Thu, Nov 5, 2020 •6 min read
Consumers used to instantly available digital products and services are now turning their attention to the financial sector. If it's possible to email practically anybody in the world, why isn't it possible to send them money just as easily? Or even offer them a loan? Such questions form the foundation of a brand-new field called Decentralized Finance (DeFi). One of the key technologies underlying the rise of DeFi in the financial services sector around the world is blockchain.
At Rumble Fish, we pay close attention to trends in this industry and help our clients address problems or build new products using the most innovative technologies such as blockchain.
Read this article to find out what DeFi is, what advantages it brings to businesses and consumers alike, what role the blockchain technology plays in it, and the key challenges of DeFi you should know before starting such a project at your organization.
Decentralized Finance (also called DeFi) refers to an ecosystem of financial applications that are built on top of a blockchain. One of the key traits of DeFi applications is the fact that they're entirely or partially decentralized. This is how companies can provide reliable financial services on top of the transparent and secure blockchain network instead of relying on traditional intermediaries.
Essentially, DeFi means that intermediaries such as payment service providers, banks, or investment funds are removed from the equation. This translates into faster and more cost-effective services like transactions or loans.
The field of DeFi is currently experiencing incredible growth. Organizations around the world have already deployed more than $2 billion across various DeFi applications that offer lending and borrowing services, monetary banking services like issuance of stablecoins, tokenization services, exchange services, and other financial instruments like derivatives and prediction markets.
That's why we can't really say that DeFi is one specific thing. Rather, it's a loosely defined collection of ideas and projects that aim to reshape the financial services market as we know it using the incredible features of blockchain technology.
Decentralized finance promises to disrupt the financial services sector by putting the spotlight on blockchain technology. While cryptocurrency communities have so far been the major recipients of this technological innovation, decentralized finance is now attracting the attention of traditional financial companies and policymakers.
However, the common problem is that these parties often lack a common understanding of what decentralized finance actually is and how to overcome major technical, operational, and regulatory obstacles that challenge its further development.
The rise of DeFi could disrupt the industry and make financial services less expensive for both businesses and consumers, faster, and better protected against cybersecurity threats that are increasingly common in this sector.
At Rumble Fish, we believe that decentralized finance is going to keep on growing, and its success is going to be closely connected with greater operation and integration between regulatory supervisors, traditional financial services organizations, political stakeholders, and cutting-edge tech startups.
Interoperability – since DeFi applications are based on blockchain, the interoperability of tokens and dapps offers a major advantage to businesses building such products. For example, when one dapp gets a brand-new feature, other dapps can easily integrate it into their products without asking for any permission.
DeFi is permissionless to participate - DeFi doesn't require any Know Your Customer (KYC) or credit score processes. The same rules apply to everyone, and liquidity is borderless. This means that users can access the market from anywhere and anytime, as long as they have access to an internet connection.
DeFi is noncustodial – this means that users have full control over their funds and can use them however they like. DeFi platforms that are open to anyone who wants to join – however, note that doing so still requires a high level of technical knowledge.
Excellent security - Smart contracts ensure optimal security since they don't rely on any centralized servers that act as single attack vectors. But if a user experiences a problem, there's nobody out there who could freeze or reverse transactions - unlike in a traditional banking institution.
Smart contracts form the core financial functions in such applications. Smart contracts are a flexible technology that offers plenty of potential use cases for industries such as healthcare, logistics, energy, and especially for the financial sector.
Thanks to smart contracts, companies can build features such as credit lending or borrowing, payments, and stablecoin. These are examples of simple features, but it's also possible to use smart contracts for more complex functions such as derivatives or trading assets. All of these features are fully automated and decentralized without the need to engage any intermediaries.
Dapps (decentralized applications) are based on a set of interacting smart contracts. They can easily serve the basic financial functions called financial primitives. Today, financial primitives incorporate functionalities such as payments, lending and borrowing, wealth management, trading, insurance, and more.
Today, decentralized finance applications are analogous to existing financial products. But we can expect that new use cases will emerge in the future as the field develops.
MakerDAO launched a stablecoin project called DAI. DAI is a type of coin that is pegged to the US dollar. It's generated whenever a user deposits Ether as collateral in the Maker smart contract and borrows DAI against their collateral.
To ensure the price stability of DAI, it's always secured with at least 150% of the collateral (Ether). For example, if you send $150 worth of Ether into a Maker smart contract, you can withdraw up to 100 DAI that is worth 100 USD. You can then use DAI for everything - exchanging them to other currencies like US dollars or euros, buying a house, or using the ecosystem to buy more Ether at a decentralized exchange.
This stablecoin is decentralized and doesn't rely on any company that could manipulate the system or go out of business. Maker is just one example of many decentralized stablecoin projects now on the market. We feature it here because it's the most relevant and widely used stablecoin today – and we actually helped the MakerDAO team to make that happen!
DeFi relies on the integrity of smart contracts and the underlying blockchain protocols, so any failure in the code could potentially lead to massive losses of the application's users. While it's impossible to write error-free code, there are many mechanisms available today that help developers increase the quality of their code.
Another weak point closely related to the technical implementation of Decentralized Finance is the user experience of the protocols. They are often unintuitive, complicated, and designed for cryptocurrency native users. Even the best projects often struggle to gain traction beyond the people who are already familiar with this area.
Many DeFi applications were started by teams or companies, so they're not completely decentralized. However, once these projects are established, they usually aim towards decentralized governance and decision-making. As long as an application is semi-decentralized and funds are transiting through an intermediary and that intermediary can freeze funds, the counterparty risk is present because the intermediary has full control over the assets.
Efficient pricing for the financial industry relies on liquidity. Today, liquidity DeFi protocols are outpaced by centralized alternatives offering many low-fee liquidity providers. The liquidity risk is closely related to technical risks such as scalability or congestion issues experienced by the story and platform. In a time of crisis, the Ethereum network might become so congested that liquidity providers won't be able to keep prices in a line across vendors. This will cause massive dislocation on individual exchanges, triggering uncertainty and market drops.
Decentralized projects currently operate without a license in the majority of jurisdictions. When it comes to taxation, the handling of DeFi is also often not clearly outlined by regulators. Right now, DeFi activity accounts for around 1% of the total cryptocurrency market activity. But as it grows in prominence, regulators need to start thinking about how to surround it with the right regulations.
DeFi is only going to rise as a trend on the tech scene. The undeniable advantage of DeFi is that it operates on set protocols implemented by different projects. This makes them interoperable. For example, you can use an exchange and a lender coming from two different projects, but when you combine them together you easily get a derivative.This is why DefI projects often build on other DeFi projects.
If you would like to learn more about how DeFi works and how blockchain could help your business grow, get in touch with us. We help experts in the field, such as MakerDAO, to create reliable products that offer fantastic alternatives to traditional financial services.
CEO / Co-Founder