Decentralized Finance

Article byPrakhar Gajendrakar
Edited byRaisa Ali
Reviewed byDheeraj Vaidya, CFA, FRM

Decentralized Finance (DeFi) Meaning

Decentralized finance (DeFi) is one of the emerging technological evolutions based on blockchain and cryptocurrency. It is an alternative to the traditional financial system, and it decentralizes both finance and its regulations, nullifying the significance of intermediaries like banks and exchanges in financial transactions.

DeFi relies on blockchain technology to decentralize the financial system, allowing for decentralized financial services and new business models. DeFi creates a financial systemFinancial SystemA financial system is an economic arrangement wherein financial institutions facilitate the transfer of funds and assets between borrowers, lenders, and investors.read more that is creative, open, global, and transparent. Decentralized finance, while intriguing, has a variety of obstacles and limitations before reaching its best extent.

Key Takeaways

  • Decentralized finance is a system powered by blockchain and cryptocurrency technology, forming an alternative to the traditional financial system.
  • It offers financial products to users without intermediaries like banks and exchanges.
  • Examples are Aave (AAVE) and Synthetix (SNX). Examples of DeFi companies are AllianceBlock and HYPR Corp. Block Inc (NYSE: SQ), Riot Blockchain Inc (Nasdaq: RIOT), and Robinhood Markets Inc (Nasdaq: HOOD) are examples of DeFi stocks.
  • Examples of its applications are DeFi crowdfunding platforms and decentralized hedge funds.

Decentralized Finance Explained

Decentralized Finance (DeFi) is a peer-to-peer financial system. It portrays an ecosystem filled with financial applications and services powered by blockchain technology. It presents alternatives to traditional financial services accessible using the internet and not backed by intermediaries; in the absence of centralized entities, the decentralized trustless framework results in more innovations. As of September 2021, the total value locked in DeFi systems is around 100bn USD.

Decentralized Finance

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An important term associated with DeFi is the smart contractSmart ContractSmart contracts are digital transaction protocols that verify, control, and self-execute an agreement, embedded in computerized codes on a blockchain, if parties meet predefined rules. Unlike traditional (physical) ones, these contracts occur among anonymous parties and are enforced automatically without the involvement of any third party. read more. Smart contracts are computer programs stored on blockchains that automatically get executed when the predetermined conditions are met; for instance, they can connect a borrower and lender if their conditions match. DeFi uses smart contracts to create protocols that replicate existing financial services in a more open, compatible, and transparent way. Furthermore, some examples of DeFi building blocks are decentralized exchanges, decentralized debt markets, blockchain derivatives, etc.

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The idea of new technology trying to overthrow or shakedown established institutions and traditional ways of transactions was not well received by many. DeFi exhibits properties like robustness, efficiency, and transparency and may manifest many benefits like optimized transaction costTransaction CostTransaction cost is the expense one incurs by engaging in economic exchange of any kind. Any activities associated with a market generate transactional costs. They represent the trade expenses that one needs to cover for aiding the trade of goods and services in a market.read more and reduced entry barriers. However, opponents advocate that it’s still like a niche market with significant risk elements. The possibility of fluctuating transaction rates on the ethereum blockchain making trading expensive in the future is an example of its disadvantages. Moreover, according to the report by Elliptic DeFi, users lost billions of dollars to theft in 2021.

According to General Manager Agustin Carstens of the Bank of International Settlements, people who believe in a decentralized future of money are chasing an illusion. He said that “there is a lot of centralization in decentralized finance in practice.” Even the smart contract protocol depends on programmers, and certain features of DeFi blockchains favor the concentration of decision-making power in the hands of large coin-holders. 

Examples

Examples of decentralized finance companies are AllianceBlock, Jeeves, Coinbase, HYPR Corp, Sommelier, Stobox Technologies Inc., Teller, Cion Digital, and Symbiont. In addition, block Inc (NYSE: SQ), Riot Blockchain Inc (Nasdaq: RIOT), Robinhood Markets Inc (Nasdaq: HOOD), and Coinbase Global Inc (Nasdaq: COIN) are examples of decentralized finance stocks. Briefly, let’s look into some of the DeFi examples.

Aave (AAVE), built on Ethereum protocol and formerly known as ETHLend, is one of the first and biggest DeFi platforms. Aave is where users get incentives for making deposits and a platform to borrow assets, hence connecting lenders and borrowers in a decentralized environment, making it a decentralized liquidity platform. Lenders get interest incomeInterest IncomeInterest Income is the amount of revenue generated by interest-yielding investments like certificates of deposit, savings accounts, or other investments & it is reported in the Company’s income statement. read more without engaging third parties. There is no checking of creditworthinessCreditworthinessCreditworthiness is a measure of judging the loan repayment history of borrowers to ascertain their worth as a debtor who should be extended a future credit or not. For instance, a defaulter’s creditworthiness is not very promising, so the lenders may avoid such a debtor out of the fear of losing their money. Creditworthiness applies to people, sovereign states, securities, and other entities whereby the creditors will analyze your creditworthiness before getting a new loan.read more; hence it is a “trustless” network. Users can earn points and discounts by staking the AAVE currency on the Aave DeFi platform. An automated and rapidly executed loanLoanA loan is a vehicle for credit in which a lender will give a sum of money to a borrower or borrowing entity in exchange for future repayment.read more known as a flash loan is a specific feature of the Aave platform.

Synthetix (SNX) is an Ethereum-based protocol for creating synthetic assets. The fast-expanding decentralized exchange allows users to create their synthetic assets, known as “synths,” which may be used to trade fiat, derivativesDerivativesDerivatives in finance are financial instruments that derive their value from the value of the underlying asset. The underlying asset can be bonds, stocks, currency, commodities, etc. The four types of derivatives are - Option contracts, Future derivatives contracts, Swaps, Forward derivative contracts. read more, cryptocurrenciesCryptocurrenciesCryptocurrency refers to a technology that acts as a medium for facilitating the conduct of different financial transactions which are safe and secure. It is one of the tradable digital forms of money, allowing the person to send or receive the money from the other party without any help of the third party service.read more, and other asset classesAsset ClassesAssets are classified into various classes based on their type, purpose, or the basis of return or markets. Fixed assets, equity (equity investments, equity-linked savings schemes), real estate, commodities (gold, silver, bronze), cash and cash equivalents, derivatives (equity, bonds, debt), and alternative investments such as hedge funds and bitcoins are examples.read more. Synthetix also supports commodities like gold and silver. Hence, It connects non-blockchain-based assets to the crypto ecosystem.

Uniswap (UNI) is a decentralized cryptocurrency exchange that enables users to buy and sell cryptocurrencies. The Uniswap system using the Ethereum platform and smart contracts was selected as the largest decentralized exchange in October 2020. In addition, Uniswap’s native token, UNI, may be available on investing platforms outside of the DeFi network, such as Voyager, because of its popularity.

Cardano, launched in 2017, is a blockchain platform using Proof of StakeProof Of StakeProof of Stake (PoS) mining is a consensus mechanism that validates blocks and transactions to secure a Cryptocurrency blockchain. In PoS, coin owners stake their coins to become a validator. Unlike the proof-of-Work (PoW) system, where users compete for their chance to append the blockchain, validators are selected at random in PoS depending on the user’s stake.read more (PoS) protocols. Its internal cryptocurrency is known as ADA. Cardano DeFi projects using blockchain technology focus on improving finance and banking by portraying decentralized bank accounts, money transfers, and financial apps for consumers and companies.

Applications

Let’s look into some of the common applications:

  • The application of smart contracts reduces the role of intermediaries providing “trust” services.
  • DeFi application helps users get exclusive control over their assets and data.
  • Creates fast, safe, and transparent payment systems.
  • It eases trading in cryptocurrencies 24/7. DeFi coins like AAVE, Cosmos, Decentraland, and Polkadot are available on a 24/7 basis.
  • DeFi crowdfunding platform is an example of its application.
  • DeFi app offers insurance for cryptos.
  • Yield farming in DeFi is a popular and riskier investment strategy. Investors engage in staking or lending crypto assets to generate returns.
  • Contributes to decentralized hedge funds in the form of decentralized cryptocurrency hedge funds.

Frequently Asked Questions (FAQs)

What is decentralized finance?

Decentralized finance is revolutionary technological evolution powered by blockchain technology. It presents an alternative to the traditional financial system by reducing the presence and significance of intermediaries like banks in facilitating financial services.

What is an example of decentralized finance?

Examples are Aave (AAVE), Synthetix (SNX), Uniswap (UNI), and the Cardano DeFi project. Examples of decentralized finance companies are AllianceBlock, Jeeves, Coinbase, HYPR Corp, Sommelier, Stobox Technologies Inc., Teller, Cion Digital, and Symbiont. Block Inc (NYSE: SQ), Riot Blockchain Inc (Nasdaq: RIOT), Robinhood Markets Inc (Nasdaq: HOOD), and Coinbase Global Inc (Nasdaq: COIN) are examples of decentralized finance stocks.

Is decentralized finance good?

It is good since it creates a financial system that is creative, open, global, fast, and transparent. In addition, it’s more user-facing, user-oriented, or user friendly because of features like democratizing nature, optimized transaction cost, and low barriers to participation.

This article has been a Guide to Decentralized Finance (DeFi) and its explanation. We explain its examples, applications, DeFi companies, stocks & hedge funds. You can learn more about accounting from the following articles –

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