What is Decentralized Finance (DeFi)?
DeFi is considered one of the fastest growing sectors in the crypto industry and is often referred to as the future of finance.
The acronym DeFi stands for – decentralized finance – and is usually used to describe all applications and companies that offer financial services based on decentralized blockchain technology. You will also come across the term – Open Finance – again and again in the course of your research. However, both mean the same thing.
What’S behind DeFi?
The concept of decentralization contrasts with traditional financial services, which are usually organized centrally, i.e., by a single institution, such as a central bank or financial institution. DeFi can overcome many of the common disadvantages of centralization, such as centralized vulnerabilities, monopoly positions, and bureaucratic obstacles, and would be redundant over time.
In this context, the decentralization of financial services is possible thanks to smart contracts, where computer code automatically enforces the rules and all transaction data is kept in one – distributed ledger. This way, no actor has sole control over transactions, preventing censorship and corruption.
For what is it used?
If, for example, a conventional bank grants a loan to its customers, it alone can decide who receives how large a loan and under what conditions. In a decentralized network, on the other hand, anyone with a smartphone and Internet access can obtain a loan that is governed by a smart contract. The terms are transparent to everyone, and anyone can check them.
The main services offered by DeFi companies include stablecoin issuance, loans, trading, peer-to-peer payments, and insurance. Users can access such services via decentralized applications (DApps), which are currently mostly based on Ethereum.
State of the Art
DeFi – Today
DeFi is an incredibly fast-growing sector that is far from reaching its zenith. Several metrics are used to estimate the size and dynamics of the DeFi market. One of them is Total Value Locked (TVL), which indicates how much in assets (in USD or ETH) is locked in the sector. According to DeFiPulse, TVL was an estimated USD 41 billion at the time of my writing, an amount that has grown exponentially in recent months.
At the time of writing, the market capitalization of DeFi coins was estimated at USD 16.5 billion. The largest projects by market capitalization are currently MakerDAO (the decentralized protocol for issuing the USD-linked stablecoin DAI) and Compound (a money market protocol for lending).
The use of DeFi
How is DeFi used? – Today
However, since TVL can be shifted upward through leverage within the system (as in many yield farming strategies), the total number of users is arguably a better measure of the penetration of decentralized financial services. According to Dune Analytics, as of August 2020, the number of DeFi users is growing exponentially and has already surpassed 250,000, a five-fold increase year-over-year.
Loans have accounted for a large portion of the DeFi market to date. Companies like Compound offer crypto owners the opportunity to borrow money with crypto assets as collateral or lend their crypto assets to other network users to earn interest. Most platforms automatically assign lenders and borrowers to each other, and interest rates are adjusted based on supply and demand.
Another important area of decentralized financial services is what are known as stablecoins. Stablecoins, such as DAI or USD Coin, are cryptocurrencies backed by a fixed reserve value designed to reduce their price volatility. Stablecoins can be pegged to a fiat currency or commodity price or managed algorithmically. The general purpose of stablecoins is to provide users with a more stable asset, similar to a fiat currency.
A view in the future
The Future of DeFi
Decentralized financial services are undoubtedly a very hot topic in the crypto economy and have been one of the fastest growing sectors ever in the past year. The exponential growth and general hype around DeFi has attracted many new crypto investors and crypto developers, and piqued the interest of traditional financial players. However, the road to widespread adoption is still long. DeFi’s future prospects depend on creating value for users and delivering on the promise of accessible and open services.
At the time of writing, DeFi offers very competitive returns compared to traditional financial markets and other crypto options. For example, lending rates are significantly higher than savings rates offered by most conventional banks. Within the crypto economy, competitive opportunities arise from staking, which allows crypto users to earn regular rewards.
At the same time, the DeFi industry is still quite new by comparison, and an investment entails corresponding risks. Fierce competition in the DeFi sector could push developers to offer new services and more user-friendly products, lower transaction fees (e.g., through second-layer solutions), and improve security.
Many crypto enthusiasts, myself included, strongly believe that decentralized finance is the future, but ultimately this will depend on the added value that decentralized financial services generate (such as lower costs, faster settlement, and further innovation) as well as the general adoption of crypto solutions by people around the world.
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