Table of Contents

April 17, 2022 5 min read

Decentralized Finance - A Quick Guide

In Brief

  • Decentralized Finance (De-Fi) is a peer-to-peer financial system that allows users to transact securely through smart contracts and blockchain technology without the presence of a central authority and data-prying intermediaries.
  • De-Fi applications support financial transactions of all kinds using cryptocurrency and provide an immutable, transparent and borderless infrastructure.
  • The De-Fi market has seen a growth of 1200 percent since 2020 and has the potential to overshadow traditional finance models in the near future.

Overview

What is De-Fi?

Decentralized Finance (De-Fi) is a blockchain-native financial infrastructure powered by smart contracts. The decentralized financial markets run on public blockchains such as Ethereum and closely replicate services offered in traditional finance. Owing to the use of smart contracts, De-Fi services are transparent, immutable and interoperable. It uses a distributed ledger technology that allows all users on the network to access and scrutinize the data on all the transactions made on the network.

De-Fi uses smart contracts and distributed ledger technology to create an open, transparent and secure platform for financial services

De-Fi is devoid of intermediaries and central authorities regulating the market. Instead the market is run on open-protocols and permission-less DApps (decentralized Applications). The usage of smart contracts ensures that transactions are enforced by programmable code that can be verified and secured on the public blockchain.

De-Fi Infrastructure

“Smart Contracts”  form the bedrock of De-Fi markets. The term “smart contract” was first coined by Nick Szabo, computer scientist and cryptographer in 1994. Smart contracts in the simplest sense, are agreements between parties, encoded digitally, that execute themselves upon fulfillment of predetermined conditions. Vitalik Buterin, co-founder of Ethereum, in the year 2013, incorporated Szabo’s concept of smart-contracts into a blockchain based protocol to create a trustless, peer-to-peer, secure and decentralized financial services platform. Although several De-Fi platforms have since emerged, Ethereum is presently the largest smart-contract platform with highest market cap, DApps and activity.

Smart Contracts are agreements that are converted into a digital code that self-executes upon fulfillment of certain predetermined conditions

De-Fi rests on a multi-layer framework. Each layer that is built on a Blockchain network serves a distinct purpose and it is the interoperability between these layers that enhances the composability of that blockchain network. Owing to the characteristics of a Blockchain network, the information coded into a smart contract, can be subject to public scrutiny and the contract’s function is verified by all the nodes on the network in parallel for its legitimate execution. Once the contract is executed, the changes resulting from the transaction, such as difference in account balances, is reflected automatically through consensus mechanisms on the blockchain.

Information on a blockchain network is publicly accessible and is validated using consensus mechanisms to guarantee legitimacy of the transactions

Since smart contracts are run by a digital code, the outcome of the contract is highly deterministic and deviation from coded behavior is rare. Due to this aspect, smart contracts can also store assets as a custodian, thereby eliminating the need for any central authority such as banks, brokers, etc., to manage assets in a financial structure. These features have led to the formation of successful and robust De-Fi ecosystems with a variety of applications and use cases.

Differences between Traditional finance and De-Fi

Before delving into the upsides of De-Fi, it is necessary to understand the features of the traditional financial framework prevalent today.

Traditional Finance

Assets are managed by central institutions and regulated by government agencies.

A series of intermediaries such as banks, securities exchanges and the government make up the financial framework, with centralized functions where the transaction data is not readily accessible.

High barrier to entry as several regulatory requirements have to be fulfilled to access financial services offered by Banks and exchanges.

Transaction activities require disclosing identity and are deeply connected to your personal information.

Decentralized Finance

Assets are managed and governed by a digital code called “smart contracts” on a public blockchain network.

It is a secure, open and transparent protocol where transaction data is recorded in a distributed ledger technology that is open for public viewing.

Low barrier to entry as any individual with an internet connection can avail services provided by De-Fi.

Transaction activities are pseudonymous.

Notable Features of De-Fi

  • One of the distinct features of De-Fi is the non-custodial nature of the framework. The DApps are programmed in such a manner that no intermediary makes any gain from an individual’s digital assets or has complete control and access to the digital assets.
  • Another aspect of De-Fi is its transparency. As transactions are recorded on the distributed ledger which is public, any node on the network (user) can review the transaction data on the protocol.
  • De-Fi protocols are also open-source; meaning, they allow the community to access the code, verify and develop the application further leading to constant improvements and novel use cases for the DApps.
  • Composability is one of the crucial aspects of a De-Fi protocol. Composability is a feature of a system which allows several components to be inter-operable. Systems with high composability can support assembly of many applications in a customizable manner to match specific use cases. Several components of De-Fi frameworks such crypto-assets, smart contracts, and so on, can be integrated to develop new applications over the blockchain protocol layer. As protocols are open-source, there is vast potential for programmers to develop novel applications over different layers of a blockchain network to provide numerous financial services.

De-Fi markets and its Future

In less than a decade, the cryptocurrency sphere has witnessed a steep rise in market value and more and more players are entering this alternative financial infrastructure. In fact the De-Fi market has seen a meteoric growth of 1200 percent since late 2020. It is estimated that the total value circulating in De-Fi is around $189 Billion early this year. De-Fi is the future of digital finance as there is increased efficiency, accessibility and transparent management of assets. De-Fi might not render traditional financial structures redundant, however De-Fi has the capacity to merge with traditional finance by retaining customer service, product custody and so on with it and sourcing liquidity from De-Fi protocols. Though De-Fi is still in its early developmental years, it is geared to become the next iteration of a highly efficient, transparent and autonomous financial infrastructure.

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