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What Is Decentralized Finance (DeFi) and Why Does it Matter?

Traditionally, currency-issuing nations and banks had control over financial markets and the ability of individuals to borrow and invest money. That was a paradigm that appeared unlikely to change until blockchain technology emerged, enabling a decentralized finance ecosystem that is now fully operational and poised to revolutionize finance.

What Is Decentralized Finance?

Decentralized finance (DeFi) is a comprehensive ecosystem of financial applications built on a digital record of transactions, known as the blockchain networks. The structure of these blockchain networks, as the name suggests, are individual records called blocks. These are linked together in an ongoing list called a chain — blockchains record transactions made with cryptocurrencies such as Bitcoin, which are finite digital stores of value.

The DeFi movement is about creating globally accessible applications that empower users to bypass central authorities like nations and banks, avoiding inflation and currency devaluations in the process. These applications provide greater ownership and control of financial interactions and transactions, using a peer-to-peer, open-source and permissionless model.

Though Ethereum, a cryptocurrency, empowers the current movement, DeFi is differentiated from cryptocurrencies in two ways. First, it uses decentralized incentive structures to encourage more investors globally to take part and exercise their newfound control. Second, it has grown through crowd-funding models called ICOs (initial coin offering), as with Dogecoin, which makes it particularly nimble for attracting funding for projects.

Individual cryptocurrencies such as Bitcoin and Ethereum (the two with the highest market capitalizations as of April 2021) are digital forms of payment that can be exchanged online for goods and services. They work on the secure, decentralized blockchain technology that manages and records transactions. Today, financial advisors see them as popular speculative investment plays rather than long-term stores of value. Unlike investing in a business, cryptocurrencies do not generate cash flow; they simply rise in value when demand outstrips supply.

What Are DeFi Projects?

DeFi projects are applications, exchanges and protocols running on top of a blockchain network such as Ethereum or Cosmos. They utilize the underlying blockchain technology and the continuing evolution of improvements to automate financial services such as lending and borrowing money, exchanging crypto-assets and trading assets such as derivatives. Users can exercise greater control and ownership of their assets while locking out "middlemen" like banks and online trading platforms. DeFi protocols have now locked in over $19 billion in assets.

One such project is the enablement of "smart contracts," an automated escrow system to manage transactions between parties. Such systems can allow transactions to clear without a centralized authority, intermediaries or arbitrators. The components of these contracts simply execute as pre-agreed conditions are met. These "smart contracts" can bypass traditional online trading platforms that extract money from buyers and sellers.

How Businesses Are Using DeFi

Visionary organizations are harnessing the power of the open-source financial ecosystem to solve problems and create new opportunities. One is a Swiss non-profit called DIA, which creates a platform using crypto-economic incentives to drive the supply, share and use of transparent, crowd-verified price data and oracles on financial and digital assets. 

One blockchain gaming startup called Spielworks attempts to make the e-wallet system easier and more accessible for more people with less technical expertise. This technology allows for free and quick account creation, automatic key backup and free blockchain resources.

Many businesses will soon be able to tap into this ecosystem to access sources of financing that are not yet available to them. The DeFi movement can revolutionize investing in foreign economies, companies and even individuals with brilliant ideas.

Trends in DeFi

One emerging trend is cross-chain technology, enabling the DeFi sector to spread the burden of demand across multiple blockchains. It is, in essence, a bandwidth solution. Other trends now gaining momentum are automated market-making on Uniswap, asset management on YFI, flash loans on Aave, faster transactions on PlasmaPay and liquidity mining on Compound.

These emerging trends are taking the DeFi movement beyond speculative cryptocurrency trading and introducing new protocols that will expand the capabilities of DeFi for technologies. Ultimately, the success of the DeFi movement will depend on the utility of systems, transaction fees and speeds and users' ability to exchange their fiat money for cryptocurrency and back again.

Just as soon as challenges arise, players in the space compete with creative solutions. Momentum is on the side of DeFi, and its possibilities for reshaping the traditional financial paradigm appear to be nearly limitless.

Learn more about the University of Wisconsin-Parkside's online Master of Business Administration with a Concentration in Finance program.


Sources:

Coinberry: What Is DeFi?

DeFi Pulse

Entrepreneur:
How DeFi Will Reshape Financial Services
Decentralized Finance Is on the Rise. What You Need to Know in 2021.

Nasdaq: Decentralized Finance (DeFi): An Emerging Giant

NerdWallet: What Is Cryptocurrency? Here's What You Should Know

TechTerms: Blockchain


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