarantees the operations. Everything is carried out automatically through smart contracts. These smart contracts have programming that guarantees the operation of the DApp and, being visible and public, they grant a high level of transparency and security. In short, users can be sure that the DApp will not do anything other than what the Smart contract code specifies.
An example of DeFi is compound finance, which also includes an incentive structure to promote transactions. This platform not only pays interest on credit activity but also distributes a cryptocurrency to lenders and borrowers (the COMP token ) to promote the exchange between savers and spenders, in addition to allowing the exchange of the currency with other platforms such as crypto-exchangers.. The need to post collateral, just like in traditional finance, is an important feature in many of these protocols like Compound. As we well know, in traditional models the lender has to contact an institution that will require certain guarantees based on its own criteria and that is also conditioned by high regulatory burdens. On the contrary, in DeFi protocols, the rules are decided by the community without there being an intermediary responsible for the decision and/or execution. In addition, the overall process is much more dynamic, since the partitions of the respective collateral assets are tradable 24/7, and their fungibility is guaranteed by construction.
Another example of DeFi is that of Uniswap, a decentralized exchange protocol that generates liquidity for Ethereum-based tokens. Since the origin of cryptocurrencies, centralized exchanges have been the cornerstone for creating liquidity. However, a parallel world is being built in the form of decentralized ( trustless ) protocols, such as Uniswap, that do not need intermediaries or custodians to facilitate trading. At its core, Uniswap is an automated liquidity protocol. It allows users to exchange crypto assets without intermediaries, with a high degree of decentralization and resistance to censorship. An algorithm creates dynamic incentives for bondholders to tokens or cryptocurrencies from pools of liquidity by compensating them through commissions. This platform, therefore, offers an alternative structure to the market-makers of traditional markets.
Read More About: What is Decentralized Finance (DeFi)?
On protocols like Uniswap, daily trading volumes are very high, but this is largely due to the existence of newly founded and highly speculative projects. However, these projects will gradually fade away and to ensure sustainable growth of DeFi it will be necessary to generate liquidity in conjunction with real-world use cases. Crypto environments and traditional environments must be able to coexist and connect. To do this, one of the great challenges that DeFi faces is compliance with financial regulations. There is currently a great imbalance between the regulatory burden that traditional Financial Institutions (FI) and DeFi have to bear, which gives the latter an indisputable advantage over the former.