Decentralized Finance ( DeFi ) is the advanced and fast growing crypto sector that is powered by Blockchain Technology. It has been trending in 2020, as most digital asset enthusiasts are praising DeFi Products and protocols. What exactly is DeFi, and what pros and cons currently exist?
What is DeFi ( Decentralized Finance )?
As the name itself refers, DeFi is "Decentralizing" the financial sector. It is oriented to build a multi-faceted and interoperable financial system to enhance the use of Blockchain technology by improving its efficiency, transparency and security. At the time of this article, $3.6 billion in value is flowing through DeFi protocols ( total value locked ). Over the last 3 years, the amount of money being deployed into DeFi smart contracts has seen epic growth. According to a recent report by Visionary Financial, this current $3.6 billion dollar market had only $4 dollars of value in 2017.
The Rise of DeFi :
The idea of Decentralized Finance was Ignited from Ethereum “dApps” back in 2018. DeFi is an umbrella concept describing financial services that completely operate on the principles of mathematics and computer science, built on top of a public blockchain such as Ethereum.
With a smartphone device, DeFi gives people around the world the opportunity to engage in “Open Finance.” Instead of relying on centralized parties such as banks, DeFi protocols are built around decentralized applications that offer advanced functionalities. This sophisticated infrastructure is creating an environment where almost anybody can cut out the middleman in finance, and have access to an abundance of financial services.
Benefits of DeFi :
The DeFi system has technical aspects that it leverages to connect the gap between traditional and decentralized ecosystems. The DeFi ecosystem is a field of technical experiments and innovation that are still in their infancy. This further explains why many protocols offer utility, but lack the proper user experience. The major benefits that make DeFi easily adoptable and usable in the near future are:
- Easily Accessible: Anyone with an internet connection can operate irrespective of time and place. This will boost the financial incorporation in every industry.
- Immutable: No third-party can reserve a transaction, and no threats of hacks on centralized servers.
- Completely Decentralized : No centralized institutions can stop any transaction, it is fully decentralized and transparent. Public blockchains (e.g. Ethereum) are completely transparent and auditable.
- Open Source: DeFi is programmable, meaning anyone can develop on or modify the code after proper consensus and limitations.
- Secured and Efficient: Less effort, energy, and time spent to achieve the appropriate result for any transaction. These validations are powered by code.
Downside of DeFi :
- The Immutable nature of blockchain technology can be a tough task to detect false transactions and bugs in smart contracts.
- In the future, DeFi may face operational risks, due to the chances of failure/manipulation of price feeds and complex governance protocols. Also the ethereum’s 2.0 proof of staking protocol could result in many delicacies during its early stages.
- Ethereum has an issue with bandwidth, meaning that high usage can lead to unsettled or pending transactions. The DeFi world is being built to enhance the traditional financial world. Therefore, it should be compatible and compete with the transaction speed of Visa.
- The bulletin architecture of ethereum and its transaction fee may prioritize transactions based on the highest gas fee. The complexity of gas is already a drawback that many people are witnessing in various DeFi protocols.
Use Cases :
DeFi has so many technical aspects that could redesign the traditional financial system. Here are a couple of use cases that are coming to fruition.
Lending and borrowing: Every traditional financial system has been organized by centralized entities. In the traditional market, major banks are the centralized organizations that work on lending and borrowing on a large scale. In doing so, these entities play a significant role in providing liquidity. The centralized structure has caused many issues pertaining to transparency, accessibility, and security.
In the DeFi Ecosystem, various protocols are being launched that perform a lot of the same tasks offered in traditional finance. The blockchain tech behind these protocols makes it more transparent, efficient, secured, and community oriented. DeFi has the potential to eliminate high level corruption, and lower individual risk.
Decentralized Exchanges : Decentralized exchanges are referred to as "DeX,” which allow users to swap cryptos directly peer to peer. Generally, centralized exchanges just focus on transparency of transactions. Hence there is a chance for cyber attacks and other events that cause liquidity issues.
In DeX, software plays the role of validation, hence the ability to access cryptocurrency is independent.
Stable Coins : Cryptocurrency has been recorded as the most volatile market. Despite volatility cooling off in 2020, this is still an issue that halts the adoption by companies and merchants around the globe. To stabilize this nature of cryptocurrency, stable coins were built, which are pegged to fiat currency and help maintain stability in the market.
Ethereum 2.0 and DeFi :
Today, almost every DeFi project is being built on Ethereum, making it the default blockchain for many DeFi products and protocols. ETH 2.0 is also one of the hot topics in the ethereum community, since many people are hoping for scalability. During the past week, an update about 2.0 was released stating that the final testnet is set to launch on August 4th.
Many believe that the “ETH 2.0” launch will be critical to the evolution of DeFi, since speed and fees are some of the top concerns.
In a recent tweet by Vitalik Buterin, he focused on the EIP 1559 (Ethereum Improvement Proposal), where developers can suggest the improvement and features to implement within ethereum's network. These suggestions then go through a consensus process for further consideration.
It is basically a proposed solution that should reduce the costly transaction issues on the Ethereum network. If implemented, this solution could enhance the adoption rate of DeFi, by giving protocols the necessary resources to scale into new horizons.
DeFi products and protocols are trustworthy and should be adopted. Since most DeFi programs are built on ethereum’s blockchain, the decisions are also dependent on the ETH 2.0 updates. It will be important to follow ETH 2.0 developments to assess DeFi potential in the near future.
Other Blockchains are working on the DeFi system, but they are not as efficient and decentralized as Ethereum. Otherwise, the DeFi sector is robust and has the potential like bitcoin to disrupt the traditional financial ecosystem.
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