Key Points
- DeFi is a loose collection of individuals, organizations, protocols, apps, technologies, and cryptocurrencies.
- The term “DeFi”, short for decentralized finance.
- DeFi is basically a term for lack of financial rules around currencies.
DeFi is a new, quickly growing modern approach to handling and managing digital finances. It is changing finance by disrupting the traditional ways presented by banks and other organizations in the past.
New decentralized technologies are at the heart of DeFi.
What is DeFi?
DeFi is a loose collection of individuals, organizations, protocols, apps, technologies, and cryptocurrencies. They all work together to create an ecosystem enabling digital financial transactions outside the traditional banking systems.
Coining of “DeFi”
The term “DeFi”, short for decentralized finance, itself was born in August of 2018 through a Telegram discussion between Ethereum developers and entrepreneurs. It’s not a defined technology with a standards body or a protocol itself but rather a prescription for a means to handle financial transactions digitally without the need for a centralized authority, like a bank.
Traditional Finance In Comparison to DeFi
Understanding the differences between traditional centralized systems and newer decentralized systems helps unravel DeFi. A centralized system will generally have a centralized authority over the transactions that take place within them. Banks are centralized institutions with a select group of decision-makers who own the business and assets involved. In a decentralized scenario, there are no central authorities involved and no powerful entities that own everything and make the rules.
DeFi Is Unregulated
Because of this lack of rules that are crucial to the underlying conceptual model of DeFi different types of problems begin to arise; as seen in the last couple of years. Scams, hackers, and a whole array of theft attempts are common and are exposed almost daily.
In addition to the “wild west” atmosphere surrounding decentralized blockchain technology, transactions are generally not private. This means transaction information for the duration of a wallet will be exposed to the world forever. The owner of the wallet can obfuscate who they are but the ledger does and will exist and could potentially be traced back to an individual.
Decentralized Applications & DeFi
Individual DeFi applications used to buy, trade, sell and lend are called dApps, short for decentralized application. One example is MetaMask, a popular cryptocurrency wallet based on the Ethereum blockchain. Many types of applications beyond wallets exist in the DeFi space and many are being created almost daily.
How Will DeFi Change Finance?
Traditional Finance Meets DeFi
The fundamental principles of both currency and ledgers have been in place for a very long time. Currencies date back over five thousand years ago and records of transactions date back even further; to nearly seven thousand years.
The 1960s and 1970s brought the first attempts at creating networked computerized financial systems and the first accounting software. Later in the 1990s with the explosion of the Internet, the financial world and computers crossed paths again.
For thousands of years with and without computers, networks, and the Internet humans have been keeping records, of transactions. It’s the basis of our economies and helps structure our societies and keep them moving. So, how can DeFi change this pre-established existing infrastructure?
DeFi Is Still Very New
DeFi is still a conceptualized reality with partial implementation, at least as of May 2022. One way DeFi is changing finance is by removing all of the third parties involved with transactions that have sprouted up over the years.
Example Scenario of DeFi & Traditional Finance
Imagine a scenario where you buy an apple from a small roadside stand with fiat currency. This is the most basic transaction, funds transfer directly from the buyer to the seller. This is one thing that DeFi attempts to accomplish using digital currencies; the transferring of funds directly from one person to another without an intermediary.
In current financial systems involving credit and debit cards, there are around seven steps to complete payment. Each of these seven steps involves a third party who charges the consumer for the transaction. This is a sweet deal for the banks and other institutions involved because they’re all making money off of every transaction. A good percentage of this framework is behind the scenes and there isn’t a lot the average consumer can do to circumvent any of it, other than pay fees.
DeFi presents the opportunity to digitally conduct transactions between two parties without any third parties or banks involved; ever. The types of transactions include loans and transfers of money or even just holding money like in a savings account. This is all radically different than the traditional computerized approach to finance involving centralized authorities and endless third-party involvement and fees.
DeFi Loans & Lending
Since DeFi is a term used to describe a set of tools, technologies, and protocols it can’t be invested in itself. The path to building a portfolio in the DeFi space can be varied including buying and trading cryptocurrencies and NFTs, staking and farming crypto assets, and many other activities in the Metaverse. The best approach is to choose one thing to learn about and invest in at a time. After that, diversifying across a wide range of assets is a great way to invest in the DeFi space.
Traditional Banks & DeFi
Banks can use DeFi in the same way consumers and other organizations can utilize it. The decision is largely up to them to get involved and contribute to the development of DeFi. Crypto and DeFi in general are extremely volatile and high risk which makes, established financial institutions weary to invest.
As DeFI matures and becomes more widespread and mainstream larger organizations will probably begin offering their dApps and DeFi products. Traditional financial institutions could potentially offer their lending services and even create their cryptocurrencies and other digital assets if they choose to do so.
Borrowing In DeFi
DeFi borrowers are generally people looking to take small, short-term loans out against cryptocurrencies they already own. Rather than straight-up selling a digital asset, individuals can now borrow against them. This is a good scenario for anyone that might need short-term cash or a way to add leverage to other crypto assets.
DeFi is different than traditional lending because individuals can now directly lend to other individuals digitally without the need for a third party. This opens the door to anyone that possesses digital assets that they can lend.
DeFi Platforms & Lending
Many platforms exist and each has its own set of return rates for lenders. Without the need for third parties and a string of others involved in the transfer and management of funds individuals can generally get a great return rate, comparable to a bank, or better.
Traditional Financial Loans & DeFi
Traditional loans are significantly different than DeFi loans for a few reasons. One of the major differences is the decentralized aspect of the relationship between borrower and lender. Traditional loans require a centralized bank or organization of some type, like a credit union. Remember the decentralized nature of the DeFi ecosystem doesn’t have centralized authorities like banks, at all.
Traditional loans also take more time than DeFi loans. As mentioned previously, the centralized approach to finance involves multiple intermediaries for each transaction. Bank loans can take days or even months to fully process and clear depending on all of the factors involved. DeFi loans do not involve any third parties and the transactions are instant.
DeFi & Over-Collateralization
Another major difference between traditional and DeFi loans is how collateral is handled. These loans require over-collateralization, meaning tokens must be provided exceeding the loan amount. If the price of the token provided as collateral causes the total amount put up to drop below the loan amount those tokens are instantly sold to repay the loan. This is called liquidation and is another difference from the traditional way loans are handled.
DeFi loans are meant for individuals who may need access to quick cash and have crypto available they don’t wish to sell. The crypto is the collateral for the loan and as long as the price of the token doesn’t dip low enough to cause liquidation the tokens can be reclaimed later for the loan amount plus interest.
DeFi Interest Rates Compared to Traditional Finance
Interest rates are another area that differs in DeFi compared to traditional loans. Both loan seekers and lenders are currently able to get rates better than those offered by banks.
Each DeFi lending platform has its way of handling the detailed aspects of loans. They each have different mechanisms for calculating rates and rewards as well. The best way to learn more is to visit each of their websites and join the Discord communities. The main platforms at the time of this writing are Maker, Aave, and Compound.
DeFi & Traditional Finances Into the Future
The primary reason DeFi is important is the move to a decentralized approach to finances. This stands in opposition to the old model of how money is managed and handled by individuals and organizations.
DeFi ushers in a new approach that cuts out all of the third parties that are involved in modern-day financial transactions. It’s now possible to truly own your digital funds. It’s also possible to act as a lender and engage in staking and other crypto-based reward and incentive programs.
Transactions happen much faster in DeFi and there are no third parties involved gouging into your money with endless fees.
