The financial industry is undergoing a major evolution, though it’s not one that big banks are necessarily happy about. The rise of “DeFi” or decentralized finance technologies and systems has led to a new understanding of commerce and economics – one in which individual users are not forced to follow the rules of large banks or other centralized organizations.
Although DeFi technology is promising, it’s too often used as a buzzword to sell products. Additionally, many people don’t fully understand what DeFi is and how it works. Today, let’s break down DeFi in detail, explore its uses and practical applications, and examine where it may evolve in the future.
“DeFi” or decentralized finance is best understood as a technological system that leverages financial products or tools to offer financial services on a public, decentralized, typically blockchain-style network. In simpler terms, DeFi systems allow anyone to use them and don’t require institutional middlemen including banks, brokerages, credit unions, and more.
Furthermore, various proofs of identity or address are not always needed to interact with or leverage DeFi systems. Instead, you need other forms of identification that are commonly used for cryptocurrency transactions, like a crypto wallet.
In this way, DeFi is more of an umbrella term than a single technology or platform. It is largely inspired by blockchain technology, which is behind Bitcoin and other types of cryptocurrencies. In a nutshell, blockchain technology and DeFi as a whole allow multiple individuals or users to hold copies of transactions, preventing financial information from being controlled or centralized by one corruptible entity.
How is DeFi Different from Blockchain Tech?
The most basic type of blockchain technology facilitates asset or value transfers – for example, someone sends Bitcoin to another person and the Bitcoin blockchain records the transaction for everyone to see. There is no middleman in the transaction, as is the case when you make a payment using a Visa credit or debit card, for example.
However, DeFi technology can be used for things beyond making payments of Bitcoin or other crypto tokens. Depending on the needs of the user and the technology in question, DeFi can facilitate the transaction of secure information, store personal information to prevent identity theft, and much more.
At the time of this writing, the full possibilities of DeFi technology are still being discovered.
The Major Components of DeFi Stacks/Systems
For any existing or future DeFi stack, system, or process to work, it must have a few major components. For example, say that you have a DeFi software stack. This software stack allows you to provide decentralized, middleman-less transactions between multiple individuals or companies.
Such a software stack will have four primary layers or components:
- A settlement layer, which is the base layer upon which the DeFi transactions or other activities are built. In most DeFi systems, this is a blockchain alongside its native cryptocurrency or digital token. All transactions that take place on a given DeFi system or application will use the currency and use the base blockchain underneath. For example, Ethereum – one of the most popular cryptocurrencies – uses the native token ether or ETH for its DeFi blockchain system.
- A protocol layer, in which the rules or standards are written to govern the activity of the blockchain. These are best understood as the principles needed to ensure that everyone uses the DeFi system or stack in the same way. For example, Ethereum uses Synthetix, which is a derivatives trading protocol, and which is used to create synthetic counterparts to real-world assets or currencies.
- An application layer, which is where any consumer-facing applications will be installed and/or utilized. The best example of an application layer is a cryptocurrency exchange and/or lending service. The exchange and/or lending service relies on the below two layers to provide DeFi services to its users.
- An aggregation layer, in which aggregators connect apps or systems to provide services to investors or users. As an example, a DeFi system may enable the transferring of money between a decentralized exchange to another financial institution. A simpler example would be a crypto wallet or a crypto banking service.
DeFi vs. “Regular” Finance
Regular or “traditional” finance has a number of major problems that have been observed throughout history. These problems include:
- A lack of easy access to bank accounts or funds for average or ordinary people
- A lack of access to financial services, which may prevent individuals from being employed, retaining their personal information, and more
- The possibility that financial services could prevent an individual from getting paid fairly
- Hidden charges or necessary fees to use middleman services to access personal funds or data
- The ability for governments, banks, and other centralized institutions to close down or throttle market activity
- The limitation of trading hours to the standard business hours of certain time zones or institutions
- And more
All of these problems are due to one simple fact: financial data and transactions are centralized. All data or information has to pass through one or a few institutions or mediums. Decentralized finance, by its very nature, is not the same and lacks those flaws as a result.
For example, with decentralized finance:
- You always hold onto your currency in a designated crypto wallet or some other personally owned storage solution. Only you can access your currency, as opposed to a traditional bank (which can theoretically access your currency at will)
- You get to decide where your money goes and how you spend your money at all times – banks cannot take the money you have stored to use for loans
- Funds transfers take only a couple of minutes
- All transaction activity is anonymous, as opposed to traditional financial activity (which is usually attached to your identity)
- DeFi systems are open to anyone, whereas traditional financial services require applications and for you to pass a variety of metrics, like credit scores
- All DeFi markets are open, whereas traditional markets oftentimes close
- DeFi markets are built on transparency no matter what. All traditional financial institutions or systems are much more closed in comparison
As you can see, DeFi technology and systems are essentially the polar opposites to traditional financial systems in most major ways. DeFi has the potential to reinvent financial activities and habits throughout the world, though it is still in the earliest days of development and experimentation.
DeFi and Ethereum
One of the biggest areas where DeFi is currently developing and pushing the limits of finance is Ethereum’s blockchain. In fact, the majority of DeFi applications or systems are built on Ethereum, as this is the second-largest cryptocurrency platform in the world (right behind Bitcoin).
Compared to Bitcoin, Ethereum makes it a little easier for other developers to build decentralized applications for purposes aside from basic transactions of crypto tokens. This was the original intention of Ethereum, in fact, as stated in 2013.
For example, Ethereum’s platform allows for the use of smart contracts which execute transactions automatically upon their conditions being met. Such contracts allow for greater transactional flexibility, and they’re at the core of all kinds of DeFi applications running on the broader Ethereum network.
However, Ethereum isn’t the only place where you can see applications or systems in action.
Common Types of DeFi Applications
DeFi apps are everywhere and are used for a variety of financial or other purposes. Let’s explore some of the most common types of DeFi applications.
Naturally, the primary purpose of most DeFi technology or platforms is to send untraceable international transactions. It’s very easy to send money all across the globe using Bitcoin, Ethereum, and other decentralized blockchain platforms. This can be very advantageous for individuals who may have difficulty accessing their funds through traditional banking systems.
Thanks to the prevalence of crypto exchanges, DeFi applications even allow individuals to send fiat currencies around the globe with a minimum of fees or fuss.
Decentralized exchanges are exactly what they sound like: online trading centers where users can exchange currencies for other currencies, such as crypto tokens for fiat currencies or vice versa. These exchanges are becoming more popular as they allow users to connect with traders for their given currencies without having to rely on a middleman like a bank or a broker, as is the case with a traditional stock exchange.
So-called stablecoins are technically types of DeFi technology in and of themselves. Stablecoins are specific types of cryptocurrencies designed to stabilize the broader cryptocurrency market. They’re “pegged” or backed by non-cryptocurrencies, usually stable fiat currencies like the US dollar or the euro.
Since stablecoins are backed by fiat currencies or other stable assets yet are still cryptocurrencies, they help to keep the prices of other cryptocurrencies under control and limit volatility. They help to facilitate crypto commerce across the board and are great for investors in crypto tokens, who can use the price action of stablecoins to help estimate what their currencies will be worth in the future.
DeFi lending platforms are also popular uses of decentralized finance technology. These lending markets can connect borrowers to cryptocurrency lenders – again, all without the need for a middleman who would take a cut or who may compromise the transaction.
Such lending platforms allow users to borrow cryptocurrencies, offer loans, and make a profit off the interest for lending out their crypto tokens.
Most DeFi lending platforms are collateral-based. That means users have to put up collateral in order to take out a loan (this is usually a token running on Ethereum). As a result, users don’t have to put up a credit score or reveal their identity to take out a loan, which they would have to do were they to take out a traditional or non-decentralized finance loan.
Ethereum runs one of the oldest DeFi applications: a prediction market in which users can bet on event outcomes in the future. This is sort of like a sports betting market, but prediction markets are oftentimes better at predicting outcomes of major political or world events compared to traditional methods like polling or speaking to pundits.
Since DeFi prediction markets aren’t run with a middleman or through a major institution, the government cannot shut them down.
Wrapped Bitcoin, or WBTC, are Bitcoins that can be used directly with the Ethereum blockchain system. DeFi platforms allow users to send this Bitcoin to the Ethereum network. As a plus, WBTCs earn their users interest on any Bitcoin they lend out to other users, oftentimes using one of the DeFi lending platforms described earlier.
How DeFi Could Evolve in the Future
DeFi technology is still relatively new. But that hasn’t stopped inventors, entrepreneurs, and other groups from trying to design new uses for DeFi tech and systems.
DeFi technology could evolve in the future for a practice called yield farming. This may be ideal for knowledgeable cryptocurrency traders who aren’t afraid of a little risk. Through yield farming, users can scan DeFi tokens and try to trade them for large returns on cryptocurrency exchanges.
Or DeFi technology may be used for liquidity mining. With such an application, DeFi applications would provide users with free tokens for using a new platform. We may alternatively see DeFi technology to foster the creation of “composable” applications, in which the public code behind DeFi apps is shared with users to create new software technologies and solutions from basic but interchangeable building blocks of code.
For the time being, DeFi technology is used to send money around the world, to access currencies, to borrow funds without collateral, and to start crypto savings. There’s no real limit to the potential uses of decentralized financial systems. Like Bitcoin and blockchain technology, DeFi shows that the old way of doing finance isn’t the only way anymore.
In the end, DeFi represents the turning of a new era in finance. As the world becomes more globalized and interconnected, decentralized financial technologies will become more practical and available to average people. Over time, it’s all but inevitable that large banks and other centralized institutions will gradually lose their power in favor of the individual.
John S. Logan has been working with cryptocurrency for nearly as long as it has been available on the market. With a professional background in the finance industry, he believes that blockchain technology, cryptocurrency, and decentralized finance play an important role in the future of the world.