Table of Contents

• What is decentralized finance (DeFi)?
• What are the main advantages of DeFi?
• What are the potential use cases for DeFi?
  • Lending
  • Money banking services
  • Decentralized market
• What role do smart contracts play in DeFi?
• What challenges does DeFi face?
• What is the difference between DeFi and open banking?
• Summary

What is decentralized finance ( DeFi)?

Decentralized finance ("DeFi" for short) is a financial application ecosystem built on the blockchain network.

Specifically, the term "decentralized finance" refers to the creation of an open source, permissionless and transparent financial services ecosystem. This ecosystem is open to everyone and operates without authorization from any central authority. Users have full control over assets and can interact with the ecosystem through peer-to-peer (P2P) and decentralized applications (Dapps).

The core advantage of DeFi is that financial services are within reach, which is especially suitable for people who are isolated from the current financial system. Another potential advantage of DeFi is that it is built on a modular framework - highly interoperable DeFi applications in public blockchains can create new financial markets, products and services.

This article will introduce the basic knowledge of DeFi, including potential applications, advantages and disadvantages, etc.

What are the main advantages of DeFi?

Traditional finance relies on banks and other institutions as media, and also requires courts to provide arbitration.  

DeFi applications can directly skip intermediaries and arbitration institutions. The code can provide solutions to various disputes that may arise, and users can also have full control over their own funds. This approach reduces the cost of providing and using products, leading to a more harmonious financial system.

New financial services deployed on the blockchain eliminate single points of failure. Data is recorded in the blockchain and widely distributed across thousands of nodes, making review a complex undertaking and reducing the chance of service disruption.

The framework for DeFi applications is built in advance, and deploying applications on it is very simple and completely reliable.

Another important advantage of DeFi is to deepen the openness of the financial ecosystem and cover more groups who cannot enjoy financial services. The main way for the traditional financial system to obtain income is through intermediary institutions, which generally do not provide services to areas where low-income groups are located. However, DeFi can significantly cut costs, and low-income people can also benefit from various financial services.

What are the potential use cases for DeFi?

Lending

The open lending protocol is one of the most popular applications in the DeFi ecosystem . Compared with traditional credit systems, open decentralized lending has many advantages, including instant transaction settlement, support for collateralized digital assets, no credit review, and possible standardization in the future.

The lending service is built on a public blockchain, which minimizes the level of trust required and is protected by cryptographic verification methods. The blockchain-based lending market reduces counterparty risks, speeds up lending while cutting borrowing costs, and effectively expands the audience.

Money banking services

By definition, DeFi belongs to financial applications, money banking services This is a typical use case. These include the issuance of stablecoins, mortgage loans and insurance.

As the blockchain industry matures, the creation of stablecoins has attracted increasing attention. Stablecoins are typically digital currency assets pegged to real assets that can be transferred digitally with relative ease. The price of digital currencies can sometimes fluctuate wildly, but decentralized stablecoins can serve as digital cash for daily use, and can be issued and monitored without central authorities.

Mortgage loans are expensive and take a long time to disburse, mainly because they require many intermediaries to intervene. With the advent of smart contracts, underwriting and legal fees may be significantly reduced.

Insurance on the blockchain can skip intermediaries and share risks through many participants. With the same service quality, the premiums that policyholders need to pay have been reduced.

For a detailed explanation of the topic of blockchain and banking, we recommend reading the article "How Blockchain Technology Impacts the Banking Industry".

Decentralized markets

This type of application may be difficult to evaluate and has the broadest space for financial innovation. DeFi sector.

Arguably, the most important DeFi application is the decentralized exchange (DEX). Through these platforms, users can trade digital assets directly without the need to hold funds through a trusted intermediary (trading platform). With the help of smart contracts, different users can complete transactions directly through their personal wallets.

Decentralized trading platforms require less maintenance, so transaction fees are much lower than centralized trading platforms.

Blockchain technology is also often used for the issuance and empowerment of various traditional financial instruments. These applications operate in a decentralized manner, eliminating the need for custodians and completely eliminating single points of failure.

For example, security token issuance platforms provide issuers with tools and resources to support the launch of tokenized securities with customizable parameters in the blockchain.

Other projects support the creation of derivatives, synthetic assets, decentralized prediction markets, and more.

What role do smart contracts play in DeFi?

Most existing and potential decentralized finance applications involve the creation and execution of smart contracts. While regular contracts spell out the relationships between the different entities in the contract through legalese, smart contracts use computer code.

The terms in a smart contract are written in computer code and can be made effective by running the code. Many business processes that originally required manual supervision can now be executed automatically, ensuring reliability.

Using smart contracts, both parties can reach transactions more conveniently and quickly, and transaction risks are also reduced. On the other hand, smart contracts also bring new risks. Computer code is prone to errors or vulnerabilities that could reveal very important confidential information.

What challenges does DeFi face?

• Inefficiency: Blockchains are naturally slow compared to their centralized competitors, which also affects the applications built on them. Developers of DeFi applications need to take these limitations into account and continuously optimize their products.
• High risks caused by user errors: DeFi applications shift responsibility from intermediaries to users, causing trouble for many people. Products are deployed on a blockchain that cannot be tampered with, so it is very difficult to minimize losses caused by user errors through product design.
• User inexperience: Currently, users have to work extra hard to navigate DeFi applications. In order to become a core element of the global financial system, DeFi applications must bring tangible value to users, causing them to bid farewell to the traditional financial system and move to DeFi applications.
• Ecosystem chaos: Finding the most suitable application for a specific use case is extremely difficult, and users must have the ability to find the best solution. The challenge comes not only from building applications, but also from how to integrate users into the huge DeFi ecosystem.

What is the difference between DeFi and Open Banking?

Open banking means that the banking system authorizes third-party financial service providers through APIs, allowing them to securely access financial data. In this way, banks and non-bank financial institutions can link accounts and data. Essentially, it can create new products and services within the traditional financial system.

However, the new financial system proposed by DeFi is completely independent of the existing infrastructure. Therefore, DeFi is sometimes called "open finance".

For example, it can securely obtain data from many banks and institutions and manage all traditional financial instruments in the same application.

On the other hand, decentralized finance supports a new financial instrument management model and creates a new way of interaction.

Summary

Decentralized finance aims to build a structure independent of traditional finance and politics system of financial services. This will create a more open financial system that effectively eliminates censorship and discrimination on a global scale.

Although the concept of decentralized finance is very attractive, it is not perfect. Finding the use cases that best suit the characteristics of the blockchain is the most critical step in building a set of practical open financial products.

If it develops smoothly, DeFi will replace many large centralized organizations and decentralize power to open source communities and individuals. Once DeFi enters the mainstream stage, it will be clear whether a more effective financial system can be created.