Decentralized finance is one of the hottest Web3 trends and for good reason. Underpinned by blockchain technology, DeFi presents a more open, accessible and democratic alternative to traditional finance (TradFi). The use of smart contracts has enabled many innovative products and services that can exist without overbearing regulatory oversight. Decentralized finance as a model appears to be perfectly positioned to take advantage of our increasingly digital world. Here’s why.
How does DeFi work?
Financial services have always presented some of the strongest use cases for blockchain technology. Bitcoin was originally invented as an alternative to TradFi and, with other crypto assets having been added to the mix, cryptocurrency trading has emerged as a viable form of investing. The emergence of Ethereum has been particularly influential.The platform’s support of smart contracts has opened up new fundraising opportunities for startups and introduced an easy way for creating new crypto assets.
Smart contracts are also at the core of the decentralized finance movement, making it possible for DeFi applications to work without oversight from centralized authorities. The TradFi sector relies on intermediaries such as banks to process transactions and is subject to strict regulatory scrutiny. This is because you need to ensure that all market participants are playing by the rules and you need someone that has the authority to enforce those rules.
In contrast, DeFi employs smart contracts to fill that role. These self-executing programs are perfect for enforcing rules and handling transactions within a DeFi service. By eliminating the reliance on central authorities and middlemen, DeFi brings some considerable advantages for the user. DeFi products and services are much more open and accessible and allow for users to remain in control of their funds. They can function 24/7 and support fast transfers of funds. Perhaps most importantly, DeFi injects a much needed dose of innovation into the broader fintech sector, as the creative use of smart contracts has led to the creation of many interesting products.
As mentioned above, the nascent DeFi sector is already producing very promising results. Next to the freedom and flexibility afforded to developers by smart contracts, the main factor for this is the composability of DeFi products. The fact that a large part of the code in Web3 is open source allows developers to use, modify and refine the work of their peers. As a result, there is a large number of available ‘DeFi primitives’ that Web3 developers can use in inventive ways to create new types of products. The moniker ‘money legos’ has emerged as a reflection of this phenomenon.
Let’s take a look at some of the products of this unbound creativity.
Decentralized exchanges (DEX)
Historically, cryptocurrency trading has been primarily driven by large centralized crypto exchanges like Binance, Coinbase and Kraken. DeFi is now challenging that model with decentralized exchanges (DEX) that use smart contracts to handle either peer-to-peer or pool-based trading.
Pool-based DEXes, called automated market makers (AMM), are particularly interesting for their ability to facilitate crypto trading even in the absence of matching orders between sellers and buyers. To achieve that, each crypto trading pair is underpinned by a liquidity pool where the value of the two assets comprising the pair is carefully managed to satisfy a set mathematical formula. This, in turn, allows the price ration between the two assets to be determined algorithmically.
Currently, the world’s biggest AMM is Uniswap V3, which often posts daily trading volumes north of $3 billion.
Lending and borrowing
DeFi also provides users with a convenient way to secure loans without the need for approval from a bank or other financial institution. Like decentralized crypto trading, borrowing comes in two main varieties – peer-to-peer and pool-based. The latter also presents an opportunity for crypto holders to earn passive income. For example, users can lend out crypto assets to lending and borrowing protocols like Aave and earn interest.
Smart contracts allow us to mint tokens that represent other assets, including real-world commodities, securities and derivatives. This has the potential to open up the traditional financial markets to a much larger pool of potential investors.
These are just a few of the most prominent DeFi applications, but the sector has already proven that it’s capable of much more. The rise of decentralized finance has also enabled innovative fundraising mechanisms, novel insurance offerings, experimental concepts like flash loans and no loss lotteries. And as the sector continues to grow and mature, it will undoubtedly produce even more impactful products.
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