Decentralized finance is the future; but what is it and why should I care?

A blockchain-based new economic system powered by codes and run by decentralized applications is emerging as a more secure, transparent, and accessible alternative, changing the way we trade. We are now looking at a probable future where the global financial industry will be on one common peer-to-peer software infrastructure independent of the traditional centralized country-dependent institutions like brokerages, exchanges, or banks, which now serve as intermediaries. This is Decentralized finance or DeFi, the future of financial services or the financial services of the future, the market of which has already started to boom with Forbes reporting in January this year that DeFi now has a total value locked (TVL) of $100 billion USD on Ethereum alone. While according to DappRadar, there were over 655,000 daily unique active wallets across all chains in Q4 2021.

What is DeFi?

DeFi or Decentralised Finance is an emerging global financial system built on public blockchains, such as Bitcoin and Ethereum. Based on open-source technology it is an alternative to and completely independent of the traditional financial (TradFi) economy that aims at democratizing finance by removing centralized institutions such as banks, brokerages, and NBFCs (Non-Banking Financial Companies), and intermediaries through peer-to-peer (P2P) transactions and self-executing computer code called smart contracts that run on the blockchain network. Here individuals can act as exchanges, liquidity providers, and lenders instead. With intermediary or central authority involved, the financial services are rendered at a much lower cost and are hassle-free.

How does it work?

The smart contracts are developed to make the users perform some specific tasks under some pre-set conditions. No one can tamper with the smart contract once it is entered into the blockchain although everyone in the blockchain network can access and read it. These smart contracts can be accessed through decentralized apps, or DApps, which enable multiple parties to lend, borrow, trade, exchange on a safe and open network.

The Defi ecosystem

• Smart contracts are self-executing and irreversible agreements that are coded and permanently placed on the blockchain. Its protocol runs on if/only commands, ie only if the first action happens, the second one will follow, making the DeFi protocols automated eliminating the need for an intermediary or third party. Apart from being available to anyone across the globe with an Internet connection, the smart contracts running on a blockchain that is trustless, immutable, and transparent, ensure that these financial protocols and platforms are not only automated to precision but are also difficult to tamper with. Smart contracts can be used for lending, borrowing, trading, and investing, apart from usages in other sectors such as healthcare, real estate, and gaming. Ethereum was the first such smart contact blockchain and today DeFi protocols operate mostly on Ethereum. Some other examples of smart contract blockchain that are popular today are Solana, Binance Smart Chain, Algorand, Cosmos, etc
• DApps are decentralized apps whose backend code runs on a decentralized network and runs on peer-to-peer (P2P) networks of multiple computers. These are the foundation of everything DeFi. While dApps are decentralized programs that are enabled by the blockchain, these are not embedded in it. DApps are websites that don’t exist on the blockchain but interact with it with the help of smart contracts. Basically, smart contracts are codes that enable the DApps to do specific actions. There are several financial services that can be done through specific DApps and these include decentralized borrowing and lending, synthetic asset and derivatives trading, Stablecoin interoperability, yield farming, liquidity pools, accessing decentralized marketplaces, automated contract settlement, etc.
• DAO or Decentralised Autonomous Organisation: It is a collective of users who are part of a particular blockchain and need to adhere to the rules and regulations coded into it. This code of conduct is created and can be updated by the collective in a democratic way. Tokens are used to make the ownership and decision-making powers equitable. These are decentralized (hence immutable and censorship-resistant) member-owned and managed communities that ensure secure, transparent, and verifiable transactions on the blockchain and eliminate the need for a middleman.
• DEX is a decentralized exchange while CEX is a centralized exchange. Both are used for buying and selling cryptocurrencies and tokens. While DEX is a peer-to-peer marketplace run by algorithms and smart contracts, CEX are human-run companies. Transactions through a DEX can securely happen online without the need for an intermediary. Another important feature of DEX is that here the user can be pseudo-anonymous; although the user can be traced there is no need to fill out one’s background information…one just needs to connect their crypto wallet and start trading.

CEX examples: Binance, Coinbase, Kraken, Coinlist, etc
DEX examples: Uniswap, Pancakeswap, dYdX, Kyber, Sushiswap, etc

However, the system is not foolproof. Why?

1. This is a new technology so unexpected hiccups may occur.
2. There is no insurance by which to recover lost money.
3. There is no authority to which you may lodge a complaint in case anything fraudulent happens to your DeFi transactions.