What is DeFi? The Most Concise Explanation

In Brief

  • DeFi is short for Decentralized Finance.
  • DeFi is a term for a group of financial services built on blockchain technology.
  • The idea is to allow anyone with internet access to be able to lend, borrow and bank without the need for middlemen.
  • DeFi is recognized as one of the fastest-growing areas of the blockchain industry.
“The goal of DeFi is to reconstruct the banking system for the whole world in this open, permissionless way,” ~ Alex Pack, managing partner at Dragonfly Capital, a $100 million crypto fund.

What’s DeFi?

DeFi is nothing less than innovative Fintech. It refers to a set of digital assets, financial smart contracts, protocols and decentralized applications (DApps) built on blockchain technology, more specifically Ethereum. It includes payment tokens such as stablecoins, marketplaces, decentralized exchanges, assets or derivatives that operate autonomously or within peer-to-peer with fewer barriers. DeFi aims to improve or replace the current financial system known as centralized finance.

Imagine a global financial system that offers you the ability to access almost every financial service from anywhere, anytime without a barrier or with fewer barriers. For Instance, taking out a loan, payments, creating a digital wallet, trading, insurance and more – accessible to anyone in the world with a smartphone and internet connection.

DeFi is crucial for everyone because of the numerous errors with existing centralized finance

Historically, currency issuance has been the sole responsibility of authorities such as the government and central banks. However, these authorities are founded on centralization. That’s because they’re the only institutions that manage the currency, money supply, and interest rates of a state or formal monetary union and oversee their commercial banking system. These central authorities consist of humans, and errors can happen in their judgments.

These are the only institutions that decide on the amount of money to be printed and to be in circulation. They decide who gets access to financial services and who does not. For example, the government has the centralized power to print more money when it feels like doing it. Meanwhile, for money to maintain its value, it must possess several features, including limited supply. This explains why the current financial system is faced with persistent inflation. For instance, the poor monetary policies of the Venezuelan government, including printing huge amounts of money amid oil price drops, resulted in inflation exceeding 1,000,000% (source: IMF data). This has destroyed the Venezuelan economy.

Also, the current banking system is characterized by strong restrictions that tend to exclude a large number of people from financial benefits. If you want to send money to someone in a different country, you need a bank account or some documents with your personal information. To create a bank account, you need to provide the same documents with your personal information such as ID cards, Tax Identification Numbers, passports or birth certificates, etc. Someone who doesn’t have these mentioned documents cannot open a bank account or send money to a different place. He cannot access other banking services such as ATMs, credit cards or receive a loan, thereby preventing him from participating in activities that involve the creation of economic value. This has contributed massively to the huge number of unbanked populations in emerging economies.

Bank accessibility is very limited. Banks are primarily located in urban areas. This is very obvious in weak economies such as Africa. Thus, excluding a large number of people living in rural areas, access to banking services. Though some emerging banks and Fintech firms such as Mobile Money payments providers promise to provide more control to their users, in reality, you are still trusting in them to manage your funds, which involves many restrictions or limitations.

Lastly, the current financial system is deeply imperfect in the sense that people must trust financial institutions with their assets. That is, if you want to save money, you must deposit it into a bank account. These banks invest that money in share markets and give loans at high-interest rates, earning huge profits. But only a small fraction of that is returned to depositors, i.e., us. People face impersonal services, excessive fees or charges, limited coverage, hours of operations, censorship of bank accounts (people’s bank accounts can be frozen in any case by a third party) and so on.

But Why DeFi?

Though, if you already know about cryptocurrencies such as bitcoin, you may be wondering what’s so innovative about DeFi. Cryptocurrencies have been around for years, providing us with a decentralized financial system. However, cryptocurrencies represent just one aspect of DeFi – the medium of exchange. Cryptocurrency aims to make money and payments universally accessible to everyone, no matter where they are in the world.

DeFi covers almost every financial use case, including the medium of exchange that cryptocurrencies offer. For instance, you can use bitcoin to pay for a good or service everywhere without any central authority, but it is still difficult to perform many financial actions, such as taking out a loan with bitcoin.

DeFi aims to expand the value that cryptocurrency has brought over the past few years from just a decentralized payment system to several financial services, including:

  • Borrowing and lending
  • Stocks, bonds, and other tradable assets,
  • Insurance,
  • Asset storage,
  • And several more areas as well.

With DeFi, everyone has the chance to engage with all the above financial services in a transparent, decentralized, and trustless system.

DeFi provides something Interesting

DeFi is offering you control of your own assets. The main aim of DeFi is to build a financial system that’s open to everyone and minimizes one’s need to trust and rely on central authorities like banks to access any financial service. By utilizing technologies such as the internet, cryptocurrency, and blockchain, DeFi enables everyone to take control of their financial well-being.

DeFi apps are mostly built on the Ethereum blockchain, the world’s most popular decentralized platform. On Ethereum, you can write code that controls digital value, runs exactly as programmed, and is accessible anywhere in the world.

Anyone can store, lend, borrow, trade, and invest their assets on blockchain securely and earn a much higher return than from the traditional financial system. Since everything is decentralized, you have complete control over your investments.

In Conclusion

The DeFi ecosystem is in a nascent stage and still very tiny compared to traditional finance. But the industry has picked up its speed rapidly to cover far more complex financial products. DeFi will definitely be the next big disruption to the financial system. Powered by blockchain technology, DeFi will help bring financial services to the underbanked, reduce transaction costs, improve international remittances, enhance security and provide financial freedom to users from anywhere in the world. With more projects and financial dApps, we can expect to reach a genuinely decentralized financial reality where the traditional financial market is interoperating with digital assets and blockchain in perfect sync.

Read More: The DeFi Ecosystem and its Products