Keeping up-to-date is a good way to explore the cryptocurrency market and consider options. A new realm of technology to consider is decentralized finance (DeFi).
DeFi is technology that merges blockchain, digital assets, and financial services. The market for DeFi started growing rapidly from $1 billion in 2019 to over $15 billion by the end of 2020.
Here’s a deeper look at how DeFi covers a wide range of business interactions.
What are Smart Contracts?
A smart contract is a blockchain-based software code that executes, controls and documents contractual business agreements when predetermined conditions are met. Smart contracts, which are based on the “if/then” principle, have been used for various business interactions, including regulating workflows and issuing automated payments when an assignment is completed.
Smart Contract Example:
Jen is a photographer who does remote freelance high-resolution photography for client websites. She agrees to a smart contract that will issue her payment once she completes the assignment. Jen is to upload a series of pictures to her client’s website. The smart contract only executes when all conditions are met, such as submitting the photos by a deadline.
She is paid for her services in cryptocurrency that transfers to her digital wallet and she is issued a virtual receipt. She can access these digital items with any computing device using an encryption key, which is a complex scrambled code generated by an algorithm.
Once the conditions are met according to the predetermined rules, the smart contract expires. Everyone in the network can verify from the blockchain ledger. Jen can trade her cryptocurrency for cash through a crypto exchange.
How DeFi Differs from Traditional Finance
While blockchain is a decentralized mechanism for financial processes, traditional financial institutions connect with the central banking system. Unlike conventional financial services, decentralized finance doesn’t require a bank as a mediator to monitor transactions.
Here are some key advantages to DeFi that differentiates it from regular financial services:
- Autonomous transactions don’t require permissions
- Deals can be arranged or completed without a waiting period
- No hidden fees
- Trust in blockchain as secure technology for transactions
- Cryptocurrency transactions are facilitated
- Digital cash is held in a digital wallet instead of a third-party bank
- Public blockchain ledger allows for transparency
- More seamless integration of services via a blockchain
One thing that makes traditional finance and DeFi similar is they are both vulnerable to cybersecurity breaches. Blockchain is considered to provide strong security through encryption, but nothing is bulletproof for the most sophisticated hackers.
DeFi Building Blocks
The three main building blocks of DeFi are blockchain, digital assets, and digital wallets. Smart contracts connect all these components together. Other important DeFi terms to remember are stablecoins (digital assets), exchanges, and derivatives. More familiar financial terms such as credit, insurance, and asset management are also part of the DeFi lexicon.
Here are other important elements of DeFi:
- Decentralized apps (Dapps) – Software apps based on smart contracts
- Governance Systems – Software-based tools for altering smart contracts or blockchain protocols
- Decentralized Autonomous Organizations (DAOs) – Entities using smart contracts
- Oracles – Data feeds such as real-time stock price quotes
Why Blockchain is Entering Financial Services
Blockchain, the underlying technology behind Bitcoin and other cryptocurrencies, is gaining favor with FinTech companies for secure digital transactions. It facilitates DeFi in various ways, providing a decentralized environment while permanently documenting transactions.
Both DeFi and blockchain are innovations designed to increase transparency, convenience, efficiency, and accuracy of transactions.
Since both DeFi and blockchain are relatively new developments, they pose risks and unknowns that must be addressed by vendors and end-users. Both have been used for fraud. There are many hurdles and government red tape to overcome before these advancements become mainstream.
DeFi Service Categories
Stablecoins are one of six key DeFi service categories as they represent risk management for cryptocurrency users. One of the main risks of using bitcoin or other cryptocurrencies is price volatility.
The value of one bitcoin can fluctuate wildly day to day, even within the same day. But the value of a stablecoin is fixed to match the underlying value of an asset such as fiat currency. In other words, stablecoins hold a steady value, unlike bitcoin.
A digital currency exchange (DCE) allows you to trade digital assets, such as buying or selling bitcoin. It also lets you exchange cryptocurrency for fiat currency or trade different types of cryptocurrency (e.g. Etherium and Solana). Current popular DCEs include Coinbase and Binance.
DeFi allows you to loan or borrow cryptocurrency with others. That’s one of the countless reasons why blockchain-based applications are rising in demand among FinTech companies. Users can also lend or borrow tokens, which are similar to digital coins tied to monetary value.
As with traditional credit, DeFi lenders earn interest from parties that borrow from them. In the DeFi ecosystem, anyone can be a lender, and crypto assets can be used as collateral for crypto loans.
This term rose to notoriety during the financial collapse of 2008. Derivatives are synthetic financial instruments in which the value is tied to how an underlying asset performs in the market. An example would be if an investment firm invests in real estate assets. At the same time, the firm is hedging against them with a derivative that reflects the inverse of the investment.
Derivatives exist in the form of futures and options contracts, credit default swaps, and a long list of specialized financial instruments that deliver value according to an algorithm that tracks market activity.
In the crypto world, various derivatives exist as well. For instance, a 3x BTCUP token. This token reflects three times the percentage gain or loss of Bitcoin in a day. So if Bitcoin goes up 3 percent in a day, the value of your token will increase by nine times.
Many other functions and algorithms exist for crypto derivatives.
The age of DeFi insurance is in its infancy, but it’s currently being explored by the insurance industry. Insurers are interested in serving crypto investors due to the risk/reward dynamic. They can sell insurance coverage to crypto investors through risk tokens. These tokens protect against the volatility of crypto assets. Ultimately, DeFi facilitates self-insurance options.
Another way DeFi is disrupting the financial services industry is through active decentralized asset management. Users of DeFi asset management don’t need to open a crypto account. While keeping crypto in a digital wallet does not earn any interest, crypto traders can use wallets, exchanges, and blockchain to manage and grow their assets.
Transparency and decentralization are keys that make DeFi asset management attractive to crypto investors.
The advent of decentralized finance is creating disruptions and innovations in the financial services industry and beyond. In many ways, this wave of blockchain technology and associated applications is redefining how people view money.
DeFi empowers you to make seamless private transactions without conventional institutions looking over your shoulder. Looking forward, the products and tools that emerge from the DeFi ecosystem will help democratize access to financial services. Essentially, by creating new ways to monitor, deploy, and manage capital, individuals will gain more freedom, flexibility, and control over their assets.
Watch the recording of our Smart Money 4.0 webinar to learn more about decentralized finance.