The Definition of Decentralized Finance Platforms
Over the past year, the financial space has gone through a dynamic remodeling. Several new services and products are now being offered on decentralized finance platforms. To understand what these platforms are, we need to establish a definition of decentralized finance, or DeFi.
With the advent of the internet and smartphones, digital banking witnessed a tremendous surge in popularity. Given the inclination towards digitization, the race is on to create financial solutions for an exponentially more efficient, cost-effective, and globally-inclusive future. The advent of blockchain technology – fueled by the core principle of decentralization – represents the much needed paradigm shift to achieve such a digitally-evolved financial landscape, primarily including lending and borrowing, exchanges, payments, and derivatives trading. DeFi aims to introduce a layer of decentralization in the global financial systems to promote inclusivity, transparency, and disintermediation, enabling platforms to function without the dependency on third parties.
It is interesting to witness decentralized finance representing an emerging and global movement, which could disrupt and even displace the conventional financial system, by introducing financial tools and offerings powered by distributed ledger technology.
What are Decentralized Finance Applications?
DeFi applications are platforms that use open-source software in the provision of financial services, made possible by creating and curating digital assets on a public blockchain (such as Ethereum). Traditional financial services architecture requires the use of intermediaries (banks) to process international money transfer, which has been slow and costly for consumers. A DeFi application leveraging a public blockchain will allow the global transfer of value to take place without any third party involvement.
There are several benefits that these decentralized finance platforms offer.
No information on a public blockchain can be altered, removed, or reversed by any party, authority, or individual — common issues that plague traditional centralized monetary systems. Users and stakeholders are obliged to trust intermediaries (banks, payment processing companies, remittances entities etc) to manage and execute their transactions with honesty and integrity. However, there is always a risk of mismanagement, hacking, or even explicit data alteration.
Since these financial services are provided on a decentralized ledger through the use of open-source technologies, they are accessibly by anyone. There is no central party that renders control and power over any of these services or products.
Trustless and Secure
A rare combination, DeFi applications have the potential to remove the need for trust in third parties and simultaneously offer complete security to individuals over their wealth, assets, and transactions.
The global financial landscape is widely regarded as incompetent when offering inclusive services to everyone alike. DeFi applications are a breakthrough for the world economy by enabling everyone on the network to be an equal part of the financial systems — a step towards the important universal goal of financial inclusion.
Digital financial services and products are less costly to develop in comparison to non-automated legacy financial frameworks that require manual processes. The low cost offered by digitization translates into lower fees for these financial services, once again offering better access.
The core features provided by decentralized ledger technologies would bridge the gap between the old economy and the future ahead, enabling the masses the right to participate in a more open and efficient financial market. Blockchain technology’s decentralized nature has made it a popular choice across all industries, and today it stands to reposition the entire global financial landscape. To accomplish this, a wide variety of DeFi applications are currently being explored.
Types of Decentralized Finance (DeFi)
There are currently hundreds of applications that are striving to integrate the flourishing DeFi system within their offerings, spanning categories that include payments, lending market, decentralized exchanges, derivatives, prediction markets, and stablecoins.
Since the introduction of Bitcoin in 2009, numerous blockchains and protocols have been designed that facilitate the creation and exchange of coins and tokens. Several other projects have also been developed to address the inherent issue of traditional blockchains. There are currently some promising protocols in existence that could optimize transaction times, and reduce the relative cost of peer-to-peer payment.
Digital payment allows users to hold a secure digital wallet with a set of private and public keys, enabling them to securely transact, pay, and transfer value in the form of digital currencies or tokenized assets, such as:
- OmiseGo: Enables interoperability and financial inclusion along with scaling solutions on the Ethereum blockchain.
- Request Network: Offers an open network to build financial systems for transactions with simple steps.
As one of the most popular categories of DeFi applications, lending protocols have received considerable limelight. Open lending offers every imaginable service provided by conventional credit institutions, together with several additional merits. With the introduction of digital assets, functions such as lending-borrowing, collateral offerings, and financial transaction can all take place on an open and secure network, thereby overcoming the shortcomings that exist with loans, whilst becoming a fundamental driver of the economy.
Furthermore, it empowers the masses to be a part of the lending ecosystem by eliminating the need for credit checks, which de facto promotes financial inclusion. The automation of lending services also introduces standardization and effective operational management, such as the following:
- Dharma: Allows everyone on the network to offer or receive a debt which includes initiating, underwriting, issuing, and managing debt agreements.
- Compound: Introduces interest rates that get fixed by algorithms, eliminating the need for negotiation between parties.
- Ethlend: Offers a peer-to-peer marketplace for borrowing against digital assets with a few clicks and negligible transaction cost.
Exchanges are platforms that represent the backbone of digital trading, by enabling the sale, purchase, and transfer of digital assets. Decentralized exchanges in particular allow users to trade with one another without the need of a centralized intermediary, allowing them to maintain complete control over their assets. Traditional exchanges require intermediaries to perform the functions of order matching, clearing and settlement that is integral to the effective functioning of an exchange. Below are a few popular decentralized exchanges.
- Ox: Offers a seamless exchange of tokens based on the Ethereum platform by leveraging open smart contracts along with scalability solutions.
- Airswap: Provides a platform to trade Ethereum tokens easily with instant price quotes from peers along with complete custody over one’s digital assets.
- Bancor Protocol: Ensures easy liquidity and real-time price discovery of digital assets with built-in evaluation mechanism and smart contracts.
Derivatives are financial securities that derive their value from a single underlying asset, or a group of them, which allows parties to transfer risk to each other. Offering derivatives on blockchain has certain natural advantages, such as cheaper transaction costs, tamper-proof contracts, and lower risks.
Being highly-leveraged instruments, derivatives possess a high-risk profile. While some utilize them for hedging purposes, and some for speculation purposes, there is always a fear of counterparty default. Derivatives backed by smart contracts automatically eliminate such risks. Here are some of the popular DeFi derivatives applications:
- Augur: Decentralized prediction marketplace with event derivatives
- bZx: Renders margin trading and lending via trustless smart contracts backed by the Ox protocol.
- dYdX: Enables crypto derivatives to be created, issued, and traded on an open peer-to-peer platform.
Prediction markets provide a platform for speculative and outcome-driven bets on world events, as well as representing a handy risk management function to hedge investment risks. A prediction marketplace leverages the natural dynamics of demand and supply for odds pertaining to the probability of specific outcomes, which can be traded by users. Blockchain-backed prediction markets eliminate censorship and introduce transparency in a secure environment, some examples of which are:
- Gnosis: Enables redistribution of digital resources, be it assets or incentives based on open market protocols.
- Veil: Leverages Augur, Ox, and Ethereum to power peer-to-peer prediction markets.
- UMA: Uses self-reinforcing smart contracts and oracle mechanism for decentralized financial offerings.
Stablecoins are digital assets backed by an underlying pool of stable assets, resulting in a stable-value peg. The most common form of stablecoins are USD-backed coins, which are backed 1:1 with the US dollars. In an attempt to offer stability within a market renowned for its rampant volatility, stablecoins have gained massive popularity over time. Some of the DeFi applications offering stablecoins are listed below.
- Dai by Maker: Offers stablecoins backed by smart contracts and collateralized against digital assets or tokens.
- Paxos Standard: Stablecoin launched by Paxos that is fully-backed (1:1) by US dollar reserves and is regulated in the US
- Gemini Dollar: Combines the benefits of blockchain technology with the stability and creditworthiness of the US dollar.
The financial system undeniably plays a vital role in society from a monetary and economics perspective, yet the centralization of such a vital pillar of society has resulted in apparent weaknesses and limitations that impairs the effective functioning of the system, much to the demise of the masses. With distributed ledger technologies in the financial industry, tremendous synergies and benefits can be attained by all stakeholders in the system.
* The information above does not constitute any form of financial or investment advice and should not be relied upon. Investing in Digital Assets carries risk. For more information please see our risk warning.