With the massive rise in cryptocurrency investments, individuals and institutions are now beginning to explore decentralized finance (DeFi). Let’s delve more into this emerging space.
What is DeFi?
Decentralised Finance (DeFi) is based on the peer-to-peer concept that removes intermediaries from the system. By relying on peer-to-peer philosophy and self-executing “smart contracts” on the blockchain network, DeFi democratizes finance and replaces traditional centralized institutions such as banks, brokerages, and NBFCs (Non-Banking Financial Companies).
DeFi uses smart contract technology on the blockchain network with zero human intervention. This reduces the chances of errors and increases efficiency.
How does DeFi work?
A DeFi protocol uses computer code called smart contracts that run on the blockchain network. The source code of most of the DeFi projects are available for anyone in the world to check and audit. Users of the DeFi protocol can communicate with these smart contracts using their wallets to transfer funds, borrow, lend or avail any service that the DeFi provides.
DeFi projects on the blockchain network provide easy and cheaper access to capital, efficient lending and borrowing and decentralised crypto and synthetic stock exchanges. Because of its decentralised nature, some DeFi projects like Uniswap have become highly efficient global financial markets catering to individuals and institutions alike. In addition, DeFi removes middlemen and enables more efficient financial services at low costs.
Because DeFi is on a blockchain network and generally open source, anyone with an internet connection can view, audit the source code and see all the transactions. Blockchain data is immutable in nature, which means once the information is on the blockchain network, it cannot be changed. This creates a trustless financial system that relies on code. One such example is a Decentralised Exchange (DEX).
The rising popularity of DEX
In the past few years, Decentralised Finance (DeFi) has managed to bring a sweeping change in the financial world. With disintermediation as the core philosophy, transactions on DeFi and Decentralized Exchanges (DEXs) on the blockchain network have gained huge popularity.
With the help of a technology called “Automated Market Makers” (AMM), DEXs can have deep liquidity by providing asset-specific liquidity pools instead of order books in centralised exchanges. Users can provide liquidity of those assets in these liquidity pools and can earn serious passive incomes via trading fee.
Unlike centralized financial services such as traditional banking, DeFi companies do not require intermediaries or custodians to provide services like buying, selling, lending and borrowing of crypto assets. DEX users can interact directly with the blockchain protocol to execute trades or avail services. This non-custodial framework of a DEX means that users can retain their cryptocurrency ownership and have complete control over their assets in their wallets. DeFi and DEXs rely on self-regulating computer code called “smart contracts” that run on a blockchain network.
Most DeFi projects are built on the Ethereum blockchain network since it has the first-movers advantage in providing an infrastructure that enables developers to build such decentralized applications (DApps). However, new blockchain networks like Solana, Cardano, Polkadot etc. are in development and are slowly creating a more competitive DeFi space.
Although fairly complex with a steep learning curve, DEXs and DeFi projects are slowly becoming a lucrative option for SMEs and startups in the FinTech space around the world. With low barriers to entry as compared to traditional finance, DeFi and DEXs around the world give easier access to cheaper credit, easy lending and borrowing activities - changing the landscape of the traditional financial systems.
Extending to the insurance industry
One of the most impactful use cases of DeFi has been in the insurance industry. While the present-day insurance system suffers from complex audit systems, paperwork and bureaucratic claiming procedures, the usage of smart contracts could make it much more efficient. DeFi projects such as Nexus Mutual, Opyn and VouchForMe also offer insurance coverage for cryptocurrency on the blockchain network. The growing rates of inflation and decreasing interest rates in fiat currencies have made savings and investments tough for middle-class people across the world. With no-loss saving strategies, DeFi projects like PoolTogether, Dharma and Argent have created alternative solutions for risk-free savings and investments.
Since DeFi has replaced traditional banking systems, borrowing and lending protocols have also become one of the major applications of DeFi. Several DeFi projects such as Compound and PoolTogether focus on the peer-to-peer (P2P) borrowing and lending market. Distributed ledger technology (DLT) has made transactions faster, more so in the case of cross-border payments where the cost of transactions and delays caused bottlenecks for both the senders and receivers. DLT has democratised banking by allowing everyone to take loans and even lend fiat against cryptocurrency collateral. In addition, the DeFi ecosystem has facilitated tokenization wherein digital assets can be created, issued and managed on a blockchain network. This has created a new form of economy. For example, digital assets are being tokenized in the form of NFTs to create, store, or trade value. The increase in DeFi adoption has led to the growth of DeFi-based prediction platforms where users can trade value by forecasting the outcome of future events.
Revolutionizing the gaming industry
With platforms like Augur, DeFi allows users to place bets on world events. Games and eSports have also emerged as major markets for DeFi technologies. Game developers can now use DeFi tokens for in-app purchases and loot box features on games. Collectible and trading games have become popular genres on blockchain by allowing players to trade unique tokens and letting developers create their own ecosystems and economies.
The aforementioned advantages of using DeFi explain why it has seen a meteoric growth in recent years, having earned a market capitalization of $128 billion. However, while decentralized exchanges offer many pathbreaking benefits, they also pose certain risks. Unlike traditional banking, there is no regulation or insurance on the investments done on DeFi. DeFi loans are collateralized with other crypto assets. However, if there is a downturn, these assets may sharply decline in value and even be liquidated. In addition, lost data and account information such as passwords can be retrieved back in centralized systems. When trading on DEXs, the user information and therefore the funds could be irretrievably lost if one loses the seed phrase. Hence, as for any investment decision, users must first vet the applications they are exploring to ensure they are safe and well-audited.
To sum it up, although centralized systems still dominate market activity due to user friendly interfaces, security, regulatory oversight, and insurance facilities, the growth of DeFi has created space for decentralized crypto exchange protocols. As more people enter the digital asset space, DeFi will have to expand its capabilities and become more robust in terms of security and scalability. This has already begun with the upgradation of the Ethereum network to Ethereum 2.0. In the near future, DEX is sure to make cryptocurrency trading more fair, private and independent, thereby accelerating the growth of decentralized finance and its supporting mechanisms. The latest developments and trends in crypto investments definitely look promising for Decentralized Exchanges.
