DeFi has seen an explosion in popularity in recent years as a new way of doing finance, but how exactly does it work and what sets it apart from the world of ‘traditional’ finance?
A report published last month by Dutch investment bank ING has posited that decentralised finance (DeFi) has opened a can of worms in the sector which could see the technology “replace traditional banking”.
However, the paper has also stressed that the ideal future may not be one of competition, but cooperation as DeFi continues its rapid growth as a sector.
“Although DeFi currently appears to be a domain on its own, we envision that centralised and decentralised financial services will converge at some stage as both have unique capabilities that are beneficial to the other”, the paper said.
What is DeFi?
In simple terms, DeFi is a system that allows financial products to be available on a public decentralised blockchain network, the same technology behind cryptocurrencies such as Bitcoin and Ethereum.
Much like crypto, DeFi is touted by its proponents as a way of allowing users to engage with financial products without having to go through middlemen such as banks and brokerage firms. Instead, DeFi allows all types of user, buyers, sellers, lenders and borrows to interact on a peer-to-peer basis with the only middleman being the blockchain software that facilitates transactions.
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DeFi is heavily underpinned by a blockchain technology known as the smart contract, digital self-executing agreements between buyers and sellers that are directly written into computer code.
This smart contract code controls how agreements are executed and ensures all transactions are trackable and irreversible, fulfilling many of the functions of middlemen in traditional finance.
Another benefit of smart contracts is that they allow transactions and agreements to be carried out among remote and anonymous parties without the need for an external enforcement mechanism such as a legal system or a central authority.
What DeFi products already exist?
Since its emergence, DeFi has exploded in popularity and led to the emergence of dozens of products fulfilling a multitude of requirements for financial consumers.
One of the most popular DeFi applications is MakerDAO, is a decentralised lending platform whereby users lock away crypto in a digital vault that is then used as collateral to create Dai, a stablecoin pegged to the value of the US dollar.
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Another popular application is Compound, a money market protocol that allows holders of digital assets to borrow and lend crypto. Users can serve as lenders by adding their crypto to a liquidity pool, for which they are paid compound interest that fluctuates based on supply and demand for various cryptos.
DeFi also extends into the trading arena, with applications such as Bancor serving as a decentralised crypto exchange that allows users to swap digital assets without having to rely on a central authority like traditional stock markets.
