Decentralized Finance (DeFi) are financial services that are conducted with no central authority.
DeFi services are controlled entirely by blockchain technology rather than intermediaries like bankers.
DeFi works using smart contracts to facilitate trustless, peer-to-peer transactions for a wide range of financial services.
Cryptocurrencies like bitcoin were invented as a way to change the way we think about currency and payments. As the popularity of bitcoin has increased, people have begun to apply its principles and technology to other facets of the financial sector. These innovations are known as Decentralized Finance, or DeFi. DeFi eliminates the need for banks, financial institutions, or intermediaries and allows people to conduct financial transactions directly with one another.
What is DeFi?
Decentralized Finance (DeFi) are financial services that are conducted with no central authority. DeFi services are controlled entirely by blockchain technology rather than intermediaries like bankers.
The challenge with traditional financial services
Traditional financial institutions like banks, lending companies, and insurance agencies are centralized, meaning someone at the top controls them. Humans are generally pretty vulnerable to compromise, so institutions run by humans are prone to mismanagement, fraud, and corruption.
Financial malfeasance is not a given, but it has happened in the past. Remember the Great Financial Crisis of 2008? Much of the blame for that crisis is on the leaders of big banks and lending companies who made some very bad decisions. Same with recent collapses at Silicon Valley Bank and other institutions.
In addition to a flawed past, the present financial ecosystem is simply not accessible to many. Traditional banking and lending are famous for high fees, slow transaction times, long waiting periods, and discriminatory practices. In general, financial structures are outdated and overly complicated.
How bitcoin can address these challenges
When it comes to financial services, we are forced to trust people with our money that have proven they cannot always be trusted. Bitcoin was invented in light of the Great Financial Crisis to remove the need for trust in finance and streamline the process.
Bitcoin is a decentralized currency used to send payments to anyone, anywhere in the world, quickly and at a low cost. Rather than relying on the trust of intermediaries and banks, it runs on a distributed ledger of millions of computers worldwide, called nodes, that use the mathematical principles of cryptography to verify transactions and eliminate fraud risk.
Bitcoin has truly revolutionized the way we think about money but is currently limited in its capabilities. Decentralized Finance takes the best parts of Bitcoin and applies them to the rest of the financial system.
How DeFi works
DeFi works primarily through the use of smart contracts. A smart contract is a software program that uses blockchain technology to create cryptographically secure, self-executing contracts with the terms of agreement written directly into the code. The code controls the execution, and all transactions are trackable and irreversible. Smart contracts allow trustless transactions and agreements to be carried out among pseudonymous users without the need for a central authority.
Ethereum is the most commonly used ecosystem for DeFi because it was the first blockchain network to introduce smart contracts. While Ethereum is the leader, there are a growing number of alternative blockchains that support smart contracts including Polkadot, Cardano, and Solana.
Beyond creating a trustless system, DeFi is incredibly transparent and immutable because all terms and transactions are recorded on a blockchain, which means they cannot be changed or erased. And because blockchains are permanent public records, they are also censorship-resistant. Plus, costs are substantially lowered by cutting out the middlemen because no lenders, lawyers, or bankers are charging fees.
Popular DeFi protocols
DeFi systems, referred to as protocols, seek to decentralize various functions of the financial ecosystem. Below are four of DeFi’s most popular projects.
1. Decentralized lending and borrowing
DeFi lending platforms provide the ability to borrow and lend cryptocurrencies directly with one another. Aave is one of the most popular DeFi lending projects. Aave allows people to borrow a wide range of cryptocurrencies without oversight from banks, brokers, or other intermediaries.
A stablecoin is a cryptocurrency that uses smart contracts to back up its value by a reserve asset like a government-issued currency or gold to offer price stability. Stablecoins are popular when using other DeFi protocols like lending because they provide the fast processing and privacy of cryptocurrencies while simultaneously offering the stability of fiat currencies like the U.S. dollar, euro, or yuan. They mitigate the volatility risk of cryptocurrencies and are often used in crypto loans.
Oracles are a blockchain software used in DeFi that act as an intermediary, translating off-chain (or real-world) data to smart contracts on the blockchain and back again. In other words, oracles provide reliable, tamper-resistant inputs and outputs for complex smart contracts. Oracles can be set up to monitor almost anything, such as weather, sports results, account balances, stocks' value, and more.
Chainlink is the most popular oracle project. It uses smart contracts to provide information from off-blockchain sources like the real world to on-blockchain smart contracts via oracles.
4. Decentralized exchanges
Decentralized Exchanges (DEXs) allow users to buy and sell crypto without centralized oversight. DEXs use smart contracts to match buyers with sellers to facilitate transactions directly, peer-to-peer. Popular DEXs include Uniswap, Pancakeswap, and Binance.
The future of DeFi
DeFi has begun to revolutionize many aspects of the financial services sector. As it stands, the DeFi sector is worth hundreds of billions of dollars. DeFi is used to streamline processes and make the financial system more efficient and equitable. It is clear that DeFi and the technology behind it are here to stay.
However, DeFi is still very much in its infancy, and the industry at large faces its share of risks. For starters, DeFi is currently unregulated (unlike the traditional financial sector, which is heavily regulated). Regulations are sure to come and, in many ways, are welcomed to bring clarity to the space. Laws that are too harsh, however, could seriously stifle innovation and stop the industry from growing further.
Additionally, new projects are popping up all the time, and the coding behind the protocols isn't always perfect. There are plenty of malicious actors out there looking for any vulnerabilities in DeFi protocol code to exploit. Unfortunately, this has happened many times already, and users of certain protocols have lost a lot of money. All of the DeFi coins and tokens supported by Olliv (listed above) are already well established in the space, so the risk of those projects being compromised is low.
I sincerely believe many of the risks associated with DeFi will soon be ironed out, and decentralized financial tools and services will be commonplace in the future. DeFi protocols make the financial ecosystem run more efficiently and provide new opportunities for those traditionally left behind from centralized finance.
If you believe in the power of DeFi and want to invest in some DeFi cryptocurrencies, Olliv has you covered.
Financial Advice Disclaimer: Nothing in this blog constitutes professional or financial advice, performance data or any recommendation that any specific cryptocurrency, portfolio, index, investment product, transaction or investment strategy is suitable for any specific person. You assume the sole responsibility of evaluating the merits and risks associated with all financial decisions and should seek the advice of a registered financial advisor when in doubt.