What do you think about when you hear the words “the future of finance?” For most people, images of mobile payments, online banking, and other cutting-edge technologies come to mind. But what about decentralization?
If you’re unfamiliar with the term, decentralized finance (DeFi) is a subset of blockchain technology that focuses on financial applications powered by distributed ledgers. In essence, DeFi represents the next generation of financial services, where individual users have more control and transparency over their finances.
Over the years, DeFi has changed the way we think about money, and with some of the key benefits of using DeFi, there are many possibilities this technology holds for the future.
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What is DeFi?
DeFi is a term used for Ethereum and other blockchain applications that allow for a peer-to-peer transaction without needing an intermediary such as a bank, central bank, or other financial institution. Because there is no central authority, all transactions are visible to everyone involved, providing more transparency and accountability.
In addition, DeFi applications tend to be more flexible and faster than traditional centralized systems, which can often be bogged down by bureaucracy. Moreover, users have direct control over their own funds in a DeFi system, meaning they can decide how to use their money without going through a third party.
While DeFi still has some associated risks, the potential benefits make it an appealing option for those looking for alternatives to traditional financial systems.
Current State and Potential of DeFi
In 2021, some outlets reported that DeFi’s growth on the Ethereum blockchain was 780% year-over-year. By the first quarter of 2022, the total value locked (TVL) in DeFi protocols was over $172 billion.
The current state of DeFi is characterized by four key trends: composability, yield farming, DeFi insurance, and governance.
Composability
Composability refers to the ability of different components to work together to achieve the desired outcome. In the context of DeFi, composability refers to the ability of different protocols and platforms to interoperate to create new financial applications and products.
This interoperability is made possible by using open standards and APIs (application programming interfaces), allowing developers to build on existing infrastructure rather than starting from scratch.
This isn’t to say that composability hasn’t existed in traditional finance. For example, when you use PayPal to buy something on Amazon or pay for an Uber, you use two different platforms that can work together. However, DeFi takes composability to the next level by making it possible to create a trustless system.
Every transaction and activity is verifiable on the blockchain. Ethereum is the neutral settlement layer, and no single entity wields power. In addition, the permissionless nature of DeFi means anyone can create new financial products and applications that wouldn’t be possible with traditional infrastructure.
As more protocols and platforms begin to interoperate with each other, we can expect an exponential increase in the number and variety of available DeFi applications and products.
Yield Farming
Yield farming is the practice of staking cryptocurrencies to earn rewards. This can be done by providing liquidity to various exchanges or participating in staking pools.
Yield farmers typically use multiple protocols to maximize their rewards. Due to the high risk involved in yield farming, many farmers diversify their portfolios across multiple projects.
Yield farming generally offers higher rewards than traditional staking, but it is also a more volatile practice. Therefore, yield farmers must carefully monitor the price of the tokens they are staking to avoid losses. Additionally, they must be aware of rug pulls, smart contract hacks, and other risks associated with yield farming.
Yield farming has become a popular way to earn cryptocurrency rewards despite the risks. However, it remains to be seen whether this practice is sustainable in the long term.
DeFi insurance
DeFi insurance is the missing piece to bring DeFi to par with traditional finance.
DeFi insurance has arisen out of necessity, as evidenced by the estimated $10 billion lost in the DeFi industry to fraud in 2021. Insurance protects against adverse events in the space, such as exchange hacks, smart contract failures, and stablecoin price crashes. Anyone can provide DeFi insurance by joining a pool.
In addition to the aforementioned coverage, other possibilities for DeFi insurance include DvP (delivery versus payment) protocols and flash loans. However, despite the advantages offered by DeFi insurance, the claims process is still uncertain. Consequently, more research is needed to assess the effectiveness of this new tool.
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Governance
Several DeFi platforms are resoundingly reaffirming the blockchain community’s dedication to decentralization by making governance tokens available to users.
A governance token grants users a certain amount of power over the platform’s protocol, products, and future features. Governance tokens are frequently created using decentralized protocols that encourage community-driven development and self-sustainability.
Decentralized networking projects require governance techniques to make critical decisions about protocol modifications, recruitment, and even governance framework adjustments.
For example, a borrowing and lending platform may utilize its governing procedure to calculate the required amount. In other words, the decisions made by a project’s stakeholders through its governing system can directly impact its success or failure.
With the right approach, governance initiatives have the potential to usher in a new era of decentralized development and cooperation.
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Challenges of DeFi
As the DeFi sector has grown, one key challenge is ensuring the playing field is level for all market participants, regardless of their size or location. Another is the need for stronger global regulatory coordination to prevent DeFi protocols from being used for illicit purposes. Finally, as DeFi protocols continue to evolve and mature, there is a need to develop more robust governance mechanisms to ensure they can adapt and respond to changing conditions.
While the challenges facing DeFi are significant, so too are the rewards. With its ability to empower individuals and communities worldwide with greater access to financial services, DeFi represents a vital step forward in achieving financial inclusion for all.
Future of DeFi
The DeFi space is still in its early stages, and it remains to be seen what the future holds. However, with its ability to reduce barriers to entry, increase access to financial services, and enable more democratic governance structures, DeFi has the potential to reshape the future of finance for the better.
Near instant and secure transactions is a critical area to watch. With traditional finance, transactions can take days or even weeks to clear. This is not the case with DeFi. Due to the decentralized nature of the sector, transactions are settled almost instantly, making it ideal for activities such as trading or lending, where time is of the essence.
Easier borrowing and lending are inevitable with DeFi. In the traditional financial system, it can be challenging to get access to loans because banks and other financial institutions are often reluctant to lend to individuals with no collateral. However, in the DeFi space, you can use your crypto assets as collateral for a loan. This opens up access to credit for many people who would otherwise be financially excluded.
Cross-communication and the ability to exchange assets are other areas of interest. In traditional finance, there are often silos between different asset classes. For example, you might have a bank account for your savings, a brokerage account for your stocks and shares, and a pension for your retirement savings. However, new DeFi applications allow users to easily trade between different asset classes without going through a centralized exchange. This increases efficiency and reduces costs.
Honesty and trust are two values that are important in any financial system. Unfortunately, they are often lacking in traditional finance. For example, banks have been known to mis-sell products to customers or charge hidden fees. However, in the DeFi space, everything is out in the open and transparent. This helps to build trust between users and developers and creates a more open financial system overall.
All in all, there are many reasons why DeFi could reshape the future of finance for the better.
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