Understanding the DeFi infrastructure: Will DeFi take Over the World?
[TL; DR]
- Decentralized finance is a technology based on the blockchain that enables peer-to-peer transactions.
- DeFi uses smart contracts when uting transactions while traditional finance has intermediaries.
- DeFi applications are transparency, interoperable and programmable
- Examples of components of DeFi are wrapped tokens, stablecoins, yield farming, insurance, staking, decentralized exchanges and lending.
Introduction
There are two broad financial s at the moment, decentralized finance (DeFi) and traditional finance (TradFi). Currently, the two s exist side by side, yet they interact in several ways. The traditional finance comprises centralized authorities such as banks and insurance firms. In their operations these institutions use intermediaries, yet the decentralized sector does not use third parties to facilitate transactions. This article will focus on the decentralized finance (DeFi) infrastructure.
What is Decentralized Finance (DeFi?)
Decentralized Finance, popularly known as DeFi, is a technology where users interact with each other using smart contracts. They do not use intermediaries such as banks, insurance companies or brokerages to authorize transactions.
Basically, DeFi is a technology based on millions of computers scattered around the world rather than a single server. All transactions occur using the blockchain and the internet which connect service seekers and service providers.
The blockchain, which is decentralized, immutable, permissionless and transparent, enables many computers (nodes) to store all transaction records.
DeFi overview
One of the important aspects of the DeFi infrastructure are the decentralized applications that enable users to connect with one another. When you are using the applications you are interacting directly with a smart contract.
There are varied decentralized applications which include lending platforms, synthetic assets, stablecoins and decentralized exchanges. These applications have many things in common. For example, they are interoperable, transparent, open source, programmable and permissionless. Let’s explain a few of these.
Transparency: The transactions are recorded on the blockchain and anyone with internet service can view them.
Interoperable: The decentralized applications that exist on a protocol interact with each other.
Programmable: The developers can program the applications so that they interact with other dApps in the eco.
Open source and Permissionless: There are no restrictions on who can use the applications as long as the individuals have the required wallets and internet connection. The users can send or receive digital assets such as stablecoins.
The importance of DeFi
The truth is that DeFi is a game changer in the financial sector. It has many use cases. For example, it enables people to send and receive money without geographical restrictions. Users can borrow funds as long as they meet the rules of the smart contracts such as a certain amount of collateral if they want to borrow funds.
Smart Contracts- Inc42
Individuals can also lend their digital assets like stablecoins, Bitcoin and Ether (ETH) to other people and earn interest. Moreover, the cryptocurrencies give investors the chance to invest in different ways like saving their tokens and coins.
As you note, DeFi offers utility in various sectors of the economy such as insurance service, asset management, yield farming, lending and borrowing and gaming sector. In essence, DeFi solves serious problems that exist in the traditional financial sector.
What problems do DeFi Solve?
Basically, DeFi uses peer-to-peer networks when conducting business transactions. What this means is that DeFi institutions do not use intermediaries which cost much money and create many delays. As a result, DeFi eradicates key problems which are inherent in the traditional financial such as inefficiency and limited access to financial resources for certain sections of the society.
The traditional financial is grossly inefficient since it has intermediaries. The intermediaries require high fees and use bureaucratic procedures. For example, when an investor wants to trade an asset the procedure is time-consuming. With DeFi, the ution and settlement of the transaction is near instant and simultaneous.
Many people cannot access some financial resources in TradeFi. This is because there are various restrictions. For instance, the users need to have banks, collateral and meet certain legal requirements such as having national identity cards. Since over 1.78 billion people worldwide are unbanked they cannot access the financial resources. However, DeFi does not require people to have banks or meet most of these restrictive requirements.
There is a lack of interoperability within the traditional financial sector. This is because there are many barriers that prevent different institutions within the legacy financial from interacting with each other. For example, someone who wants to open a trading account online may need to transfer funds from his/her bank. This takes much time and requires funds. However, DeFi applications can easily interact with each other.
DeFi applications and Components
DeFi has different applications, tools and components. Let’s have a brief rundown of these components which include stablecoins, decentralized exchanges and wrapped coins.
DeFi lending and borrowing:
Individuals have an option to lend their money to people who want to borrow it. The borrowers have to pay interest for using the funds, which is usually in the form of stablecoins.
Decentralized exchanges (Dexs): Decentralized exchanges enable people to exchange their cryptocurrencies without need for KYC. Also, Dexs are permissionless and allow users to trade their assets anonymously.
Stablecoins: These are cryptocurrencies whose values are constant because they are pegged against other assets such as gold and Bitcoin. For instance, most stablecoins are pegged against the United States dollar. However, in some cases the price of some stablecoins remain constant-usdt “stablecoins remain constant”) as a result of algorithms that control their supply and demand.
Tether USDT is a popular stablecoin- Cryptonomist
Yield farming: This involves investors who stake their cryptocurrencies to earn interest. As such, they earn passive income without putting in much effort and with very low risk.
Wrapped coins: These are cryptocurrencies that represent other coins and exist on different blockchains. This is important because it increases interoperability, adoption of cryptocurrencies and leads to fast transactions in some situations. For example, wrapped Bitcoin (wBTC) is a token that represents Bitcoin but exists on the ethereum blockchain. It maintains the same value as Bitcoin.
Prediction markets: Predictions markets are platforms where people make predictions about possible outcomes of certain events or activities. The betting covers fields such as sporting, trading forex and cryptocurrency or politics. For example, sports fans bet on the possible outcome of soccer matches.
Asset management: Users now have ways to control their assets in a transparent manner through DeFi. They can easily transfer or sell their digital assets without using third parties. Also, they can purchase the assets they require without strings attached.
E-wallets: Digital wallets, also called e-wallets, help people to interact with different applications. These wallets function independent of crypto exchanges and other dApps. Basically, the wallets allow you to control your digital assets since you own the private keys.
applications, components and tools is long. Apart from the ones we discussed above, we also have insurances, gaming industry apps, DeFi banking and many more.
DeFi vs Traditional FinTech infrastructure
As we said earlier on, there are clear differences between traditional finance and DeFi. With traditional finance, the users carry out lengthy processes to register and get approval to use their services. Sadly, there are also biases and discriminations in terms of the beneficiaries.
Nevertheless, with DeFi the onboarding process is very simple. The user only needs a digital wallet to interact with DeFi applications. The platforms do not carry out verifications or background checks. Racecapital uses a simple table to compare TradeFi and DeFi.
There are several differences between traditional finance and decentralized finance. However, DeFi has an upper hand over traditional finance. For example, in the traditional finance sector the institutions hold the assets while in DeFi the users have custody over their assets.
The traditional finance sector uses fiat currency while DeFi has digital assets such as stablecoins. There are intermediaries in TradeFi but smart contracts in DeFi. The traditional financial sector uses clearinghouses while DeFi uses smart contracts to effect the transactions. Although collateral exists on both sides, DeFi uses over-collateralization to secure borrowed assets.
DeFi applications
Blockchains may have different decentralized applications based on the products and services they offer. Also, some blockchains have different layers such as base layer and layer-2. The base layer can host various applications such as lending and asset management dApps. The following diagram shows the different applications that exist on the Solana blockchain and Ethereum one.
Some blockchains such as Ethereum have layer-2 blockchains. The layer-2 blockchains offer scaling solutions to the layer-1 chains and mostly conduct the transactions off-line. Optimism and Arbitrum are examples of layer-2 blockchains that exist on the Ethereum blockchain.
The future of decentralized financial applications
Although DeFi seems to have better features and components it still needs improvements. Mostly, the developers can improve on future applications to make them more user-friendly and increase their utility.
Consumer applications:
The future of DeFi should encompass consumer applications which improve user-experience as the users do not interact directly with the underlying protocol. This can simplify the front ends of the DeFi space and improve the user-experience.
Customer Relationship Management (CRM):
Currently, DeFi does not use customer relationship management as it does not collect personal information of the users. This is good because it enhances privacy. However, if DeFi uses CRM the customers will get products and services that best meet their needs and preferences.
There are no notifications in the DeFi sector. In the future notifications will enhance communication with the users.
Transaction rollbacks:
Currently, if a user makes a mistake when processing a transaction, he/she cannot reverse it. Transaction rollbacks will help the users to reverse the transactions they conduct by mistake.
Identity:
In DeFi users make their transactions anonymously. This has resulted in some bad actors using DeFi platforms to conduct illegal business activities such as drug trafficking. Due to this pseudonymity, it is very difficult for law enforcement agents to track and apprehend the offenders. Therefore, in the future there should be a way to identify bad actors such as hackers.
Conclusion
Decentralized finance (DeFi) transactions occur on the blockchain and require internet connection. DeFi is different from traditional finance in that it does not involve intermediaries. On the other hand, TradeFi involves third parties when uting some transactions. As well, DeFi uses smart contracts that allow peer-to-peer transactions.
FAQ
What are the components of decentralized finance?
DeFi lending and borrowing, decentralized exchanges, stablecoins, yield farming, wrapped coins and e-wallets are components of DeFi.
What is DeFi infrastructure?
DeFi infrastructure is the blockchain network that supports smart contracts.
What are the characteristics of DeFi wallets?
DeFi wallets are non-custodial, key-based, accessible and compatible with smart contracts.
What are DeFi tools?
DeFi tools are the software required to access DeFi services.
What is the backbone of DeFi?
The backbone of DeFi is the Smart contract.
