DeFi (Decentralized Finance) attracts plenty of attention in the world of cryptocurrencies and blockchain. This relatively new concept promises a lot. You might hear of a few uncertainties too, which is common for anything new. What is DeFi? What does it do and how? How it might benefit businesses and society? We examine these questions, furthermore, we assess the uncertainties surrounding DeFi. Read on.
DeFi (Decentralized Finance): An introduction
Before we discuss the concept of DeFi in more detail, let’s see a small piece of statistics. DeFi Pulse, the popular website with useful resources about DeFi states that the “Total Value Locked” (TVL) in DeFi as of August 2017 was zero. As of February 2nd, 2021, TVL in DeFi is $28.238 billion. That indicates phenomenal growth.
DeFi broadly refers to a collection of financial software applications built on the blockchain, and these software applications can be stacked together to deliver value to users. What if we look deeper? DeFi refers to a collection of “Decentralized Apps” (DApps), blockchain-based protocols, smart contracts, and cryptocurrencies.
Entrepreneurs and developers typically use the Ethereum blockchain platform to develop DeFi applications. We talk more about it shortly.
How DeFi differs from traditional financial software applications?
Financial services-related software applications aren’t new. When you buy something on an eCommerce store, you might use your VISA credit card. A bank has issued this card to you. Alternatively, you might use your PayPal account.
Credit cards, traditional banks, PayPal, Stripe, etc. use financial services-related software applications to deliver their services. These are centrally-managed, traditional financial services institutions.
The bank or financial services institution facilitates your payment transaction as an intermediary. They might charge a fee, depending on the nature of your transaction. Banks might deny you their services in some situations.
They record your transactions, and they need to follow stringent disclosure-related laws. The government of your country would know about your financial transactions.
You explicitly trust the credit card company. Furthermore, you trust the credit card-issuing bank and your government. That’s all fine if all goes well!
However, the financial crisis of 2008 showed what happens when banks don’t operate responsibly. The crisis made it clear that people can’t fully control their money in the traditional financial system.
DeFi intends to use blockchain to remove the need for you to explicitly trust a bank or financial services institution. You have the power to verify. Blockchain offers decentralization, transparency, immutability, and security. You take charge of your money, instead of relying on intermediaries.
The deep link between DeFi apps and the Ethereum blockchain network
We talked about how most DeFi apps use Ethereum, and we will elaborate on it. Ethereum is a popular public blockchain network. It’s quite like Bitcoin (BTC), however, Ethereum has its own native cryptocurrency. That’s called Ether (ETH). It’s the second-most popular cryptocurrency.
The Bitcoin network allows one user to send BTC to another user. Ethereum offers that, however, it offers more. Entrepreneurs and developers can use it to create “Smart contracts” and “DApps”.
Smart Contracts: What they are
Smart contracts are pieces of code with the following characteristics:
• They are open-source.
• Smart contracts contain “If-Then-Else” statements, and they transfer cryptographic tokens based on predefined conditions.
• They execute automatically when the triggering condition is met. Their autonomous nature eliminates intermediaries.
• You can’t modify them after you deploy them since smart contracts are stored on decentralized blockchain networks.
• The execution of a smart contract is irreversible. The result of the execution is stored on a decentralized blockchain, which can’t be modified.
The Ethereum blockchain platform offers the “Ethereum Virtual Machine” (EVM). This is a runtime environment to execute smart contracts. Developers create DApps using this platform.
DApps: A brief overview
DApps are software applications with the following characteristics:
• They are open-source.
• You can create the front-end of the DApp using any technology, however, the back-end must consist of smart contracts.
• DApps run on a decentralized blockchain.
• DApps use a cryptographic token, which is created using established cryptographic standards.
• No one use of a DApp can control the majority of the cryptographic tokens.
• You can modify a DApp only after its user community reaches a consensus about the modification.
• A DApp stores the data it creates on a decentralized blockchain, and it uses established cryptographic standards for that.
Creating DeFi apps on Ethereum
When entrepreneurs and developers create DeFi apps, they develop DApps. They code smart contracts for this. Ethereum was the first smart contract platform, and developers took to it to create DApps.
Other smart contract platforms emerged subsequently, e.g., NEO and EOS. However, the Ethereum ecosystem is rich. E.g., Ethereum offers Solidity. This proprietary language to create smart contracts has powerful features. The rich ecosystem is another reason for the growth of DeFi apps on the Ethereum blockchain network.
Where DeFi apps are making an impact: Examples of DeFi use cases
DeFi apps promise a lot in several use cases. We talk about the following examples:
Borrowing and lending platforms
Banks and financial services institutions offer loans. They manage the entire lending process centrally, therefore, borrowers need to depend on them. Banks use their risk rating programs. People deposit their money in banks, and banks lend that money. Banks earn fees in the process.
DeFi lending and borrowing platforms use blockchain. They offer complete transparency to lenders and borrowers, therefore, both of the parties can understand the risks better. DeFi lending platforms use smart contracts to enforce contracts. These autonomous contracts eliminate middlemen, which reduces costs. Eliminating middlemen reduces the processing fees too.
The cryptocurrency market tends to be volatile. Many popular cryptocurrencies like Bitcoin, Ethereum, Ripple, Monero, etc. experience frequent ups and downs in their price. This impacts their adoption since merchants find it hard to deal with such fluctuations. Stablecoins address this challenge, and DeFi apps help users to use them.
Stablecoins are cryptocurrencies, however, they are pegged against an asset outside the world of blockchain and cryptocurrencies. They might be pegged against USD, Euro, Gold, etc. USD Coin (USDC) is a good example of stablecoins, and it’s pegged against USD. Every 1 USDC is backed by 1 USD.
Decentralized exchanges (DEXs)
Cryptocurrency users buy cryptocurrencies on crypto exchanges. They mostly use centralized exchanges. Centralized exchanges are centrally managed, which exposes them to the risks faced by every centralized system. These exchanges operate like banks. However, they don’t follow the stringent regulations that govern banks. That’s not the ideal scenario for cryptocurrency users.
Decentralized exchanges (DEXs) address these challenges. These exchanges use smart contracts to enforce trading rules. Autonomous smart contracts execute trades, furthermore, they keep funds secure. These exchanges don’t require any centralized operators. They are popular among DeFi apps. “0x protocol” is a well-known DEX.
The challenges concerning DeFi apps
Every new technology or business concept faces challenges, and DeFi apps aren’t exceptions. They face the following challenges:
• Investment risks: Blockchain is a new technology. Even within that, DeFi is a relatively new concept. This sector is witnessing rapid developments. Many countries lack clear and pragmatic regulations concerning blockchain and cryptocurrencies. Some DeFi projects see poor planning and execution. These uncertainties expose your investments in the DeFi space to risks.
• The limitations of the Ethereum blockchain network: Most people develop DeFi apps on Ethereum. However, the Ethereum blockchain network faces notable scalability issues. The Ethereum project team is working on resolving it. However, that’s a complex and lengthy project. Scalability issues of Ethereum adversely impact the prospects of DeFi apps.
• Smart contract bugs: You can’t modify smart contracts after deploying them, and you can’t reverse their execution. Smart contracts with bugs can be risky due to this. You would need to code smart contracts without bugs. That’s easier said than done! Like every computer program, smart contracts will likely have some bugs. Verification and testing of smart contracts become important in this context. Many organizations and developers are trying to develop solutions in this regard. E.g., Microsoft offers VeriSol, a verification tool for smart contracts written in Solidity.
We looked at what is DeFi. We examined how it varies from traditional financial applications and how DeFi apps work. After reviewing a few prominent use cases of Decentralized Finance, we reviewed the key challenges associated with them. Watch this space for more information on lending and DeFi.