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Market Research & Development

What is Decentralized Finance (DeFi) and why it is innovative

Introduction

In the last few months DeFi (Decentralized Finance) has found more and more space in the economic and market context. This trend is now in steady growth and is generating a real revolution in the field of finance with such a development potential for that a future mass adoption, currently still in its embryonic stage, is expected.

What is DeFi?

DeFi is an innovative financial ecosystem that refers to financial applications based on the Distributed Ledger Technology and Blockchain. More precisely, the concept of Decentralized Finance refers to an approach that aims to create open source financial services through public and decentralized, permissionless and transparent platforms that are publicly available and operate without any central authority and without the intermediation of financial institutions. In this scenario, users would therefore retain full control of their financial activities by interacting with this ecosystem through decentralized applications, the so-called Distributed Applications – DApps (P2P) that operate exclusively through blockchain.

The Ethereum platform and the smart contract

DeFi builds on Bitcoin’s and in general cryptocurrency pioneering concepts, but offers additional types of services. The DeFi system is not based on the Bitcoin network, but mainly on the Ethereum decentralized platform, that supports smart contracts, the software that are automatically executed by the network and that make up for the absence of the traditional intermediary making the financial transactions completely autonomous and free from administration overhead. The real paradigm shift is that the financial management takes place through an automatic mode implemented by open software verifiable by anyone, whose behavior is therefore predictable, based on pseudonym and the basic market logic. In short, the DeFi ecosystem completely eliminates the discretion of classic intermediaries, delegating the entire management of the system exclusively to smart contracts. This is only a first step towards the creation of a parallel financial system that is supposed to overcome those limits now evident and intrinsic in the classic financial modus operandi.

DeFi applications

DeFi’s applications are numerous, a major one is certainly open and decentralized lending and borrowing, which has clear advantages: by using public blockchain platforms the counterparty risk is minimized and lending and borrowing become consequently cheaper, faster and more accessible. Banking monetary services are also a common use case and include granting of mortgages and taking out insurances, once again eliminating the significant costs that in the traditional process are mostly caused by the involvement of the involved intermediaries: thanks to the use of smart contracts, underwriting and legal costs are significantly reduced. Blockchain technology through DeFi can also be used to issue and enable ownership of a wide range of conventional financial products, favouring projects that could, for example, enable the creation of decentralised forecasting markets. As outlined above, the greatest innovation and the resulting advantage of DeFi is the easy access to financial services. By avoiding the obligatory intervention of institutions as mediators, DeFi applications are much more efficient and faster, allowing users to maintain constant and direct control over their assets. In addition, another significant advantage is that the DeFi low cost and open system allow a particular ease of access to those people who remain for various reasons out of the current financial system whose services usually exclude low incomes citizens. In the DeFi approach, however, costs are significantly reduced. One of its main claims is in fact “bank the unbanked” which implies the involvement of low income potential customers.

Between innovation and risk

DeFi goes beyond the concept of open banking which, while guaranteeing access to data from banking and financial institutions and making new types of products and services possible, stand inside the traditional financial context. The world of Decentralized Finance offers users a completely innovative perspective to look at the financial world dynamics: the open finance, independent from the current infrastructure, is placed in the foreground and promotes new ways of interacting with financial instruments. The DeFi ecosystem, with its promise of decentralization, is certainly an attractive idea, but before we will see a real mass adoption of its new approach, there are some aspects to tackle: alternative investment systems create interesting diversified scenarios and are accessible to a very wide range of users, but the DeFi field, being extremely dynamic and autonomous, is necessarily potentially more subject to changes, exposing customers to a higher risk potential than the traditional model. A solid organization of DeFi with a clear information process to safeguard savings on decentralized financial platforms is the basis for the spread of a system that is already today evidently more performing than the traditional one due to its intrinsic characteristics.

Conclusion

Anyway, the DeFi is currently in continuous growth: traditional financial services and DeFi applications are moving on converging paths, separated by an ever decreasing distance. Whatever the future scenario that awaits us, we are undoubtedly already facing a progressive change in financial services, within which DeFi proposes a radical rethinking of the financial system: shifting the power of action from centralized organizations directly into the hands of the community and the individual himself, an autonomous and independent entity with the prospect of an increasingly less centralized and more automated future.