Decentralized Finance: The Driver of Digital Transformation and Innovation?

Previously, we've already reviewed digital identity as a new way to manage personal data and analyzed enterprise blockchain adoption, its applications, and business use cases. And today, we're going to discuss the third, last but not least, blockchain trend to watch out for in 2021.

A Case in Point

Many consider it superior to the current global financial system. Some call it a solution for unbanked people to become banked. Others may have heard of it but couldn't make up their mind to start using it.

The case in hand is Decentralized Finance (DeFi).

This article will consider the idea behind DeFi, its strong and weak points, and whether DeFi is the driver of technological transformation and innovation or a transient phenomenon.

So, let’s start understanding the importance of DeFi and its role in the financial sector by sifting out the facts that prove (or justify) the utilization of decentralized financial services.

What is DeFi: The Concept of DeFi

DeFi is undoubtedly one of the most exciting and rapidly growing technological innovations to happen in financial services over the past few years. With DeFi emergence, the focus has shifted from traditional—centralized—economic systems to peer-to-peer finance enabled by decentralized technologies built on distributed blockchains.

At its core, DeFi uses a distributed system of nodes that enables buyers, lenders, sellers, and borrowers to interact. The new financial system allows holding financial transactions such as money transferring, making loans, earning interest on a loan, and borrowing cryptocurrency.

As a trust factor in conducting transactions, DeFi uses smart contracts. A smart contract is a programmatic code where developers describe a particular set of conditions needed for a transaction to happen. Since DeFi is based on blockchain technology, all transactions are transparent and can be publicly verified.

Most of the DeFi apps are built on the Ethereum blockchain network. Due to Ethereum’s versatility, many digital transformation solutions employed in the fintech sector only strengthen the concept of DeFi.

To better understand the practical value of DeFi, further, we will break its advantages and disadvantages apart. Then, we'll put them on a scale and see which weighs more. So, let's start with limitations.

DeFi Spotted Drawbacks

DeFi aims to create an environment where users can interact without a central authority and work transparently and in a permissionless way. However, as DeFi systems mature, imperfections start to show. Some of them are:

User blockchain unawareness. This friction is connected to users who transfer significant amounts of cryptocurrency to the wrong blockchain addresses. This behavior pertains directly to how transactions work in the blockchain: they simply cannot be recalled.

Custodial wallets. Custodial wallets are wallets in which a third party holds the private keys. Probably, the biggest disadvantage of custodial cryptocurrency services is that they have an unconditional right to decide what to do with users’ funds. In most cases, to obtain an account, users have to proceed with a Know Your Customer (KYC) procedure (to prove one’s identity.)

Overcollateralization. In the case of lending and borrowing services, overcollateralization may be seen as an obstacle. That said, lenders are forced to set high collateral in order to ensure their finds can secure a loan. This condition results in many lenders refusing to lend borrowers unless the latter can provide a large amount of assets upfront, which reimburse initial expenses several times.

These probably were the major roadblocks that slow down decentralized finance platforms from growth and mass adoption. Now, let’s examine the advantages of DeFi.

DeFi Practical Benefits

The DeFi benefits include the following points:

Digital Wallets. Modern digital wallets offer safe storage for users to deposit, swap, trade, borrow, and lend their crypto tokens and coins. Wallets ensure smooth funds transfer and fast transactions processing.

With digital wallets, users are the owners of both accounts (not a bank or a company) and private keys (required to access funds.)

The wallets are also compatible with different blockchain networks and dapps (decentralized applications), offering a seamless user experience.

Yield Farming. By locking assets for a specific period on specialized platforms that provide staking services, yield farming allows users to get several times higher interest (in some instances from 20% to up to 80%) compared to those traditional banks offer. But it's worth noting that high percentage rates come with risks: to predict token price behavior is a challenging task. At the same time, the returns are determined based on the Annual Percentage Yield (APY) or Annual Percentage Rate (APR).

Decentralized Exchanges. Decentralized Exchanges (DEX's) use a secure peer-to-peer system that enables users to trade digital assets directly (without a commercial broker).

Token Governance. In token governance, voting rights are distributed among users and those granted to participate in DeFi platform management. DeFi tokens are highly capital efficient and offer more returns through leverage trading.

Non-Fungible Tokens (NFTs). Tokens are digital objects which represent the right to perform some operation. NFTs, in turn, are unique tokens that have their subjective value. Unlike fungible, non-fungible tokens cannot be replaced by other NFTs.

Users can tokenize any digital asset and make it an NFT. When an object is tokenized with an NFT, its data is turned into a digital form on a blockchain with unique digital information.

NFT is a promising new market that is already generating revenue. The market presents a vast number of use-cases: artworks, sports goods, digital cards, games, etc. 

The other competitive advantages of DeFi are the following:

• DeFi projects are more accessible for unbanked people (no matter their place of residence).
• DeFi projects have a broader range of financial services.
• DeFi maintains a high level of transparency.
• DeFi offers different services such as loans, yield farming, staking, asset management, insurance, margin trading, decentralized exchange of assets, and many others.
• DeFi development involves creating financial applications on existing blockchain networks.
• Users get continuous control over their funds.
• Cheaper and faster transactions compared to conventional financial institutions.

Summary

To determine if DeFi will replace a traditional financial system, we reviewed its cons and pros.

Despite DeFi’s evolving status, we can conclude that the decentralized systems have gained their right to exist. From stablecoins and tokenized assets to borrowing and interest rate platforms, the DeFi ecosystem has formed a network of integrated protocols and financial instruments. Many use cases for individuals, developers, and institutions have been successfully developed (and more are yet to be created.)

Furthermore, financial forecasts predict that the focus will be on stimulating adoption. With it, DeFi will gradually take its niche in the new era of digital transformation and innovation.