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What is DeFi and how does it aim to change the financial architecture of the world?

Home > Defi > What is DeFi and how does it aim to change the financial architecture of the world?

The centralized financial architecture has been causing a lot of trouble for quite some time. After blockchain arrived in the market in the form of cryptocurrencies, it demonstrated the potential of completely disrupting the finance system, which also kept it from being accepted widely. The unstable nature of cryptocurrencies obviously did not help much. However, financial and blockchain consulting services joined forces and came up with a much more sustainable solution in 2019, in the form of Decentralized Finance or DeFi, and it has taken the crypto world by storm since then. By the end of July 2020, the crypto collateral locked in the DeFi economy increased from $275 Million to $4 Billion. However, the knowledge of this new discovery is still majorly limited to the crypto world, yet the application of it can benefit everyone in the whole world, while not vanquishing the financial world completely. So let us learn everything there is to know about DeFi here and how it might change the world of finance.

What is DeFi

DeFi or Decentralized Finance is essentially the middle ground between the traditional centralized financial system and the decentralized cryptocurrencies like Bitcoin and Ethereum. DeFi is a platform where one can build small conventional financial applications in a decentralized manner. In order to be deemed as DeFi, a financial network must have one or more decentralised functions. 

The majority of DeFi platforms take the form of dApps or decentralized apps. Most of these apps are developed on the blockchain platform Ethereum as it provides the option of creating blockchain applications based on the same cryptocurrency. Although that does not mean dApps are only built on Ethereum – there are many other cryptos like it which can be used for developing these. However, the apps that are indeed based on one specific blockchain, it is possible to merge, modify, and integrate them according to various requirements.

The key characteristics of Decentralized Finance

Predominantly DeFi applications have the following characteristics in common:

  • Use of decentralized system

    The interest rates and currencies in this system are defined by decentralized data and algorithms.

  • Minimum human interference:

    DApps use smart contracts instead of human intervention to automate financial and other forms of transactions.

  • Open source coding:

    The coding of DeFi apps is mostly open-source, which means anybody can check it and verify its features, protection and capabilities. This makes the code more stable and trustworthy as all users are aware at all points that the apps are not running any pernicious hidden code in the background or stealing any data without the user’s knowledge.

  • Inclusive:

    Being an open-source platform, dApps are truly inclusive of everyone, without any bias or even the control of the country border. Anyone around the world with a computing device and internet access can be a part of the Decentralized Finance community. The aim of DeFi, at the end of the day, is to create a truly borderless economy.

  • Permissionless:

    There is no need for anyone’s approval for either creating a DeFi app or using it. So this platform relieves you off of the substantial amount of regulatory verification systems you need in the conventional financial system to be included in the global economy. For being so open and flexible, DeFi is often named as “open finance” as well.

  • Flexibility in development:

    The users can safely integrate third-party applications over a dApp for certain functionalities as required, which gives the developers more flexibility. What is even more interesting is that the users can create their own interfaces in case the current options are inadequate for them.

The technology behind

The technology that decentralized finance uses is called “blockchain”. In simple words, blockchain is a series of time-stamped “blocks” containing digital information, stored in a public database using cryptographic principles or “chain”. This information has 3 parts – information about a transaction, information about the participant of that transaction, and special information (hash) which distinguishes every single block from one another.

Characteristics of the technology of blockchain in Australia

The features that technology possesses are revolutionary and have the potential to transform many industries, including finance.

  • Decentralized network:

    Blockchain ledgers are controlled by a cluster of computers all running independently, acting on a peer-to-peer basis.

  • Distributed ledger:

    For every single transaction to happen, a “block” is verified by potentially millions of computers distributed around the network before being added to the “chain”.

  • Cryptographic Security:

    Each member of a blockchain holds a public key which is seen by all the members in the network. However, the identity of the member shown in this information will be hidden with a unique obfuscation called “digital signature”, which can be deciphered only by the owner himself/herself with the private key given to him/her at the time of registration. This cryptographic security of user access makes it almost impossible for identities to be hacked and data to be compromised.

  • Immutability:

    Also, blockchain only supports “create” and “read” functions, which means if data in one block changes, data in all the subsequent blocks change and the whole network is notified. This feature practically makes the data immutable and thus extremely secure.

  • Data provenance:

    The ownership of a digital asset registered on a blockchain can only be modified by the owner itself. Therefore, the origins of the assets are traceable and therefore, are verifiable and reusable. 

  • Transparency:

    Each node point in a blockchain has a copy of the entire history of all transactions, hence all data exist simultaneously in multiple places in the network. This reduces the chances of data being lost.

How will DeFi change the financial architecture of the world?

There are several issues that the current financial architecture has which have been going on for too long. By integrating blockchain technology in finance, DeFi promises to resolve almost all of them.

The current structure of the financial world

The conventional structure of the financial industry is centralized. This means the regular currency that we use is issued by a central authority like the reserve bank which is further regulated by the national government. This is the currency that is used for every trade and therefore, drives our economy. In this system –

  • You give over the power to manage and control the flow and supply of this currency in the market to these central bodies.
  • Your assets are controlled by centralized financial organisations for investment and you give up the control over to them hoping for high returns.
  • All the funds and control over those funds is centralized and therefore, the risk of investment is also completely born by this central body.

The issues with the current structure

This centralized system as explained above has a few problems.

  • Human error:

    When everything is run by a central body, which in turn is run by humans, there is a good chance of human errors occurring. Even though most of the accounting calculations are performed by computers nowadays, there are a lot of errors that might happen in the judgement.

  • In making the decision about printing money:

    The central body is in charge of making the decision of how many money bills will be printed and circulated based on the economic situation at a certain point of time. However, in case there is an error in deciding this, things can take a disastrous turn.

    For instance, amid oil price drop, the Venezuelan government printed huge amounts of money and performed a number of other terrible judgements in their monetary policies, which ended in inflation exceeding 1,000,000%, according to the IMF data.

  • In calculating market risks at the time of investment:

    If you don’t run in the field of finance and wish to invest your money for extra returns on your assets stored in the bank vaults, you take the help of financial experts who advise you on various schemes, mutual funds, and share markets in exchange of a certain percentage in your profit from such investment. In case they make calculation mistakes or fail to see the market risk in your investment, you lose money or at best receive only a fraction of what you could have gotten.

  • Corruptions:

    The biggest issue of a centralized system, however, is corruption and criminal activities, which in the majority of scenarios are internal. When the banks have full control over printing money and investing them, little of their operations’ details reach the public eye. A number of times they act only in self-interest and/or the interest of the rich and powerful. Sometimes they print more money without a public record, some other times they keep a big chunk of the profit gained from your assets to themselves. 

  • The disparity between the rich and poor:

    Even though nowadays the middle-class invests in the stock market way more than in the past, there is a huge difference between their investments and that of the rich. The rich hold a majority share in most profitable companies, gaining them the majority of profit returns. The middle-class collectively owns much less share in any company and there are people who don’t even have access to the stock market.

  • Loans:

    The current process of taking out loans is time-consuming and at the same time, you are forced into working with lenders who prioritize their own returns above everything else. In most cases, your physical assets are used as collateral and in case you miss an instalment or fail to pay off the loan, you may end up losing everything. Moreover, there are a number of criteria that you will have to meet in order to be eligible for a loan at all.

  • Expensive intermediaries:

    From the stock market to every single transaction to cross-border payments – in a centralized system, everything requires an intermediary for transactions to be verified and performed. This makes the system slow as well as extremely expensive as money drips out for each such middle-man.

How DeFi aims to solve it

The blockchain technology that Decentralized Finance is based on provides you with full control over your assets and investments as well as transparency of the said investments. All the transactions are conducted over smart contracts which are based on the technology of blockchain in Australia.

What are smart contracts:

A smart contract is practically the digital equivalent of legal contracts. It is a self-enforcing software managed by a p2p network of computers that facilitate, verify, or enforce the negotiation or performance of a contract. 

When a blockchain-enabled smart contract is used, transactions between the nodes are only triggered when all the conditions are met and this is verified digitally by a cluster of independent computers with no human help. Since blockchain is decentralised like this, it cuts off the intermediary which reduces the possibility of corruption and human error, along with making the entire procedure much faster, cheaper, and much more secure than regular contracts. 

Smart contracts in decentralized finance:

Smart contracts can allow simple features such as payment (Stablecoin) and credit (lending/borrowing), as well as more complicated functions such as derivatives (leverage, swaps) and crypto-asset trading (decentralised exchanges) – without any intermediaries, completely automated and decentralised. DApps based out of smart contracts are called financial primitives which can perform functions like DeFi payments, lending & borrowing, trading, wealth management, derivatives, insurance, and many more are guaranteed to be added in the near future.

Decentralized finance makes the entire financial system automated by using smart contracts which takes care of the security and record-keeping much better than the current system, as mentioned earlier. Its applications hold the potential to resolve almost all the issues we suffer from because of the centralized financial system.

  • Tokenization of assets:

    In a decentralized financial system, all your assets can have a digital representation, or “tokenized”. When the value is added to a distributed ledger, anybody who has access to the DeFi framework can use the tokens to exchange, borrow against, sell, invest in, etc. This not only makes the entire process of investment much faster, but it also removes the possibility of market manipulation, data secrecy, and other forms of corruption, as well as makes it possible to have all investments available to everyone – rich and poor alike.

  • Faster and cheaper transactions:

    In this kind of lending protocol, users deposit their money just like banks and they earn interests when someone else borrows those digital assets. However, deciding and verifying the terms of the loan, connecting the lender and the borrower, as well as distributing the interest – all is automated and done securely via smart contracts instead of a central administrative body. This way, the lender gets the full percentage of his/her profits from the investment, and at the same time, understands the risks and gains of it more.

    Open lending protocols are strictly based on a public blockchain protocol like Ethereum. The transactions, in this case, take much less time, your collateral can be any digital asset and therefore your physical assets can be safe. Moreover, no credit checks are necessary, so literally, anybody can apply for a loan.

    One such example is “flash loans”, a unique form of loan that must be taken out and paid back within a single transaction, which is gaining immense popularity right now.

Conclusion

Decentralized Finance is spreading and growing far and wide already and a number of dApps have already begun to cause a stir. Even so, no matter how inclusive the concept of DeFi may be, it still deals with money and assets, and just like in the world of centralized finances, you may lose big without proper education. It is best to consult a certified and professional blockchain consulting service to learn about the technology now when it is just starting out so that you can get really into it when it picks up its pace and make a strong foothold in the new normal of finances.

Ralph Kalsi

Founder and CEO, Blockchain Australia ™

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Ralph Kalsi
Ralph Kalsi

Founder and CEO, Blockchain Australia