More specifically, the term Defi refers to the trend of creating an open source financial services ecosystem with completely transparent and permissionless applications, allowing anyone to freely use it without any control. of any agency.
Users will maintain full control of their assets and interact with this ecosystem through peer-to-peer (P2P) and decentralized applications (DApps). A core benefit of DeFi is easy access to financial services, especially for those who are isolated from the current financial system.
Another potential of DeFi is the frameworks and modules on which it is built. In other words, DeFi applications can interact on blockchain publicity has the potential to create entirely new financial markets, products and services.
This article will take a deeper look at DeFi, its promising potential applications, limitations, and more.
What are the biggest advantages of DeFi?
Traditional finance has institutions such as banks or courts to mediate arbitration. DeFi does not need any intermediaries or arbitrators. Because the system's code already specifies how to resolve any possible disputes, and users always maintain control of their funds.
This reduces the costs associated with the provision and use of products, and allows the financial system to operate in a more stable manner.
As these new financial services are deployed on blockchains, single errors will also be eliminated. In addition, data is recorded on the blockchain and spread across thousands of nodes making censorship or service downtime a complicated business.
Since the mechanism of action for DeFi applications is pre-built, their implementation also becomes less complicated and more secure.
Another significant advantage of the open ecosystem is that individuals who do not have access to any financial services will have easier access. In other words, because the traditional financial system relies on profit-making intermediaries, their services are often not available in locations with low-income communities.
However, with DeFi, costs are greatly reduced and low-income individuals can also benefit from a wide range of financial services.
Potential applications in DeFi?
Borrow & Lend
Lending protocols are also among the most popular and are an important part of the DeFi ecosystem. The open, decentralized lending and borrowing system has many advantages over the traditional credit system. They provide instant transaction settlement, digital asset collateral, no credit checks, and future standardization capabilities.
Since these lending services are built on public blockchains, they minimize the credit requirement required, instead they are guaranteed by cryptographic verification methods. The blockchain lending marketplace reduces counterparty risk, making borrowing and lending cheaper, faster, and available to many.
Money-related banking services
As the definition and the name suggests, DeFi is basically financial applications, banking services and money. This includes the release stablecoins, mortgage and insurance.
As the blockchain industry is growing, there is more and more investment in the creation of blockchains stablecoins. Stablecoins is a kind cryptocurrency, which is typically tied to a real-world asset, but can be transferred digitally with relative ease.
Because of the price cryptocurrency can fluctuate rapidly at different times, decentralized stablecoins can be used every day like digital cash, even though not issued and monitored by a central authority.
Typically, with the number of intermediaries involved, the mortgage process in traditional finance is often expensive and time-consuming. With the use of smart contract, underwriting fees and legal costs can be significantly reduced.
Insurance on the blockchain can eliminate the need for intermediaries and allow risk distribution among multiple participants. This can lead to lower premiums with the same better quality of service. If you want to read more on the topic of blockchain in the banking sector, we recommend you to read the article: How Blockchain technology will impact the Banking industry.
This type of application is difficult to evaluate, as in the financial sector, this is inherently the most innovative aspect of DeFi. Arguably, the most important application of DeFi is decentralized exchanges (DEX). These platforms allow users to trade digital assets without the need for a trusted intermediary (exchange) to hold the funds on their behalf. Transactions are made directly between user wallets with the help of smart contract.
Since they require less maintenance, decentralized exchanges typically have lower transaction fees than centralized exchanges.
Blockchain technology can also be used to issue and enable ownership of a wide range of conventional financial instruments. These applications will operate in a decentralized manner, offloading supervisors and eliminating single errors.
For example, a security token issuance platform can provide tools and resources for issuers to launch tokenized securities on the blockchain with customizable parameters.
Other projects may allow the creation of derivatives, synthetic assets, decentralized prediction markets, etc.
What is the role of smart contracts in DeFi?
Most of Defi's existing and potential applications involve the creation and execution of smart contracts. While conventional contracts use legal terminology to define the terms of the relationship between the parties to the contract, smart contracts use computer code.
Since their terms are written in code, smart contracts are the only thing capable of enforcing those terms - also through code. This allows for reliable and automated execution, unlike a large number of business processes that currently require a lot of manual monitoring.
Using smart contracts is faster, easier, and reduces risk for both parties. But on the other hand, smart contracts also create new types of risks. Since they are code, they are prone to code errors and security holes, and value and confidential information locked in smart contracts is also at risk.
What challenges is DeFi facing?
- Poor performance: Blockchains are inherently slower than centralized systems, and this will also be “inherited” to the applications built on them. DeFi application developers need to take these limitations into account and optimize their product accordingly.
- High risk from user error: With DeFi applications, the risks from the middle party have now turned into user error. This can be a negative aspect to many people. Designing products that minimize the risk of user error is a particularly difficult challenge when developing products on immutable blockchains.
- Bad user experience: Currently, using DeFi applications still requires users to make more effort to perform more complex operations. For DeFi applications to become a core element of the global financial system, they must deliver tangible benefits to encourage users to switch from the traditional system.
- Complex Ecosystems: Finding the most suitable apps for a particular use case is still a challenge for users, and users must be able to find the best options. Building applications is already hard, but making them easy to use in a large DeFi ecosystem is even more challenging.
What is the difference between DeFi and Cefi?
Cefi is a banking system where third-party financial service providers are granted secure access to financial data through APIs. This allows the connection of accounts and data between banks and non-bank financial institutions. It also essentially creates new types of products and services that are part of the traditional financial system.
However, DeFi proposes an entirely new financial system that is independent of the existing infrastructure. DeFi is also sometimes referred to as open finance.
For example, open banking can enable management of all traditional financial instruments in one application by securely pulling data from several banks and institutions.
Meanwhile, Defi can also enable completely new management of financial instruments and entirely new ways of interacting.
Defi focuses on building financial services that are separate from the financial system and traditional politics. This will enable a more open financial system and be able to prevent precedents of censorship and discrimination around the world.
While an appealing idea, decentralization doesn't make everything beneficial. Finding the most suitable features, based on the characteristics of the blockchain is crucial in building useful open financial products.
If successfully developed and scaled up, DeFi could take power away from large centralized organizations and put it in the hands of the open source community and individual individuals. Would that help create a more efficient financial system? This will be decided when DeFi is recognized and adopted in the mainstream finance.