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What is DeFi?

The traditional financial system relies on institutions such as banks, which act as intermediaries, and courts to resolve disputes. In such a situation, the participants in a transaction need to trust the other party and the intermediaries, both private and government entities.

Unfortunately, not all countries in the world can boast a high level of trust among their society and even towards government structures. This gave rise to the idea of creating the possibility of conducting transactions without intermediaries and the need to trust the other party. Thus, the concept of decentralized finance (DeFi) emerged in the world, with blockchain as the platform for it.

Decentralized finance (DeFi) refers to applications and protocols built on blockchain networks that allow users to manage their assets without the involvement of traditional financial institutions.

The concept of "decentralized finance" encompasses the idea of creating an open, free, and transparent ecosystem of financial services that is accessible to everyone and operates without the intervention of any authorities. Users retain full control over their assets and interact with this ecosystem through decentralized applications.

In the world of DeFi, there is no need for courts to settle disputes because disputes should not arise in the first place. The code defines the resolution for every possible dispute, and users maintain control over all their funds.

The main advantage of DeFi is easy access to financial services, especially for those who, for various reasons, are isolated from the current financial system due to sanctions, physical remoteness, or other limitations.

Since the traditional financial system relies on intermediation for profitability, it usually does not provide its services in areas with poor populations or low population density. On the contrary, DeFi, due to its low operating costs, allows anyone with internet access to use the necessary financial services.

All DeFi applications and protocols are algorithms for specific actions integrated into the blockchain code. When the conditions specified in this algorithm are met, a predefined sequence of automated actions can be executed. These algorithms in the cryptocurrency sphere are commonly referred to as "smart contracts."

A smart contract is a computer algorithm that allows for the creation, maintenance, and automatic execution of transactions. The algorithm's actions are embedded within the blockchain, making the transaction rules immutable and binding for all parties.

Currently, we are still in the early stages of the era of smart contracts. The potential of smart contracts is immense, as they can be integrated into virtually any area of life where clear, transparent, and efficient execution of simple routine tasks is required, without the need for expensive legal support.

There are already various prototypes for use in areas such as finance, jurisprudence, elections and voting, logistics, accounting and auditing, smart gadgets, transportation, private identity verification, property rights registration, and much more.

In order for a smart contract to interact with the outside world beyond the blockchain, there are "oracles" - special programs that collect information from external sources and format it for use in smart contracts.

Despite the fact that technology is capable of automating most routine operations, smart contracts are currently primarily used for creating multi-signatures and various tokens, as well as automating simple financial transactions. We are still far from the mass adoption of smart contracts in all areas of our lives.

One of the main inhibiting factors for the implementation of smart contracts is the relatively low level of computerization and lack of connection in remote small towns around the world. Not to mention that only a few of all the devices with internet access are connected to the infrastructure of any particular blockchains.

However, despite all this, many countries, including those with relatively poor populations, are creating an alternative to the traditional financial system and mitigating the consequences of financial crises in their territories through smart contracts. DeFi, which stands for decentralized finance, has gained the most widespread adoption due to its practical utility in the financial sector. Storage of funds, transfers, loans, trading, investments—all of these can be automated within the realm of decentralized finance.

The most common use cases are:

  • Loans and credits
  • Monetary and banking services
  • Decentralized markets
  • Stablecoins
  • Property rights registration
  • Financial derivatives, etc.

Since DeFi applications are inherently financial, it is obvious that they would include monetary and banking services. One of the earliest functions in the world of decentralized finance was the issuance of stablecoins. As early as November 2015, the Tether USD (USDT) token was introduced, allowing transactions in US dollars within the Ethereum blockchain (now available on multiple blockchains).

The second most important and popular direction in DeFi is decentralized exchanges (DEX), which resemble exchange points rather than traditional exchanges. They consist of smart contracts that enable direct token-to-token exchanges between two individuals without the need to trust each other or buy from a "liquidity pool" (a special reserve collected from deposits of users).

Furthermore, this field gave birth to another function, which is the ability to invest funds in DEX and earn proportional commission fees based on the investment amount.

Smart contracts also perfectly serve the function of asset "freezing," enabling the creation of open lending protocols that, unlike traditional banks, offer instant transaction settlement, the ability to secure digital assets, and the absence of credit checks.

Nevertheless, decentralized finance is still in its early stages in the global economy. DeFi provides access to money for anyone interested, free from censorship and without a central controlling authority. These factors attract enthusiasts to the world of DeFi, leading to high growth rates in the industry over the past few years.

Despite the convenience and usefulness of smart contracts, their application in everyday life is currently limited by technical, legal, and social factors.

One of the main challenges is weak regulation and the absence of legal frameworks. At present, smart contracts cannot interact with courts and other government structures during the transitional period of the economy.

Additionally, blockchains operate noticeably slower than their counterparts in the traditional financial market. There are issues with critical code errors, insufficient privacy for transmitting sensitive confidential information through public ledgers, and a high risk of user errors (in DeFi, you bear all the responsibility for data correctness, unlike in the case with such as banks).

However, the crypto space is not standing still, and developers are working to solve all these problems. If successful, DeFi could wrest power from large centralized organizations and place it in the hands of the open-source software development community and its users.

© – , updated 07/13/2023
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