Understanding Decentralized Finance (DeFi) Evolution
27 Jun 2022
DeFi, short for “Decentralized Finance” has been among the hottest topics in the past couple of years. In this post, we will discover the evolution of Decentralized finance and also explore what is hidden in the future for us.
DeFi is one of the revolutionary applications of cryptocurrency and blockchain technology. It’s an alternative to traditional finance without the involvement of third-party.
Due to its potential to disrupt the existing status quo in global financial ecosystems, DeFi and DeFi-based applications are slated to provide limitless opportunities to the global population while forcing their traditional counterparts to innovate.
To realize the importance of DeFi, it is necessary to understand the underlying principles of DeFi and how it is different from the more traditional, centralized financial ecosystem that has been in use for a long time.
Centralized and Decentralized Finance
Centralized Finance (CeFi) is a broad term used to denote not only the traditional financial ecosystem but also the early crypto platforms.
The principle of Centralized Finance involves an irreplaceable role of certain intermediaries acting as trusted third parties to facilitate transactions. These intermediaries as we know today are the banking and financial institutions.
By acting as the gatekeepers to financial products and services, individuals across the world have no other option but to depend on these banking and financial institutions to manage their funds or meet any financial requirements…
… meanwhile, the traditional model requires the institutions to maintain custody of all the user funds, effectively controlling them.
The actual owners, on the other hand, are left at the mercy of these institutions depending on whether they approve or reject requests to access funds in their custody.
Further, the services offered by centralized traditional financial institutions are not only expensive but also inequitable as they have the freedom to decide who gets access to financial services and who doesn’t which has resulted in a significantly sized unbanked population.
Some of the early crypto exchanges and trading platforms are also considered as part of the CeFi ecosystem as they used centralized solutions that were in control of all its user funds.
The Dawn of DeFi
The introduction of Bitcoin as a transparent, decentralized mode for peer-to-peer value transfer established, for the first time, the possibility of executing transactions without the involvement of any third party.
Soon the launch of Ethereum as a programmable blockchain protocol with smart contract support opened doors for the creation of decentralized applications (dApps) that leveraged blockchain’s transparency, immutability, and decentralization characteristics to create globally available, censorship resistant applications.
The extension of these applications to create financial solutions resulted in the creation of an entirely new industry segment, which we know as DeFi.
Extending Financial Services to All
The blockchain-based, crypto-driven DeFi technologies are a collection of smart contracts and specialized dApps that are designed to provide financial solutions analogous to those available in the traditional sector.
The decentralized nature of these applications allows them to transcend geographical and censorship restrictions to provide low-cost financial services to anyone, anywhere in the world.
Further, it eliminates the need for third-party intermediaries to process transactions while enabling users to maintain complete control over their private keys throughout the process.
Capable of operating beyond boundaries to offer low-cost financial services to all, DeFi technology is considered to be the ideal solution to address the problems faced by unbanked and underbanked populations across the world.
The applications of DeFi range from savings to quick and cheap cross-border transactions, loans, insurance, fundraising and plenty of yield generation products.
Lack of intermediaries and direct interaction between participants reduces costs otherwise associated with commissions and pay-outs, in return to provide better value to users.
Popular DeFi Applications
Today, the rising popularity of decentralized finance has given rise to many DeFi companies offering a range of applications.
Some of the popular DeFi applications include Decentralized Exchanges, Lending Platforms, Staking and Farming Contracts and more, each offering various benefits to the participants.
Investing in DeFi is a straightforward process where the community comes together to pool their liquidity and utilize it to provide the necessary services to those in need. In return, they receive rewards proportional to their contribution to the liquidity pool.
Staking, a broad term to define the process where the community members lock their tokens in a smart contract for a certain duration and earn rewards in return.
Symbolizing support for a particular activity, the utility of staking ranges from providing the necessary collateral for validation of transactions on a PoS network to providing liquidity for DeFi services and regulating the supply of assets in the open market.
As an incentive, stakers receive rewards in the form of project tokens, voting privileges in governance and even discounted or privileged access to the products and services offered on the platform.
Meanwhile, yield farming allows stakers to maximize staking rewards across different protocols. Both staking and yield farming are popular passive income generation opportunities that benefit both DeFi protocols and its participants.
DeFi lending is another popular use case where users can borrow crypto funds, mostly in stablecoins or a particular digital asset against crypto collateral.
The necessary liquidity for lending will be provided by community contributions to the lending pool. Compared to traditional finance, borrowing over DeFi protocols is a lot easier and transparent, with less or zero paperwork and attractive interest rates.
DeFi lending allows anyone, irrespective of their credit score or geographic location to access liquidity in need. In addition, the interest earned from borrowers will be shared proportionally among the liquidity pool participants during the loan tenure along with their share of the principal.
Decentralized exchange (DEX) on the other hand, are platforms that allow users to buy or sell various digital assets across the DeFi ecosystem. With most DEXs following the AMM model, the necessary liquidity for trading different decentralized assets is contributed by liquidity providers to earn a share in the transaction fees in return.
On a conventional DEX, liquidity providers need to deposit equivalent value of funds in tokens in both assets representing the trading pair.
The utility of DEXs range beyond buying and selling certain token pairs on a particular protocol to include a variety of assets across protocols and even bridge the gap between crypto and fiat ecosystems.
While the basic principles governing the DeFi ecosystem are simple, efficient use of tools and smart contracts can open new avenues to address a lot of real-world problems.
The industry is gradually evolving to increase the applications of DeFi infrastructure to include real-world assets while solving the problems like impermanent loss, interoperability issues and more.
The Future of DeFi
Even though the concepts of DeFi have been around for a while, the industry is still in its nascent stages with lots of room for improvement.
Starting with crypto-only transactions across a single protocol, DeFi’s potential to solve real-world issues involving the entire crypto as well as traditional financial ecosystems has gained prominence in recent times.
DeFi protocols have established that they can replicate almost all the traditional financial solutions on-chain in a decentralized environment, which is received with great interest by conventional institutions.
Thanks to steady improvements in interoperable blockchains, stablecoins, fiat on/off ramps etc., a practical solution to offer a level playing field, with universal access to financial products and services is now close to reality.
DeFi is set to transform global financial systems with fast, transparent, peer-to-peer transaction processing capabilities that will remove middlemen and make financial services accessible to even the remotest parts of the world.
At the same time, unique hybrid instruments incorporating the strengths of different protocols, combined with tokenization of conventional financial assets could soon enable seamless transfer of value across DeFi and CeFi ecosystems for everyone’s benefit.
At Instaraise, we are working on creating the next-generation DeFi solutions that addresses the existing shortcomings and paves the way for the expansion of DeFi across various domains.
As we continue to innovate, we also help other innovative projects capable of offering real-world solutions gain the necessary foothold in the market by offering an entire suite of end-to-end incubation and fundraising solutions.