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Jun 18, 2020

11 min

226

226

11 min

DeFi: Explained

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There is a brand new monetary system on the horizon. As evidenced by the 2008 global financial crisis, cryptocurrencies have emerged as a solution given the inequalities and inefficiencies of traditional institutions.

Since the advent of Bitcoin, the adoption of blockchain technology in the finance world has increased the decentralization of financial services, creating a new world of decentralized financial services, also known as DeFi.

In this article, we will take you through what DeFi is, its advantages, risks, and challenges while highlighting some of the top DeFi projects to look out for soon. But first, how does DeFi differentiate itself from existing FinTech solutions?


DeFi vs. Fintech

At its core, FinTech (Financial Technology) is the use of innovation to enhance and replace existing traditional financial methods of delivering financial services. Although it might be easy for anyone to argue that decentralized finance DeFi is the same as FinTech solutions, nothing could be further from the truth.

Sure, both FinTech and DeFi aim to establish financial inclusion, efficiency, and freedom through the use of technology.  

However, one of the key differences that distinguish the two is that FinTech solutions emerge from specific centralized companies. At the same time, DeFi applications are open source systems that operate autonomously without the support of a centralized entity.

DeFi applications stand out from the fact that they take on a new open-source approach that allows many services to be launched on top of the blockchain. An excellent example of how DeFi operates is how the internet, a decentralized network of computers, is designed to be a platform from which other services with a central entity can be built. The internet itself has no owner.


DeFi’s Main Advantages

One of the main benefits of DeFi is permission-less finance. DeFi applications apply practical solutions to the world’s unbanked by offering access to financial services that were previously inaccessible.

Although there exist some FinTech solutions such as Mpesa that have succeeded in encouraging the inclusivity of the unbanked, the data reveals that there is still much to be done. Despite the emergence of mobile money solutions, banks still rely on IDs and credit scores to verify customers, yet most of the unbanked lack these credentials. With DeFi applications, users do not need to have IDs or credit scores to benefit.

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Another advantage that DeFi offers is its efficient methods of user verification. Given the vulnerability of financial products to fraud, KYC (know your customer) and AML (anti-money laundering) protocols have been put in place as a solution for verifying and identifying customers. 

However, these methods put the customer’s identity at risk since that data is stored by the central entity collecting a customer’s ID for verification. If a hack was to happen at a specified FinTech company, the customer’s identity could be sold on black markets. 

DeFi applications come to the rescue with a solution that efficiently prevents fraud while ensuring installing a reliable verification process without the need of a customer’s details. 

By design, DeFI solutions are taking trust out of the hands of humans and embedding it into the code that runs the entire technology. This protects the customer’s identity in the event of an attack and makes it impossible for corrupt and malicious activities to thrive on the network.

In light of the current pandemic, DeFi solutions could provide a much more effective and efficient alternative for disbursing a universal basic income from governments. With DeFi, millions of people can get funding from the government in an instant with traceable payments that are cost-effective. 


DeFi’s Projects

Various industries can benefit from decentralized finance. You will find DeFi projects in different sectors, including insurance, merging trading, asset management tools, and analytics, to mention only a few.

Here is a quick look at some DeFi projects out there.


Decentralized exchanges

Examples of DeFi exchanges include applications such as AirSwap. This is a peer to peer token trading platform built on Ethereum’s blockchain. AirSwap’s most outstanding feature is that it operates as an exchange without trading fees. Another one is 1inch.exchange. As a cost efficiency measure, this application splits orders to several decentralized exchanges such as KyberNetwork, Bancor, and UniswapExchange.


DeFi Lending

Here you will find applications such as Atomic Loans, which allow you to lock your Bitcoin in a non-custodial escrow. Then, you can borrow stable coins and lend them out while you earn interest. Fulcrum is another DeFi platform pushing the idea of margin trading and lending to the next level. With Fulcrum, users not only get to lend assets for interest, but they can also get into short or leveraged positions through tokenized margin trading. By this design, Fulcrum makes it possible for users to maximize gains through issuing loans and taking compassable margin trade positions. 


DeFi Marketplaces 

If you are looking for an online marketplace free from the controls of a central entity, these DeFi marketplaces will be a good fit. GitCoin, for instance, acts as a market where freelance developers get to interact with one another and with clients to work remotely on open source software projects. Another one is OpenSea, a peer-to-peer marketplace for crypto enthusiasts looking to exchange crypto collectibles.


Decentralized prediction markets 

With a decentralized finance solution, the outcome of events can be traded on a peer-to-peer platform where predictions can be priced based on the market’s judgment. One particular application in this area is Augur. This DeFi application enables users to vote and put a price on the outcome of events. By this logic, anyone can tap into the crowd’s collective wisdom and make predictions of future events.  


What’s next for DeFi?

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As the world continues to embrace blockchain technology, the future of DeFi applications seems to get brighter. As time progresses, the DeFi industry is set to redesign all the services present in the traditional finance world today. 

In the face of crypto and blockchain’s mass adoption, the future will see crypto wallets become the gateway to all digital asset activity. Picture using your crypto wallet as the interface for interacting with a variety of blockchain networks where you can manage your digital assets, lock some of it on an open-source finance protocol or even create smart contracts for your next mortgage. 

While there is still a long way to go to achieve this, significant strides are being made by DeFi developers in sectors such as insurance. Projects such as Opyn are developing insurance layers for the benefit of decentralized finance projects, while projects like Etherisc are providing insurance protocols that enable collective risk transfer solutions. 

There is also a progressive shift towards decentralized governance with projects like Maker Dao showcasing how large organizations can be run by stakeholders who vote and make decisions.


Challenges & Risks

DeFi applications present unique and practical solutions to the problems faced by the current financial system. However, as much as DeFi solutions offer a direct route to the customer, improving efficiency and security in the process, DeFi applications are challenged by speed, scalability, and liquidity.

Currently, DeFi application on public Blockchains cannot process large volumes of transactions as traditional FinTech solutions like Visa. While Visa is capable of 24,000 transactions per second, Ethereum can only manage 15TPS, and Bitcoin can manage 7TPS.  

This lack of speed makes it challenging to scale DeFi solutions to the masses. Lack of liquidity is another problem faced by DeFi applications, as evidenced by the price volatility of cryptocurrencies. 


Solving DeFi’s challenges (Preparing for the future)

Even though the DeFi landscape is plagued by challenges highlighted above, several projects are working towards solutions. 

Bitcoin’s lightning network is a good example of an attempt to make the Bitcoin blockchain scalable by recording some of the transactions off-chain. The Ethereum blockchain is also set to move from a Proof of Work protocol to a fast and power-efficient Proof of Stake protocol soon.

Furthermore, like any other emerging financial product, DeFi applications are in their nascent stage and therefore bound to have a list of challenges beyond what could be covered in this post. 

Overall, DeFi applications present a huge potential for transforming the world of finance as we know it. Even though the current landscape is playing catch up to the traditional financial system, anyone can guess what the future holds if the industry is given room to grow.

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