Decentralized finance, or DeFi, has become more than just a trendy buzzword in the crypto community. Today, it has become more than just a concept that's upending the centralized financial services paradigm. It’s spreading connectivity, transparency and is giving people more power all over the world.
We'll go over everything you may want to know about DeFi in this article, including what is DeFi, what the DeFi components are, DeFi versus traditional finance, and the current state of DeFi.
What is DeFi?
DeFi is a catch-all word for trustless and open protocols that don't rely on the need for third parties to function. Traditionally, centralized authorities such as banks, clearinghouses, and financial advisers have provided the usual financial services and goods. DeFi has entirely restructured and transformed this to deliver the same financial services systemically without the need for a central regulator. This, in turn, has lowered costs and increased access to financial services and goods for more people on a global scale.
The “De” refers to “decentralized” or “distributed” authority. DeFi turned a historically centralized government structure into a decentralized and transparent one with no central authority by transferring it through programmatic and autonomous code.
The letter "Fi", on the other hand, in DeFi stands for "finance," and more precisely, "financial services." Traditional finance is continuously being challenged by DeFi, which has turned long-standing financial services and institutions into fragmented versions of no central authority. DeFi offers a viable alternative to traditional financial services such as investing, borrowing, insurance, lending, saving, and crowdfunding.
DeFi has also brought to the table cryptographic tokens. Cryptographic tokens come in a variety of forms. One of the most common is a "utility token," which performs a particular role within the crypto ecosystem. The Basic Attention Token (BAT), for instance, is a cryptocurrency that is used to compensate advertisers, consumers, and content developers on the Brave browser. It has also brought non-fungible tokens, also known as NFTs. These tokens transform intangible images (such as pieces of art, tweets, videos, and GIFs) into specific properties that can be exchanged on the blockchain. So not only does DeFi replace and transform existing financial services, but continues to innovate and bring more than what ordinary financial institutions are used to offer.
What are DeFi Components?
DeFi has a number of components similar to those of the current financial ecosystem where they include stable currencies and a diverse range of use cases. Stablecoins and utilities such as lending services and crypto exchanges are some of the pure examples of the many DeFi elements. Smart contracts, for instance, provide the basis for DeFi apps function and with them, the terms and activities required for these applications to operate are encoded. A smart contract code, for instance, holds a unique code that specifies the precise terms and conditions of a particular loan. Such as a traditional loan, collateral may be liquidated if such terms or requirements are not fulfilled. However, rather than a bank or other entity doing this task manually, it is achieved in a programmable way.
Another main component of DeFi is a software stack. A software stack holds all of the underlying elements of a DeFi structure. The elements of each layer act as individual functions that are designed to serve a particular role in the overall DeFi structure. Composability is a specific feature of the stack that allows for the creation of a DeFi app with all the components from each layer combined.
There are four layers to each software stack:
- Settlement Layer: The settlement layer, which is also known as Layer 0, serves as the foundation for all other DeFi transactions.
- Protocol Layer: Software protocols are written specifications and guidelines that regulate particular tasks or operations.
- Application Layer: The application layer is where consumer-facing apps are stored and are abstracted into basic consumer-focused utilities.
- Aggregation Layer: This is where aggregators bind different applications from the previous layer to deliver a service to investors.
DeFi vs Traditional Finance
DeFi has the potential to transform the existing financial market entirely. At the heart of the decentralized finance vs. conventional finance, controversy is the need for an open, accessible, and stable financial system. So, it's no wonder that decentralized finance is increasingly gaining traction as a possible alternative to current financial systems.
One of the most attractive aspects of DeFi is its capacity to be a financial instrument that is independent of political and regulatory oversight. An example of this is decentralized banking, which is a blockchain-based concept, that has the potential to challenge conventional finance. The development of fully autonomous financial networks has accelerated since its beginning, despite increasing demands for privacy and data protection.
There are three main aspects that differentiate between the potential of DeFi over traditional finance. The first of them is a shared blockchain in DeFi that serves as the confidence base of decentralized finance, overseeing all financial transactions. In conventional finance, on the other hand, there is a central authority or public government in control. This authority serves legislation and approved financial institutions, which acts as the basis of confidence that oversees all activities.
DeFi is also gaining popularity due to the fact that it is more flexible and straightforward than traditional finance. In DeFi, there are no barriers to entry, anybody with computer expertise can contribute to the development of financial services and resources on top of public blockchains. In conventional finance, on the other hand, as found it difficult to follow the new trend due to high entry barriers. The requirement of obtaining proper licenses and approvals from regulators has stifled creativity in conventional financial markets.
The Current DeFi State
DeFi has been around for years, although it boomed so recently that it seems as though it came out of nowhere. Ventures like 0x (ZRX) and MakerDAO (MKR) lifted the overall DeFi market cap to over $5 billion in 2018, when the price of Ether (ETH) hit new highs. As of March 2021, the gross volume of DeFi contracts was over $41 billion according to DeFi Pulse. The total value locked is determined by multiplying the number of tokens in the protocol by their USD value.
The total value locked up in DeFi contracts has soared from $2.1 million to $64.9 billion since September 2017 and the time of publishing (April 2021). It has risen by $53.9 billion since only October 2020. As a result, the market cap of all the tradeable tokens used in DeFi smart contracts has skyrocketed. It is currently about $128 billion, almost triple what it was at the end of January. Several tokens have increased in value three to four times in a year due to DeFi– and others have increased significantly further.
Today, there are a number of things you can do using DeFi services. Using apps like Compound or Aave, you can borrow and lend cryptocurrencies to gain interest. A betting platform, Augur, allows you to wager on the outcome of events. You can purchase stablecoins, which are cryptocurrencies tied to the valuation of a certain currency or product. DAI and USDC, for example, are also pegged to the US dollar. Synthetix, a token trading platform, allows you to create and trade derivatives of real-world assets like currencies and precious metals. With DeFi, you can also take part in a no-lose draw on PoolTogether, where everyone gets their money back and one lucky player wins all of the interest earned in a pooled pot.
On top of all this, DeFi adoption levels are also increasing, particularly by wealth management funds. Grayscale, the world's first crypto investment company, is one to mention. In just the first half of 2020, it was handling over $5.2 billion in crypto assets, where $4.4 billion of it was Bitcoin.
DeFi has the potential to transform the financial industry. It currently provides very favorable returns when comparing it to conventional financial markets and other crypto opportunities. For instance, lending interest rates alone are far higher than savings rates at most traditional banks. Staking, which helps crypto users to win monthly prizes, is a competing opportunity within the crypto industry also helping users make money through DeFi.
The question remains; is DeFi the way for the future of finance? There are loads of crypto enthusiasts and investors alike believing it is. The benefits it adds, such as cheaper prices, quicker settlement, and technologies like flash loans, along with the global crypto adoption will eventually give us the answer and determine if our financial future will revolve around DeFi.