What Is DeFi

Olga Shirimova
May 18, 2020
What is Defi article featured image

DeFi abbreviation stands for “decentralized finance”, one of the biggest blockchain trends that will probably shape the future of our financial interaction. Let’s see what DeFi is and what it promises us.

What Is DeFi: Definitions

If you ask several crypto enthusiasts what DeFi means, you may get a broad range of answers. The popular versions would be “the biggest financial revolution in the last 200 years”, “blockchain-based financial software” or “a solution to the failures of traditional finance.”

We can narrow it all down to 2 basic definitions.

Depending on the context, Decentralized Finance can refer to:

  • the open ecosystem that consists of blockchain-based financial apps, digital assets, and protocols;
  • the Open Finance movement that promotes the development and usage of decentralized financial products.

Simply explained, DeFi means putting all the existing financial services on blockchain.

Traditional, FinTech, and Defi projects. Image source: HEDGETRADE

Cryptocurrencies, Fintech, and DeFi: Key Differences

For many people, Decentralized Finance, cryptocurrency, and FinTech sound synonymic. All three terms refer to fast and hassle-free global payments. But there are some important differences.

  • Cryptocurrency is the blockchain-based digital money that makes transfers direct, cheap, rapid, secure, and borderless. No matter where the payer and payee are located — they can send and receive crypto funds in a peer-to-peer manner within the same network.
  • FinTech (Financial Technology) is often confused with DeFi, and for a reason. First, they sound alike. Second, both things seek to make financial services more accessible and convenient for the average user. Note that FinTech is broader than DeFi: this umbrella term may cover both centralized and decentralized financial solutions. Thus, most FinTech projects aim to improve, and not to disrupt traditional infrastructure. Good examples would be Transferwise, a global money transfer service, crowdfunding platforms like GoFundMe, and mobile payment apps like Venmo by PayPal.
  • DeFi as a term is broader than cryptocurrency but more narrow than FinTech. This ecosystem builds upon the blockchain technology and relies on peer-to-peer transactions between network users.
Best DeFi projects based on the Ethereum blockchain. Image source: DeFi Prime

DeFi and Ethereum

The Open Finance ecosystem relies on decentralized financial apps (DApps). In the vast majority of cases, such Dapps stand on the Ethereum platform, the pioneer of the sector. As all these applications root in the same blockchain and operate under the same set of rules, they can interact with each other. Therefore, the users can combine, adjust, and customize various DApps to better suit their needs.

It’s like Lego: you construct your financial reality clicking blocks together. Though the blocks may differ in color and design, they are always compatible with each other.

Decentralized and traditional (centralized) financial systems have different structures. Image source: Stably

The Decentralized and Centralized Compared

To understand how a DeFi app works, let’s juxtapose it with a centralized payment service, like Transferwise or PayPal. Both aim at making money transfers fast and cheap, compared to the traditional banking system — costly and slow.

PayPal consumer fees for international transfers depend on the country you send money to.

Centralized Transfer: Example

Let’s consider a real-life example. Alice sends $100 to Bob living in another country. The company, providing the service, takes these $100 from Alice’s account in Bank A. Bob receives this amount from the company’s account in Bank B. This scheme allows the guys to move money faster and reduces transaction fees. 

Ok, everything looks rather affordable and convenient. But there are a few important things to keep in mind. First of all, Alice has to trust the company she uses. Second, she depends on the service provider to approve and execute her transaction. As we know, each payment undergoes a screening process. In this respect, PayPal (and similar FinTech companies) are not different from banks. If Alice’s transaction seems “suspicious”, her funds may be locked. It will take some time to solve the problem with the company, depending on how responsive their customer service is.

Besides, Alice may be unable to send money to Bob if he lives in a country where the payment system doesn’t operate. Or if her card issuer (another centralized organization) is experiencing some technical problems.

You can buy, send, receive, trade, borrow, or hold DAI stablecoin using the platforms that support it. Image source: MakerDAO

DeFi Transfer: Example

Now, let’s consider a decentralized payment scenario, where Alice uses a DeFi product to send her friend $100. For it, she can opt for the Dai stablecoin, a “digital dollar”. Stablecoin is a hybrid between crypto and fiat currency that matches the benefits of both.

In this case, Alice does not depend on any company or bank to approve and perform her transfer. She pays a fee to the Ethereum miners who validate her transaction and add it to the blockchain. This fee is tiny compared to what Alice would pay to a money transfer service like PayPal. Also, the funds will reach Bob very fast. Normally, it takes between 15 sec and 5 min to process a transaction. If the network is busy and Bob needs money badly, Alice can always speed things up by increasing the standard gas price.

Total USD value of funds locked in the DeFi sector (2019). Image source: CryptoMonedas&ICOs

DeFi: Main Products

The decentralized finance system offers various types of products. The list includes:

  • Stablecoins. This type of cryptocurrency features minimal volatility, as its value is pegged to a fiat currency (USD, EURO) or a commodity (gold, oil, and other basic goods). Therefore, such coins add stability to the crypto ecosystem. Currently, the most famous Ethereum-based stablecoin is DAI by MakerDAO.
  • Landing protocols. On decentralized platforms like Aave, users can lend and borrow money and earn interest. The key difference between Aave and a bank is that there are no central authorities to determine interest rates and loan terms. The system applies smart contracts to connect borrowers and lenders and distribute interests. There are no rigid conditions: you can choose between fixed and flexible rates. It’s up to your to decide what looks better.
  • P2P marketplaces and exchanges. A good example is OpenSea, a peer-to-peer marketplace. It allows users to buy and sell various digital items, including collectibles. The non-fungible assets, traded on the platform, comply with the ERC-721 and ERC-1155 standards. Read more about these standards and non-fungible tokens in this article.
  • Investment platforms like Synthetix. They give users an opportunity to create “synthetic” versions of real assets like currencies, commodities, and stocks. On this non-custodial platform, you can trade such “synths” in a peer-to-peer manner.
  • Insurance. Due to smart contracts, insurance agreements become more convenient. As we know, normal insurance payouts may take up to several months (or even years). It’s because a company has to carefully examine and process every claim. A DeFi insurance platform using smart contracts can streamline this cumbersome procedure. As soon as the pre-agreed event (like a flight delay) happens, a certain amount of money comes to your wallet automatically. 
Defi and traditional finance: trusted intermediaries versus blockchain protocols. 

DeFi: Distinctive Features

Several properties make DeFi apps stand apart from other financial innovations:

  • As the name suggests, these apps are decentralized in nature and backed by smart contracts. If you are not familiar with this concept, read this guide to fill the gap.
  • No trusted authority is necessary to make smart contracts work. They are self-executing agreements, with terms and conditions written in the form of computer code. When certain conditions are met, the program runs automatically. We call it a “trustless system”.
  • Thus, a DeFi system doesn’t need any intermediaries. Potentially, it could make the bureaucratic machine, with its complicated hierarchy, unnecessary.
DeFi: the benefits are balanced by a few major challenges, including regulation risks.

DeFi Benefits

Here is an incomplete list of benefits DeFi has to offer:

Inclusiveness
Most importantly, unbanked people all over the world get access to financial products and services. It becomes easier to send, receive, loan, and borrow money. Those unable to afford a traditional insurance contract now can protect themselves from emergencies.

Alternative to traditional forms of investment
There is no central body (like a government) to control and guide your investment policy. Also, more people get access to the forms of investments they couldn’t afford before. For instance, a tokenized piece of art or a building can be owned by many individuals, each holding a fraction of the asset.

New money-making opportunities

You can make your money work by depositing them on a landing platform. Other people will borrow it and you will get your interest. Therefore, you can avoid holding your money in banks. This is a big advantage, especially if you live in a politically unstable area and don’t trust centralized institutions.

As you see, Decentralized Finance takes the dreams of Satoshi Nakamoto to a whole new level. Just imagine every smartphone user having a decentralized alternative to every financial product.
It’s the future we are looking forward to.

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