The decentralized finance (DeFi) market is growing in leaps and bounds. According to Statista, it stood at around $11 million in 2020, while this year it has climbed to over $80 million. Although these numbers don’t necessarily capture the whole market, the upward trend is still more pronounced in 2022 than it used to be a few years ago.
A rich landscape of DeFi applications also contributes to the growing popularity of this tech phenomenon. Decentralized exchange markets, dApps, stablecoins, and decentralized games are just a sliver of the DeFi capabilities and potential. But what is DeFi in crypto? And what makes it a game-changer for tech scions?
Today, we’ll flesh out the basics of decentralized finance and five things that make it a standout in the current technological market.
What is decentralized finance?
Let’s revisit the definition first. In the simplest terms, decentralized finance (DeFi) is the use of smart contracts on a blockchain to create new financial products and services. DeFi builds on top of traditional finance products but uses blockchain technology to remove the need for a third party. This could include things like decentralized exchanges, loans, or asset management.
The uniqueness of this technology lies in its blockchain nature. Unlike traditional centralized financial systems, users don’t need any banks or stock exchanges to proceed with the transactions. These middlemen are replaced by software in DeFi. People trade directly with one another (peer-to-peer) instead of addressing the bank with blockchain-based “smart contracts” settling trades and ensuring that the entire process is fair and trustworthy. But let’s dwell on that.
How do DeFi applications work?
DeFi applications rely on cryptocurrencies and smart contracts to deliver intermediary-free financial services and guarantee transparency of all transactions.
DeFi services include a wide range of offerings, including:
- Lending – users can instantly take out a crypto loan against crypto collateral;
- Exchanges – peer-to-peer marketplaces where users can trade tokens with no intermediaries;
- Prediction markets – exchange-traded betting platforms for trading the outcomes of events, etc.
Users employ dApps or decentralized applications to facilitate peer-to-peer business transactions. Built on Ethereum, decentralized applications provide the interface to access blockchain-based services on the platform. Moreover, DeFi is open source, which means that protocols and apps are potentially available for people to investigate and improve. As a result, by designing their dApps, users can mix and match protocols to uncover new combinations of opportunities.
Decentralized applications are then connected to lay the foundation for a whole variety of decentralized services.
Summing up, all DeFi services consist of the following layers:
- The settlement layer includes blockchain platforms such as Ethereum;
- The asset layer, which consists of all the platform-native tokens and digital assets;
- The protocol layer defines the protocols for smart contracts;
- The application layer refers to decentralized applications;
- The aggregation layer connects dApps into different combinations to power a variety of DeFi services.
What makes DeFi different? Top five things
To understand how disruptive DeFi is, we will pit it against traditional financial institutions or CeFi. DeFi, or decentralized finance, is a movement that aims to take power away from centralized financial institutions and return it to the people. These products and services are built on top of decentralized networks and aim to provide more financial freedom and inclusion for all users. Therefore, the majority of its advantages challenge CeFi and act as protagonists to legacy and bureaucratic procedures.
Decentralization is the lifeblood of any blockchain-powered solution. Hence, the overriding objective of decentralized services is to move away from centralized bodies that monitor and control transactions, server space, data storage, and other aspects.
Ethereum is among the most popular mainnets for DeFi applications since it offers a wide range of ready-made templates. As a public blockchain, Ethereum is the epitome of decentralization and is accessible to all users who aim to build or use DeFi services. Also, the decentralized nature of DeFi solutions makes them friendly to third-party integrations.
DeFi products are built on top of decentralized networks, which makes them inherently more secure than traditional financial products. It means that cryptocurrency funds are stored in decentralized wallets rather than with a central authority. This makes it difficult for hackers or thieves to target funds and also removes the risk of institutional failure.
Also, every transaction on the Ethereum blockchain is visible to and verified by other users on the network. It means that all transactions are transparent to every user which adds bonus points to security and user trust.
According to FDIC, around 5.4% of U.S. households didn’t have a checking or savings account at a bank or credit union in 2019. It means that around 7.1 million people are unbanked. Decentralized finance addresses this issue, thus offering a more accessible option for customers.
Unlike traditional bank accounts, decentralized finance caters to all users regardless of geographic location, credit history, or other limitations inherent in a centralized financial system. However, the tech curve of decentralized finance still hampers its wide adoption. In other words, some wallets and protocols may be complicated to use, especially for newbies.
Lower transaction costs
Along with faster processing, DeFi solutions are characterized by lower transaction costs. Since all applications are interconnected, there is no need to pay a fee to another bank. According to Etherscan, the average gas fees differ by action. Thus, a USDT transfer will cost you around $6 in gas fees, while a sale on OpenSea will take around $22. However, Ethereum gas fees are known to be exorbitant, which makes the mainnet unsuitable for small transactions. On the bright side, there are no broker fees on all platforms.
Finally, DeFi platforms eliminate any level of intermediaries due to their automated nature. Since all business rules are executed automatically within the smart contracts, this minimizes the risk of human error and intervention. It also means that decentralized services come with faster, cheaper, and more secure agreements, while also decreasing the risk of manipulation by third parties.
The Final Word
In 2022, DeFi applications are spearheading the revolutionary movement of open and more accessible financial services. While the traditional banking systems are shrouded in bureaucracy and complexities, DeFi takes the hassle away by bringing smart contracts and blockchain to the table.
While there aren’t any accurate predictions of decentralization, the tendency points out the limitless potential of DeFi and ever-evolving blockchain-based applications. Therefore, we will likely see the maturation of decentralized services in the coming years.