Can DeFi defy traditional finance? An introduction.

Blockchain is much more than cryptocurrencies like Bitcoin. Increasingly, developers are using the technology to create decentralized finance applications – DeFi to defy traditional finance.

The finance industry has traditionally been opaque and slow to innovate. But in recent decades it has embraced digitalization, vastly accelerated the pace of transactions and created entirely new classes of financial products. Arguably, this set the stage for the global financial and economic meltdown of 2008.

In the wake of this crisis, blockchain-based Bitcoin emerged as an alternative to the financial system, yet still lacking features to enable creation of complex financial instruments. Bitcoin became a peer-to-peer cryptography-based digital cash system, but developers saw broader potential in the underlying technology. This led to the concept of the decentralization of finance with the purpose of giving more power to consumers and enabling smart management of their assets without the need for a central authority.

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Today, decentralized finance (DeFi) is a peer-to-peer electronic financial system that uses cryptographic currencies on a distributed database to empower anyone to issue, transfer and own financial products. Without a central authority, DeFi allows everyone to access financial services with a high level of autonomy and fewer barriers. But of course, this didn’t happen by itself: since the Bitcoin blockchain was not designed to support different business models, DeFi needed a more flexible blockchain in order to become reality.

Smart contracts – the game changer

Enter Ethereum, the blockchain with smart contracts. Smart contracts – computer protocols to verify transactions recorded on a blockchain – make it possible to create different financial instruments on one and the same blockchain. There are potential alternatives to Ethereum, such as the Lightning Network, which opens up Bitcoin to micropayment use cases, and networks like EOS, Cardano, Dfinity and many others with smart contract functionality. But for now, Ethereum is the market leader with the largest developer mindshare and lots of ether holders looking to make their money work for them.

Features of DeFi

It’s important to differentiate between open finance and decentralized finance. They might share some of the same features, yet the differences are coherent and clear: open finance refers to a bundle of banking services provided by API-enabled startups in a limited geography, since adherence to regulations is mandatory. Open-finance solutions are often consumer focused. Decentralized finance, on the other hand, is considerably more transparent, thanks to operations that run on public permissionless blockchains. The features of a DeFi project include:

  • Decentralized: Ownership and changes in records are simultaneously governed across thousands of processing units
  • Censorship resistance: No central party that controls user activities
  • Programmable: Assets and business logics are programmable by developers
  • Pseudonymity: Users interact and authenticate transactions using a cryptographically generated ID rather than a real identity
  • Transparent: All transactions are publicly auditable and can’t be reversed
  • Trustless: No requirement of trust within the ecosystem to conduct transactions
  • Permissionless: Anyone in the world can connect with the network, no permission required

DeFi is an ecosystem comprised of applications built on decentralized networks, permissionless blockchains and peer-to-peer protocols for the facilitation of lending/borrowing or trading with financial instruments.

This is just the beginning. You’ll find much more on the world of DeFi in this space.

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