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Is the World Ready for Decentralized Finances (DeFi)?

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).

Ethereum. (2022). Building with neon lights [Illustration].

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.