Having doubled its market share in the last three years, decentralized finance (DeFi) is starting to dominate the crypto market. They do have potential, and the proliferation of these innovations is being compared by many to the invention frenzy of the early Internet.
It is part of the fourth technological revolution, which should give birth to an entirely new and fairer architecture for the digital economy, in which archaic perceptions of finance will no longer exist.
While there is yet to be a consensus on what this entails for Wall Street, you and me, we are witnessing the active development and emergence of a new market whose prospects are now difficult to gauge. Crypto is growing in value, interesting new products are emerging, and many are building businesses on it and making good money. We at Defiway offer practical solutions for paying with cryptocurrency in several decentralized networks. This article will introduce you to the basic concepts, how DeFi works, and its advantages, disadvantages, and perspectives.
Decentralization and centralization
There are two subsystems in the financial system - centralized and decentralized. The former refers to economic relations associated with the formation and use of funds accumulated in a state-regulated budgetary system. The latter refers to providing financial products and services within the cryptocurrency market.
Centralized finance
Centralized finance comprises budgets, extra-budgetary, credit, and insurance funds with a territorial connection. The parties that hold and move funds charge fees for their services. Vendors have to pay for the use of cards, and financial transactions from loan applications to local bank services are centrally controlled.
Decentralized finance
DeFi offers an alternative route aimed at distribution rather than concentration of power. It refers to a wide range of financial products and services without centralized control. All rules are written in smart contracts, open to audit, and products are available to as wide a range of people as possible. Therefore, users can carry out financial transactions almost anonymously wherever there is an internet connection.
What is DeFi?
It is a model of financial organization based on service delivery without financial intermediaries or centralized processes, characteristic of traditional financial service delivery, and organized using a variety of decentralized applications built on DLT (Distributed Ledger Technology).
A financial system built on decentralized networks and blockchain technology does not rely on intermediaries and provides direct access to financial services. The level of decentralization can vary depending on the stage of DeFi's life cycle, starting with a centralized project at the creation and application development stage and becoming increasingly decentralized as it is deployed and shared with a wide range of participants.
The foundation of DeFi is generally considered to be the direct control of users over their assets (participants hold assets, and due to disintermediation, the risk on the intermediary is minimized) and the automatic execution of transactions using smart contracts executed on a DLT basis.
The architecture consists of components that enable the creation and deployment of various financial applications.
For example, the non-custodial MetaMask wallet boasts more than 21 million active users. Incidentally, this is 38 times more than two years ago. Examples of trading applications include decentralized exchanges (DEX), DODO, Balancer, Uniswap, etc. Binance NFT, Rarible, and OpenSea are popular for NFTs, while DAI, WBTC, and DefiDollar are famous for Stablecoins.
How DeFi Works
Many, if not all, protocols are centralized in one way or another. The relevant protocols are adapted to users at the application level - online user interfaces based predominantly on the Ethereum platform, smart contracts, and transforming the underlying protocols into accessible add-on services for executing transactions and tracking the execution of smart contracts, so records cannot be changed.
Connection to applications and protocols is through platforms that provide the ability to select and manage various DeFi services and products, connecting the two sides of the medium - liquidity providers and consumers of DeFi services.
Because DeFi is decentralized, the money provided for financial services does not come from one centralized institution. As a result, everyone can participate at different levels of service. To provide liquidity, the platform offers an incentive. It is often presented as the platform's share of transaction fees. Other users can use the liquidity provided by exchanging or borrowing.
DeFi ecosystem
At the heart of DeFi is a framework - a blockchain that allows multiple parties to work according to standard data and rules without having to refer to each other. Each blockchain has its standards for tokens - technical specifications that allow templates to be used for specific development scenarios. The standards are necessary for tokens to be accepted by the system in which they can circulate and interact with smart contracts and other tokens. The Ethereum blockchain, for example, uses the ERC-20 standard for interchangeable tokens and ERC-721 for non-interchangeable tokens.
Based on the standards, different scenarios for token transactions - product protocols - are developed. The execution of the scenarios is determined by the functionality embedded in the smart contracts connected to the protocol. DeFi products replicate classic traditional financial products.
The key elements of DeFi
Blockchain
Core technology. And a distributed and secure database or registry that allows multiple objects to store copies of historical transactions.
Smart contracts
It is blockchain-based software code that executes, monitors, and documents relevant events and actions according to predefined conditions and rules.
Stablecoins
These are cryptocurrencies tied to some fiat currency or physical asset (such as gold). In theory, Stablecoin can be bought or sold at any time at a fixed price. When exchanged for fiat money, a stablecoin is usually "burned" and goes out of circulation.
DApps
These are computer algorithms designed to automatically manage the transfer of asset ownership information after certain conditions are met. More narrowly, they are a set of functions and data (current State) located at a specific address on a blockchain.
Digital assets
Also called DeFi tokens, they represent value that can be sold or transferred on the blockchain. They have a range of functions beyond payments.
Wallets
These are software user interfaces for managing assets stored on the blockchain. Using a non-custodial wallet gives the user complete control over their funds. If the wallet is custodial, the service provider manages the private keys.
Traditional and centralized finance infrastructure executes transactions, records and controls rights transfer to financial assets, and collects stores, and reports information. The infrastructure includes trading, accounting, information, and other organizations.
In DeFi, some of the functions of traditional financial infrastructure are implemented without intermediaries. For example, a distributed ledger records all transactions and their parameters, and this information is available to all blockchain participants. In addition, unlike traditional and centralized finance, transactions are recorded and controlled anonymously or pseudonymously. DeFi participants, without their consent, are generally not subject to scrutiny.
How DeFi eliminates intermediaries
Mediation in the traditional sense is replaced by software tools that work automatically. It is achieved through peer-to-peer networks that take advantage of blockchain's capabilities.
For example, there is no exchange operator on all DEX because smart contracts handle transactions, and the platform itself has no access to the funds. AMM removes the intermediary in determining quotes, and liquidity is supplied by pool participants, who are reimbursed for it. The trading pairs ratio is automatically determined by the algorithm provided by the liquidity pool, not a human.
Benefits of DeFi
DeFi offers plenty of benefits:
- Accessibility and inclusiveness. Transactions happen without any geographical restrictions. No verification is required. With DeFi tokens, users can transact with each other using multiple computers of other participants. It allows any DeFi product to be launched for any project without the need for authorization from banks and regulators.
- Transparency and immutability. Based on open-source code, the system makes all transaction information available to any user. It makes it easy to be audited and creates a fair marketplace. Published smart contracts and transaction records are available for anyone to view without revealing their identity and are immutable by the very definition of blockchain.
- Efficiency and speed. DeFi allows parties to negotiate directly. The system is cross-border and requires no intermediaries. Loans are processed in a few clicks from home, without bureaucratic hassles or inflated interest rates. And low fees are ensured.
- Security and privacy. The decentralized nature of DeFi's protocols reduces most of the risks. The smart contracts on which they are based eliminate the possibility of errors and fraud.
Risks and Challenges of DeFi
So far, DeFi has a small market share in the global financial market, but it has potential because it can provide new opportunities. And yet, for them, there are no boundaries.
However, for all its appeal, the decentralized financial system has not yet become mainstream for several reasons:
Risks of the smart contract
Low performance. Blockchains are slower than their centralized counterparts, requiring additional applications and product optimization. Ethereum can only process 13 transactions per second. When the network is fully loaded, transactions would take too long or prove prohibitively expensive.
Smart contracts are most vulnerable at the time of deployment. Practice shows that if hackers fail to establish a vulnerability early in the protocol's existence, it is less likely to be compromised over time.
Liquidity risks
DeFi uses different variants of liquidity pools. One of the algorithms, Constant Market Maker, provides a constant flow of liquidity. The ratio of tokens in the pool determines the asset price.
The pricing algorithm sets the asset price, which is constantly adjusted depending on trading activity. If it differs from the world market price, arbitrage traders can use the price difference on different platforms to profit.
Because of the pricing algorithm, small pools can suffer from slippage if someone suddenly wants to place a large trade. Therefore, DeFi-protocols currently need more liquidity for a larger audience. And the existing liquidity models could be better too. For example, MakerDAO has a complex pledge mechanism, and Uniswap has a gradual liquidity decline as the asset price changes. There is also fragmentation of liquidity between different networks.
Security risks
DeFi projects do not take responsibility for intelligent contract and oracle errors, malicious use, or loss of keys. High volatility, including in the automatic liquidation of positions, and the lack of regulation of cryptocurrencies can put assets at risk at any minute. In case of a breach or failure to comply with DeFi protocol, users cannot take legal action against a specific responsible party because there is none.
Regulatory challenges
While regulators are still more preoccupied with ICOs and large centralized exchanges, they are also starting to take notice of the fast-growing sector. For example, the US Securities and Exchange Commission (SEC) is investigating Uniswap. It submitted a statement on DeFi's risks, regulations, and opportunities, which was the first step in an attempt to impose taxes and restrictions on crypto traders.
2022 also blocked the most significant transaction mixer, Tornado Cash. Github, RPC Infura, and Alchemy Platform repositories were also blocked, as well as some domains. Because of this, the mixer's website and related services stopped working. More than 250 addresses at the frontend level were blocked by the decentralized exchange Uniswap.
DeFi is also entirely inherent in the risks that are present in traditional finance and that the regulation of the financial and monetary sector is aimed at limiting:
- threats to financial stability;
- reduction in the effectiveness of monetary policy;
- possible distortion of competition;
- weakening consumer protection in financial services
Future of DeFi
Will this sector be able to revolutionize and supplant the traditional financial market, or will it remain a niche for professionals and speculators? It probably can.
Potential growth and adoption of DeFi
The DeFi market goes far beyond cryptocurrencies and simple transfers. It provides access to DEX, liquidity, lending, borrowing and escrow protocols, insurance, and derivatives trading. Theoretically, this sector offers a complete replacement for the traditional financial market, which would operate automatically without intermediaries.
Challenges and obstacles to widespread adoption
Although the sector is growing at a fantastic rate, the number of users and transactions and the volume of liquidity could be more impressive. The number of DeFi addresses now exceeds 3.3 million. It is less than the total number of cryptocurrency holders, estimated at over 220 million. That said, the highest DeFi activity is among the big players.
The mass user still needs to understand all the possibilities and prospects of DeFi, so they are cautious. They are intimidated by the lack of responsibility, the complexity of use, and security issues. They see what happens to some exchanges and cryptocurrencies and don't want to lose their hard-earned money.
The adoption of DeFi is moving fastest in high-income countries with already mature cryptocurrency markets. This market is currently geared towards crypto-insiders - people who have been in the industry for some time and have enough money to experiment with new assets. In the long term, when Ethereum prices fall, the DeFi sector will become more accessible.
Potential impact on the traditional financial system
Enthusiasts believe DeFi is more than just about high returns and speculation. This sector can potentially displace the conventional financial market, replacing banks and fintech companies for billions of people.
This view is based on DeFi's ability to conduct transactions faster and cheaper than classical financial service providers. At the same time, such transactions are completed without minimum transfer amounts and with greater transparency. It could encourage many people to abandon traditional banks and brokers in favor of DeFi protocols.
As we advance, DeFi has the potential to grow tenfold in terms of funds raised. Another growth driver is institutional investments. Currently, institutions cannot own cryptocurrencies directly and must use custodial services. However, there are already plans to create investment funds for Uniswap and Aave, and the latter's credit protocol is working on launching liquidity pools for institutional investors.
Conclusion
DeFi is transforming the familiar infrastructure and interface of traditional finance. Technological solutions and disintermediation allow for variations in transaction speeds and costs.
So far, this sector needs to see something regarding mortgages or benefit payments. DeFi technology and principles will likely move into traditional fintech companies to one degree or another. We will see the same p2p products but with regulation and a central management body.
DeFi will remain a niche for professionals in the coming years. Still, decentralized finance gradually becomes more popular among the masses if the industry gets regulated and attracts more institutions.
For DeFi to become more mainstream, the sector needs to address security issues, introduce minimal regulation, sites need to improve the interface and user experience, as well as increase scalability and attract liquidity. Then the benefits of decentralization will become apparent to a broader audience. And if you want to take advantage of them now, we're here to help. Visit the Product Section on our Website to get DeFi's advanced solutions low fees and lightning-fast transaction speed!
