In 2022, blockchain-related applications have already made a dent in the market. Decentralized finance, in particular, attracts investments as a lucrative and far-reaching undertaking secured for the future. As of January 2022, the total value locked in all DeFi applications amounts to over $77 billion. This number encompassed decentralized exchanges, lending, assets, derivatives, and others.
But what is DeFi? And what makes it unrivaled in the rich technological landscape? Let’s find out.
What is decentralized finance?
In the simplest terms, decentralized finance (DeFi) is the umbrella term for financial applications that operate on a decentralized network. This could be something as simple as decentralized lending or borrowing, but can also include more complex products and services like decentralized exchanges, derivatives, and insurance products.
DeFi has seen significant growth in recent years as blockchain technology has made it easier to create trustless and transparent systems. As the industry grows, it will be interesting to see how traditional financial institutions adapt (or don’t) to this trailblazing invention.
How is DeFi different from traditional financial institutions?
Unlike legacy banking institutions, DeFi is a completely new financial system, different from the existing infrastructure. Although it came into the mainstream only recently, it was able to challenge traditional systems and win the minds of forward-looking investors.
DeFi’s main advantages that differentiate it from centralized finance (CeFi) include the following:
- Complete accessibility to any user regardless of geographic location, credit history, or other limitations present in CeFi.
- Transparency is ensured by smart contracts with open source code that is visible to anyone on the blockchain.
- Cross-chain interoperability in crypto-based lending that allows for optimal capital access for companies.
- The openness of the system lets users interact directly with the applications through browser extensions and create custom applications.
Thereby, unmatched benefits of DeFi applications make them an area of untapped potential compared with stringent traditional transactions. These benefits also translate into accelerated adoption rates. Thus, the blockchain market is projected to grow to around $70 billion by 2026, according to MarketsandMarkets.
Of course, it’s not all butterflies and rainbows with decentralized finance. In its current, nascent state, it is susceptible to attacks and disruptions, as seen in the total amount of funds stolen in DeFi attacks. The latter stood at $680 million in 2021. Moreover, most DeFi projects on the Ethereum platform are not very suitable for high-load trading since their computational power is limited.
Nevertheless, the trade-off between advantages and cons still seems acceptable for users which can be attested by growing DeFi adoption.
How does DeFi work?
Decentralized finance, or DeFi, is a term for financial applications that run on a blockchain. DeFi applications are based on visible, open-source code, meaning anyone can audit them. This also allows for peer-to-peer lending and borrowing, as well as intermediary-free exchanges.
DeFi relies on cryptocurrencies and smart contracts to ensure intermediary-free financial transactions. Smart contract is a computer protocol (or simply, code) designed to verify or execute contract terms automatically. This way, transactions are performed safely and faster.
Besides decentralized finance, smart contracts are used extensively in many different sectors of our lives. They are already actively used in real estate, medicine, logistics, and video games.
To access the DeFi functionality, users employ dApps or decentralized applications. The latter is mostly available on the Ethereum mainnet and provides user interface for P2P transactions. Crypto coins, stablecoins, digital wallets, mining, yield farming, staking, and ledning are among the leading DeFi services and dApps.
What can you do with DeFi?
Since DeFi is an umbrella term, it includes many areas capable of replacing centralized financial services with autonomous organizations. Decentralized finance has the potential to provide the ability to manage entirely new types of financial instruments and open up access to new ways of interacting with them. With that said, let’s go over the most popular directions of decentralized finance sector development.
Decentralized exchanges
Decentralized exchanges or DEXes are an alternative to traditional exchanges. However, unlike centralized asset marketplaces, DEXes do not need either a single management body, third-party intermediaries, or custodians who store and protect the funds.
Instead, decentralized exchanges operate on a peer-to-peer approach, where transactions are executed directly between users. Moreover, there is no lengthy registration required. On Uniswap, for example, users handle their exchange transactions by connecting their Metamask wallets.
Stablecoins
As the name implies, stablecoins are designed to be less volatile than other cryptocurrencies. Their firm stand is ensured by the value tied one-to-one to a fiat currency. The most popular stablecoins are pegged to a dollar or another cryptocurrency. These include Tether, Dai, Binance, True and other tokens. Unlike volatile cryptocurrencies such as Bitcoin, stablecoins come with better stability and predictability, thus being popular among investors and traders.
Lending
Lending decentralized platforms is another popular offshoot of DeFi applications. Those are similar to taking out a traditional loan, however, all you need is another fiat or cryptocurrency as collateral. Thus, DeFi lending makes all users eligible for a loan with no meticulous and lengthy checks, or monstrous interest. Users also keep their identity and credit score discreet. Curve Finance is a prominent example of leading DeFi lending platforms with over $4 billion value of digital assets locked in its liquidity pools.
Prediction markets
This decentralized implementation is much similar to regular betting shops. However, unlike standard betting platforms, DeFi prediction markets can be accessed with no third party to monitor trades and bets. Betting areas can be diverse and include elections, sales of a company, price fluctuations, etc.
Other differentiators of DeFi betting include lower fees (compared with centralized prediction markets) as well as added liquidity due to open and free participation.
Some of the widely used crypto prediction markets are:
- Augur – a prediction market platform based on Ethereum
- TotemFi – an innovative staking-based betting platform
- Markets.vote – an evolving prediction market with quadratic voting and token rewards.
- OptionRoom – a defi forecasting tool that allows its users to participate in event derivatives that are tied with real-world outcomes by governance consensus.
- PolyMarket – a information market platform to trade on the world’s most highly-debated topics.
As you see, decentralized finance is now a vibrant field with diverse investment opportunities. DeFi has the potential to make the traditional financial system more efficient and equitable. It also holds great potential for reducing entry barriers for those without traditional banking access or who live in countries with developing financial systems.
The final word
The DeFi market has been growing at an astonishing pace over the past year and will continue its march. Being an innovative alternative to centralized financial services, DeFi applications have an impressive number of advantages over CeFi, including transparency, reduced fees, and transaction speed. However, as this market is still young, investors have to pay due diligence before injecting money into DeFi or building their own dApps since the decentralized ecosystem is still prone to vulnerabilities and susceptible to malicious actors.