Within the blockchain sphere, and following the article on DApps and DAOs, the present one will address the so-called decentralized finances or, as they are more commonly known: DeFi.
DeFi can be construed as a technology that runs in a blockchain-primarily Ethereum— which seeks to provide financial services; and is structured by means of smart contracts and DApps. So far, the technology has been used for loans, coin exchanges, and interest revenue. DeFi is rapidly evolving in the blockchain world due to its potential to provide traditional financial services but with a more decentralized and transparent approach, that is, skipping intermediaries —like financial entities or brokers. Although there are many challenges to address, like the ones that come with blockchain technology, the potential impact of DeFi is enormous. As stated in the white paper Decentralized Finance (DeFi) Policy-Maker Toolkit by the Economic Forum:
"DeFi aims to reconstruct and reimagine financial services on the foundations of distributed ledger technology, digital assets and smart contracts. As such, DeFi is a noteworthy sector of financial technology (fintech) activity." (Economic Forum, 2021, p. 3).
It is worth noting that DeFi platforms do not run with regular money but with cryptocurrencies like Bitcoin (BTC), Ethereum (ETH), and Cardano (ADA) and stable coins such as USDT and DAI. Stable coins are cryptocurrencies associated with standard money values such as USD or EUR. They were born to guarantee stability to investors when facing volatility risks associated with cryptocurrencies.
The rationale behind DeFi translates into the idea to convert centralized finance structures into decentralized ones, in which, thanks to blockchain technology, transactions are transparent and secure and do not require the additional monitoring and pre-approval of an entity that may or may not discretionally authorize a particular transaction.
This is done mainly via smart contracts, which have been programmed with specific instructions and conditions that will govern the financial service, such instructions being unalterable and public. Let’s assume that a user wants to obtain a loan for a specific project. The user can enter into a DeFi platform and apply for a loan instead of going to the traditional financial institutions. Using the DeFi platform, the conditions, risks, and loan opportunities would be reflected in a smart contract, which contains all the relevant information in a clear, immutable, and transparent way. These types of transactions often require the user to offer some guarantee or collateral to secure the return of the loan. Once the smart contract is executed, all its terms and conditions will be executed automatically.
According to the Economic Forum white paper, DeFi services may be made available to users through centralized web applications or permissionless interfaces such as programmable wallets or smart contracts. They may be provided by a traditional controlling entity, a community around a non-profit entity, or a decentralized autonomous organization (DAO), where rights and obligations are specified in smart contracts.
This financing system opens the door to people who may not be eligible for traditional loans granted by financial entities, provided that they can comply with the conditions of the smart contract (i.e., provide guarantees or collateral). This does not mean that DeFi platforms grant funding to everyone. It only means that people may be able to get funds without having to adjust to unilateral conditions set up by a few centralized entities. It can also be a handy alternative for international financing for cross-border transactions.
Needless to say, this technology is not exempt from flaws and disadvantages. For instance, the flaws associated with blockchain technology are also attributable to DeFi. However, with time and proper reduction and mitigation of risks, it will surely become a much-needed relatable alternative to traditional financing.
Currently, DeFi is still a work-in-progress. Security and reliability are a must, especially when it comes to finances. Some DeFi platforms have suffered from security hacks and failures in executing smart contracts. Most existing ones retain some degree of centralization, so they can guarantee immediate intervention if needed —like an “emergency exit”— in case malicious actions, like a cyberattack or a dropdown of cryptocurrency, take place. There is also money laundering and regulatory evasion potential, owing to its anonymity.
Also, it must be remembered that, in addition to the traditional complex world of finances, DeFi also incorporates the complexity of understanding blockchain, smart contracts, and their related world. For a smart contract to work well, it needs good coding and instructions, which is generally not something easy to achieve and, most importantly, maintain.
Not everyone will be able to adjust to this promising new technology at first. It may take a while but, to get there, users will need education, which is what this article and the previous ones related to blockchain have been about. Again, training and education on this topic is the best asset the user can have to navigate the times the world is facing.
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Economic Forum. (2021). Decentralized Finance: (DeFi) Policy-Maker Toolkit. https://www.weforum.org/whitepapers/decentralized-finance-defi-policy-maker-toolkit
Ethereum. (2022). Decentralized finance (DeFi). https://ethereum.org/en/defi/
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