Decentralised Finance - DeFi
Decentralised Finance - DeFi
What is Decentralised Finance (DeFi)?
Decentralised Finance or DeFi are applications that run on a blockchain and aim to replicate the dynamics of traditional financial services and products, but in an open, decentralised, and automated environment, eliminating the need for traditional financial intermediaries and centralized counterparties.
Decentralized finance relies on smart contracts to establish agreements that are automatically executed on permissionless networks. This allows financial transactions, such as loans or investments, to be carried out without the need for intermediaries.
Origin
The origin of Decentralised Finance (DeFi) lies in the emergence of Ethereum's smart contracts in 2013.
The emergence of these smart contracts enables the creation of decentralized applications (dApps), also known as protocols, which function in the same way as traditional applications (users notice no difference in their use), but internal management is carried out automatically through these smart contracts. This represents a significant change, as it eliminates the need for a trusted central authority to manage the application.
Characteristics of Decentralised Applications (dApps)
- A Decentralised Application (dApp) must be open source and operate autonomously.
- All information must be kept on a public, permissionless blockchain.
- Decentralised Applications (dApps) may have a crypto asset associated with them to access services and/or reward participants.
Block 4 details the differences between dApps and traditional centralized applications and classifies the different types of dApps that exist.
Descentralised Finance (DeFi)
In the traditional financial world, people go to financial institutions to deposit their money, apply for a loan, make investments, open a savings account, make transfers, etc. These financial institutions implement significant security measures and have strict procedures and policies in place to prevent fraud and protect the money that their customers have deposited in their accounts. However, customers depend on the financial institution to carry out deposit and investment activities or to make transfers.
However, in the case of Decentralised Finance (DeFi), instead of conducting these financial activities through a financial intermediary, financial activities are conducted directly between counterparties.
The key point here is that this is a P2P process, as financial intermediaries are replaced by smart contracts that operate and execute autonomously according to pre-established premises.
Characteristics of DeFi
- Disintermediation: Decentralised Finance (DeFi) uses smart contracts for the automatic execution of orders on the blockchain, therefore, the presence of an entity acting as a financial intermediary is not required.
- Automation: smart contracts are used to automate transactions, enabling the creation of programmable systems.
However, it is also important to note that DeFi is still in its early stages and there are many risks and challenges that need to be addressed.
Uses of DeFi
- Lending plataform: A user can request a loan by locking a certain amount of crypto assets in a smart contract on a decentralised finance (DeFi) protocol. These crypto assets serve as collateral for the loan request, which will be other crypto assets, and will remain locked until the loan is repaid.
- Decentralised Exchanges (DEX): They work through liquidity pools, whose function is to ensure that there are enough crypto assets on the exchange platform for different users to exchange crypto assets with each other without the need for a counterparty in the market interested in carrying out exactly the same transaction. Similarities can be found between these operations and those traditionally carried out by market makers in the traditional financial market, which are entities that provide liquidity to the system to ensure that transactions can be carried out at the time, in the manner, and for the amount desired by each party. In the case of decentralized platforms (DEX), instead of an entity guaranteeing the liquidity of the system, there are liquidity pools, which maintain a certain amount of crypto assets so that the desired transactions can be carried out.
- Users who offer their crypto assets to be part of these liquidity pools receive compensation.
- Stablecoins: In decentralised finance, it is useful to have a unit of account that maintains a stable value, unlike most crypto assets, which are highly volatile. As discussed in section two, stablecoins seek to maintain their value on par with legal tender and thus fulfill the three functions of money, which are: to be used as a means of payment in places where it is accepted as such, as a store of value, and as a unit of account.
- Initially, stablecoins emerged as an alternative to switching positions between different crypto assets without having to exchange those crypto assets for legal tender and then repurchase crypto assets, with the implications that this has in terms of fees and exchange times.
Risks of DeFi
- Incomplete decentralisation: although Decentralised Finance (DeFi) is presented as completely decentralised, there may be areas where centralisation still exists. Some protocols incorporate features that allow the platform to be suspended if necessary.
- Security risks: some Decentralised Finance (DeFi) projects have experienced serious security issues, highlighting the need to act with particular caution and responsibility when using any of these applications.
- Dependence on third parties (“Oracles”): the operation of some DeFI projects requires a third party to provide or verify certain conditions or data (for example, a specific interest rate at a given time) in order for the smart contract to be executed in one way or another. These third parties, known as oracles, may be subject to attacks or security issues that compromise the integrity or reliability of this data.