With a focus on its features and subsets, this article will analyse a number of studies and researches on decentralised finance with the goal of providing a summary of how the ecosystem is changing and how it might alter the structure of contemporary finance by fostering new opportunities for innovation.
Decentralized financial innovation, or DeFi, is the shift in the economic paradigm made possible by decentralised technology, primarily blockchain networks, which gave rise to a whole movement with the invention of bitcoin (S.Nakamoto, 2008). Blockchain and Distributed Ledger Technologies (DLT) serve as the foundation for technology that is transparent, immutable, and without boundaries. Launched in 2015, Ethereum is the first programmable blockchain in existence. The idea behind the Ethereum Virtual Machine is that it can run more complex applications, allowing for the direct control of digital assets by a piece of code, the implementation of methodical rules, or even the creation of decentralised autonomous organisations using blockchain technology (DAOs).
Because Ethereum is programmable, programmers can use it to create new sorts of apps (G. Wood, 2014). It is feasible to execute programme logic decentralizedly using smart contracts as the foundation for Decentralized Applications (dApps), as all peers in the blockchain network validate transactions to maintain the accuracy of the ledger. The programme logic is executed as a result of these transactions, which causes modifications to the state of globally shared objects.
The concept is to build and run financial decentralised applications (dApps) on top of transparent and unreliable infrastructure, such permissionless peer-to-peer (P2P) protocols. This emerging idea of “Open Finance” mainly refers to digital assets, financial smart contracts, protocols, and decentralised applications created using distributed ledger technology or open blockchains. There were 214 DeFi projects mentioned as of June 2020, 199 of which utilised the Ethereum Blockchain architecture (DeFiPrime, 2020). In conclusion, the DeFi movement is moving traditional financial goods to the open source and decentralised world, eliminating the need for intermediaries, cutting costs generally, and significantly increasing transparency.
What is DeFi, and why is it so popular right now ?
DeFi, also known as “Open Finance,” is a collection of Blockchain/DLT-based financial services and applications that aim to supplement or replace the current financial system, also known as “Centralized Finance.” Decentralized Finance offers many advantages over conventional financial services thanks to the usage of distributed platforms and smart contracts. Deploying a financial application or product becomes far less difficult and demanding as ecosystems develop. For instance, a lot of decentralised applications (dApps) are being created on top of the Ethereum blockchain, which offers cheaper entry costs and operations costs (Binance Academy, 2020).
Numerous efforts are already making progress in the various sub-sectors that make up the larger DeFi landscape. These specific projects were formed on the Ethereum network, although others have been 317 developed or already exist on other permissionless blockchains like Bitcoin. The developers of DeFi are able to make their services available to everyone with a device and an internet connection by employing permissionless networks.
Currently, DeFi’s three main purposes are :
1.interpreting financial banking services (e.g., Issuance of stablecoins)
2.offering platforms for peer-to-peer (or pooled) lending and borrowing
3.enabling cutting-edge financial tools including Decentralized Exchanges (DEX), Platforms for Tokenization, Derivatives, and Predictions Markets
Some of the most common use cases
A cryptocurrency that aims to keep its market price steady is known as a stablecoin. Since these digital currencies have become more widely used, many stablecoin projects have emerged. Stablecoins are designed to offer some of the benefits of both the fiat currency and cryptocurrency worlds. Stablecoins can be used as a stable currency that offers improved transparency and decentralisation, although they are currently largely employed as a hedge against the extreme volatility of cryptocurrency markets. Additionally, compared to conventional fiat currencies, they offer quicker transactions and reduced fees, with an average of $0.2 per transaction (Ethgasstation, 2020), which makes them a great alternative for international transfers and regular payments.
Stablecoins are designed to be fairly immune to market volatility, thus they shouldn’t undergo big price movements, though the specific processes vary from currency to coin.
320 The value of many stablecoins is fixed by tying them to the value of another asset. Although the majority of them are tied to the US dollar, stablecoins can also be linked to the value of other cryptocurrencies or even physical commodities like silver or gold. These currencies avoid the dramatic price swings produced by the high levels of volatility, which are quite typical in cryptocurrency markets, by being tied to real-world assets (Binance Academy, 2020).
Borrowing and Lending
One of the most popular subcategories of open finance, lending and borrowing dApps, are supported by the Blockchain in large numbers. Users can use their cryptocurrency as collateral in smart contracts and borrow money against it. Following that, it automatically paired lenders and borrowers and dynamically adjusted the interest rate based on supply and demand as well as open lending rules (C.Bhardwaj, 2020).
2020 is already looking like the year that decentralised exchanges take centre stage. The DEX ecosystem is growing stronger every day thanks to improved usability, greater liquidity, and rising composability. Due of their fiat onboarding and convenience of use, centralised players have long attracted the attention of many when it comes to cryptocurrency exchange. Contrary to popular belief, many have been quick to point out that centralised exchanges have their own unique hazards, particularly those related to custody. Many traders have learned to respect the non-custodial options provided by decentralised exchanges, which were famously highlighted by hacks on formerly well-known exchanges like Mt. Gox in 2014.
Funding protocols, software development tools, index creation, subscription payment methods, and data analysis software are a few further examples of products and use cases.
The Advantages of DeFi
Wider global access to financial services
According to the World Bank Group’s 2017 report, 1.7 billion adults globally do not have access to any financial institutions. Decentralized Finance aims to provide basic financial services for all of its users using a smartphone and an internet connection, breaking down the status, wealth, and geography barriers that limit global access to the financial world most industrialised nations take for granted.
Affordable Cross Border Payment
DeFi services are anticipated to reduce the average global remittance charge from its present, frequently outrageously expensive 7% to a much lower 3% average by doing away with the need for some intermediaries (C. Hoffman, 2020).
Improved Privacy and Security
Data breaches in centralised organisations, such as the First American Financial breach in May 2019, exposed almost 885 million personal and financial details (Krebson Security, 2019). A decentralised system, by definition, lacks a centralised single point of failure that may enable this kind of breach.
Censorship resistant transactions
Governments or big businesses cannot filter or turn off a full DeFi system. In countries where the current governments and financial institutions may be dishonest or unreliable, a system like this can deliver stability and an alternate option. Developers of these new DeFi applications will concentrate on making a simple and straightforward user experience so that any user may fully benefit from the new system that is being implemented in an effort to popularise their services. While each of these advantages is strong on its own, together they have the potential to have a significant impact.
Due to a number of difficulties relating to fraud, volatility, usability, and regulatory ambiguity, DeFi has not yet realised its full potential. Decentralized finance can be susceptible to fraud and the spread of unproven financial ideas, to start.
By offering collateral that can be utilised to collateralize other actions taking place in the DeFi ecosystem, a DeFi savings account enables you to lend to others in an efficient manner. Your savings are used to finance other people’s purchases, just like in a traditional bank. The difference is that in traditional finance, your savings are multiplied through fractional reserve banking to extend many times more than the actual amount of savings, whereas in DeFi it’s the opposite because DeFi requires over 330 collateralization. Given that you can only lend an amount that is less than what you have in savings, it is more like a negative fractional reserve rate.
There is a new class of risks, though, when you place your savings in an account that is a component of a smart contract in a DeFi system. The risk is not that your bank will fail and the deposit insurance won’t be able to cover all the covers, which is a counterparty risk; rather, the risk is that the smart contract itself will have a coding security flaw. A defect in the smart contract could cause your savings account to be emptied or allow for theft by a third party. At this point, this can be applied to all DeFi applications. There are bugs, but the questions are “how serious they are” and “how easy it is to exploit these vulnerabilities,” not “whether there are bugs.”
Due to the environment’s complexity, the risk has moved from counterparty institutions and third-party custodians to software coding risk, when one or more errors were committed by the smart contract’s creators.
The next significant change to the financial system may be decentralised finance. This new wave of applications and services, powered by blockchain technology, will give the unbanked access to financial services, lower transaction costs, increase security, and give users a seamless experience from anywhere in the world. As with any new technology, it’s vital to step back from the marketing hoopla and consider the obstacles in the way of widespread adoption. For DeFi, they include difficulties that touch on interoperability and transaction speeds as well as legal issues. DeFi won’t be able to realise its full potential until these difficulties are dealt with and overcome.
DeFi now takes a great deal of information because the technology is still in its infancy and prone to issues, hazards, and security flaws.
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