Decentralized Finance (DeFi)

Introduction to legacy financial systems

Before talking about Decentralized Finance, DeFi, it's important to understand how traditional financial systems work. Traditional financial systems are the banking systems we are all familiar with, although possibly we don't fully understand. These systems are centralized, because we are giving our money to a central entity called bank. If we want to store our money, lend our money to get interests or borrow money to execute a project, traditionally we are counting on banks. We are putting our trust on an entity who custody our assets and acts as a middle man.

For most of us this is normal, we have been educated with it, but if you pay attention you will notice the following:

• You are not really the owner of your money. You are giving the custody to an entity who claims to be reliable, but in certain scenarios they can prevent you from using it. This seems impossible for some people, but if you review the history, you will see that it is quite frequent.
• Not everybody has access to a banking account. Although in developed countries most of the people do, globally around 30% of the population is unbanked, whatever the reason.
• Processes are slow. Transactions take days, borrowing process is time consuming, etc.
• Financial activity is tightly coupled with your identity
• Lack of transparency: you can't ask to see the loan history of a financial institution, a record of their managed assets, and so on.

What is DeFi?

Basically, DeFi is an open and global financial system built on top of Internet. This system is resolving all the negative points mentioned above, giving people the full control and visibility over their money and being open for every single person who has connection to Internet. DeFi means Decentralized Finance, and as the term suggests, DeFi markets are not depending on centralized authorities who can block the service or deny accesses. These are the pain points that DeFi is resolving nowadays compared with legacy financial systems:

• You are then only owner of your money. You hold it, and nobody else in the planet (including top authorities) can take it without your consent. It is technically impossible.
• Everybody with access to internet has access to DeFi, no matter who they are or where they live.
• Nobody can stop the service; no single authority can.
• Services are fully open not only at business hours, anytime and anyday.
• Processes are fast, transactions takes seconds instead of days.
• DeFi systems are fully transparent. Every single transaction gets permanently recorded, and anyone can validate them.
• All the activity is pseudonymous, meaning that your identity is not as exposed as in traditional systems.
• The business rules of a particular DeFi protocol cannot be changed or manipulated by anyone.

How DeFi works?

Nowadays, the supporting technology behind most of the DeFi ecosystem is blockchain and smart contracts. Smart contracts are pieces of code containing all the business logic. These pieces of code are deployed to a blockchain like Ethereum, so then they are fully decentralized, censorship resistant and immutable. You can find more detailed information about this topic in my Smart Contracts blog. These smart contracts together are creating what is called a DeFi protocol.

So, in the end, we are replacing banks by protocols. We are replacing humans by code. DeFi protocols can play the role of a bank, but the main different is that everything is immutably programmed, the code is the law and there are no middle men to charge you fees for the service.

DeFi use cases

This ecosystem is just in its first stage. New use cases are being created year after year, but here I want to mention the most common uses cases we can see in the top DeFi protocols:

• Send money: users can send digital money around the globe, with no single restriction.
• Stream money: users can get their salary paid by the second instead of at the end of the month, allowing them to use their money whenever they need it.
• Borrow funds with collateral: users can borrow money from others you made deposits, but always providing collateral to avoid fraud.
• Borrow funds without collateral: this is commonly known as flashloans, and they consist in borrowing money without giving any collateral. There are certain mechanics in the smart contracts to avoid fraud, but this is quite advanced for now.
• Deposit: users can deposit funds, providing liquidity to the market and getting rewards for it.

Again, there are more advanced use cases, and new ones are constantly popping up in the ecosystem, but these are the most important ones and with this you can have an idea about the utility of DeFi.

Is DeFi being used?

Although for most of the people this is completely unknown, the adoption is massively growing and there are many users and a huge amount of money flowing into these DeFi protocols. A lot of people is already taking advantage of the high yields this ecosystem is providing, and it is a matter of time that this becomes mainstream.

The blockchain supporting most of the DeFi protocols is Ethereum. The most used protocols are Aave, MakerDAO, Curve Finance, Uniswap, Instadapp and Compound and the approximate total value locked into these protocols at the time of the publication of this blog is around $98 billion. This is the evolution of this total value locked into these protocols during 2021:

Conclusion

DeFi might be the future of financial systems because all the reasons exposed in this article. On one hand we can think that people from traditional financial systems will never lose their power and they will not allow this new paradigm to happen. On the other hand we can think that technology is unstoppable, and the history shows us a lot of examples about it. The reality is that banks and institutions are slowly offering services related to DeFi, they are silently putting their foot in the door because they know that it is too hard to put resistance on technology evolution.

This new paradigm is inevitable, but this doesn't mean traditional systems are going to die. We can live in a world where both systems coexist.