What is Decentralised Finance?
Decentralized finance (Defi) is an emerging financial technology that could revolutionize the way in which financial markets function. It removes the need for third parties such as banks and other institutions to ‘interrupt’ in transactions between customers and merchants. Many of the perks include elimination of credit card service charge fees, personal digital wallets, instantaneous transfer of funds, all of which are available to those with an internet connection.
For example, if one wants to trade, lend and borrow, they can just access peer-to-peer financial networks backed with security protocols and software which records and verifies financial actions in distributed databases across various locations. In other words, Defi technology declares centralized finance models a thing of the past by allowing people to use financial services whoever or wherever they are. Furthermore, users enjoy the benefit of better money control through digital wallets and trading services as opposed to relying on banks for this.
Another feature of Defi is that it uses blockchain technology similar to cryptocurrency which provides extra security and data encryption to a transaction for users. For example, Defi applications called dApps are used to handle these transactions and run the blockchain.
Defi vs Tradfi
Now comes the interesting part of stacking Decentralized finance up against its Traditional finance counterpart. Both models use an exchanging platform for trading of crypto. However, the ace in the hole for Defi is its decentralized exchanges (DEXs), which has been growing in popularity these past few years to challenge centralized exchanges (CEXs). In short, DEXs let users directly hold their own assets, lower transaction fees and avoid regulatory burdens.
For instance, an advocate of DEX, Bancor, states: “Liquidity on traditional asset exchanges has historically been provided by a small handful of professional trading firms with permissioned access and specialized tools. This concentrates liquidity in the hands of a few actors who can withdraw their assets during periods of volatility and restrict trading of an asset when users need it the most”.
In contrast, DEXs allows users to hold their assets with full exclusive control over them. Furthermore, a company which builds a DEX avoids acting as a financial intermediary or counterparty and does not have to meet know-your-customer (KYC) or anti-money laundering (AML) standards because it operates autonomously.ShapeShift used to be a CEX until its CEO said the company lost 95% of its users as a result of KYC measures it was forced to implement in 2018. In 2021, Shapeshift decidedly pivoted and became a DEX to shrug off this problem.
Example of Defi Products
Some of the products of Defi include peer-to-peer (P2P) financial transactions, where two parties agree to exchange cryptocurrency for goods or services with a third party involved. Then, one could use the aforementioned dApp to enter loan needs which is governed by an algorithm matching their needs with that of peers.
Upon agreement of the lender’s terms, one receives their loan. All of this is recorded with blockchain technology. Moreover, a start-up like Block Earner might best illustrate how it uses Defi’s financial product to aid ordinary investors in accessing Defi lending protocols known as Aave and Compound, which pay returns determined by the supply and demand for lending and borrowing crypto.
Block Earner allows investors to change the Australian dollar in a bank account to the stablecoin known as USDC, pegged to 1 to 1 US dollar. Then, customers lend the USDC into Aave and Compound for a yield.
For next week look forward to seeing what are the different applications of AI in the world of finance.
The views expressed within this article are those of the authors and do not represent the views of the Finance Student's Association. All images and references in this article are for fair and educational purposes only. The content in this article is not intended as legal, financial or investment advice and should not be construed or relied on as such.