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Introduction to Decentralized Finance (DeFi)

In this post we will be introducing the concept of decentralized finance. We will look at what decentralized finance is and how it can benefit the average person in today’s digitally interconnected world. We will highlight some of the main benefits of decentralized finance as well as how it can be consistently and positively implemented into our daily lives.

What Is DeFi?

DeFi (Defi) is short for decentralized finance. It is a relatively new term that was coined in 2017. The concept of DeFi has been around for a while, but it wasn't until recently that it became a widely used term.

Decentralized finance is the process of transferring money and financially backed assets without the use of a third party. Presently this is done through the use of smart contracts via blockchain technology. Smart contracts are essentially programs that execute a set of instructions when they receive a specific set of data. In order to utilize smart contracts, one must have access to a computer network with internet access in order to facilitate digital peer to peer transactions.

Smart contracts are also referred to as autonomous agents. The most popular form of smart contract is the cryptocurrency bitcoin. The bitcoin network has a system that is built in where transaction details are recorded and time stamped on the blockchain.

The most common application for decentralized finance is individual peer to peer exchange. Peer to peer exchanges allow people to trade financial assets directly between each other. This type of trading is known as bartering. A person can use an online currency exchange to make a purchase. Then the person can use a decentralized exchange to sell their goods to someone else. This way, everyone gets an unencumbered, fair market price for the item being traded with low transaction fees.

Benefits of DeFi

Lower cost structure - As noted, one of the biggest advantages of decentralized finance is the ability to cut out the middleman and therefore minimize overhead and transaction costs typically associated with a centralized exchange.

Wider industry application - Due to the flexibility of smart contracts, decentralization can also be applied to a diverse spectrum of different industries since peer to peer exchange of smart contracts can be adapted to the specific details within each industry.

Widespread access and liquidity - Since defi is based upon peer to peer transactions, this type of marketplace is always open and available for value exchange via digital environment providing global reach and continuous, immediate liquidity.

Transparency and legal foundation - Holders of smart contracts via cryptocurrency tokens seamlessly digitally receive full time stamped details of their transactions which provides a level of transparency and legal clarity that otherwise typically requires multiple third party work, cost and input to receive in a centralized financial transaction. Not only does this reduce cost and time, but it also promotes more trust on both sides of the financial transaction.

DeFi Lending and Liquidity Pools

DeFi is the process of building financial applications that are powered by smart contracts and blockchains. The most popular use of DeFi is in the creation of decentralized lending platforms. Lending platforms are essentially a liquidity pooling system where multiple users can quickly, seamlessly and directly lend their funds to other users. The platform then uses a smart contract to track who owns what asset and when.

The applications of DeFi have expanded beyond lending to include other types of financial services. Some of these services include asset management, insurance, and even futures trading. In fact, the first application of DeFi was actually the creation of a decentralized exchange. This was done with the intention of providing a safer and more secure way to trade different digital assets.

DeFi and Crypto

The term DeFi is often used interchangeably with the term crypto. However, this is not entirely accurate. While DeFi is a type of crypto, it is not the same thing as crypto. Crypto is an umbrella term for all cryptocurrencies. This includes bitcoin, ethereum, litecoin, and many others. DeFi, on the other hand, refers specifically to the use of smart contracts and blockchains in the development of financial applications.

In the future, we may see a merging of DeFi and crypto. This will be especially true as more and more people become familiar with the concept of DeFi and begin to understand how it works.

Applications of DeFi

Some developing applications of DeFi include:

1. Stocks, bonds and derivatives trading - The creation of stock securities, bonds and derivatives contracts is one of the most common applications of DeFi. There are various kinds of derivative contracts, such as options, futures, forwards, swaps, and credit default swaps. While traditional investment securities and derivatives are traded on centralized exchanges, DeFi stocks, bonds and derivatives can be traded directly between 2 parties on developing DeFi platforms that eliminate the need for a central exchange while reducing trading transactional costs and optimizing transactional speed.

2. Investment management - The creation of smart contracts allows investors to invest their money seamlessly and directly with a counterparty without the need of third parties such as brokerages or clearing houses. This helps to create more efficient investment strategies and drastically reduces trade settlement times.

3. Insurance - The creation of insurance policies using smart contracts that are accounted, recorded and time stamped across the blockchain can help to reduce previously typical third party costs while also improving recordkeeping and legal transparency.

4. Loan management - Smart contracts allow for a tremendous streamlining of cost and time in the loan generation, signing and recordkeeping process previously requiring multiple third party input requiring more time and money. Thus DeFi loan management via utilizing smart contracts on the blockchain can help minimize significant cost and time factors to create more efficient loan management systems.

5. Payment processing - DeFi can be used to create blockchain driven, smart contract payment processing systems which enables direct transaction and record for both parties without a central third party needing to be involved in the transaction. This helps to reduce costs, increase efficiency, and make transactions much faster.

As more and more people become familiar, they will also become more comfortable with the idea of using smart contracts and blockchains to create financial applications. When this happens, we will likely see the rise of decentralized financial services. These services will allow users to create and manage their own financial products without the need for a middleman.