Decentralized Finance (DeFi) and Cryptocurrency
DeFi applies technology to remove third parties from financial transactions. Those third parties include banks and financial service providers who traditionally control monetary transactions. DeFi is supported by cryptocurrency, which relies on the peer-to-peer exchanges of funds. No middleman is required.
In the traditional model, the third parties provide security and recourse in the event of non-payment. They make money based on fees and interest. DeFi charges no such fees and secures the transaction using blockchain. Blockchain is a type of database that’s configured differently than a standard DB.
A standard database is set up using tables to manage the data. A blockchain captures data in blocks that hold transactions. When a block is complete, it’s linked to a “chain” of previous blocks. The blockchain maintains a record of each transaction, similar to a ledger.
The obvious benefit of DeFi is there are no additional fees from third parties. Privacy is the next. Buyers and sellers are anonymous – to the platform and each other. This anonymity gets mixed reviews. Cryptocurrency can be a tool for bad actors making illicit or illegal transactions. There is no regulation before, during, or after a transaction. The only people aware of the details are the buyer and seller.
Concerns are raised about money laundering, funding for terrorists, and other financial crimes. DeFi relies on transactional anonymity, there is no effort (or method) to control illegal monetary exchanges.
DeFi as a Market Disrupter
In the past decade, the industries have been upended by disruption. Disruption is a process when the market is infiltrated by start-ups with non-convention business models. The initial product or service of these startups requires multiple iterations as it gains early adopters. Businesses that focus on those flaws do so at their peril. Consider the impact of Airbnb, Uber, Netflix, and Skype on their respective industries.
DeFi is a disruptive force for third-party financial service providers. The claims of a new currency, driven by internet exchanges, were initially met with industry-wide skepticism. The platforms, like Bitcoin or Ethereum, were not taken seriously. Today cryptocurrencies are being traded on the stock market. Many financial service providers are including those platforms in their client offerings.
DeFi does more than utilize cryptocurrency. It disincentives the centralized systems that control access to money. It provides an opportunity to wrest control from the same institutional models that contributed to the global economic recession of 2007. These models promote interdependency – what affects one can affect all. The domino effect from an industry segment – mortgage/banking – brought down the entire economy.
DeFi is a challenge to the architecture of that institutional model. The broad hierarchy of financial hubs and interconnected systems was designed in the last century. Given the failures since 2000, the viability of the system is losing credibility.
Anonymous peer-to-peer transactions remove the chance of a domino effect. DeFi also eliminates systemic controls over access to money. Bias is less prevalent in a decentralized system. Transactions are decided by the parties conducting them. This minimizes bias based on ethnicity, age, or other cultural factors. The same anonymity which protects illegality also prevents systemic bias based on race, gender, age, and religion.
Decentralized finance systems rely on self-regulating, peer-to-peer networks. The platforms for cryptocurrency exchanges meet that criteria. Bitcoin was the first cryptocurrency network and is still one of the best-known currencies. But true decentralization comes on “smart contract” platforms, like Ethereum. Smart platforms define rules for transactions, similar to a paper contract. They are, in essence, the terms of the deal.
Small applications stored on the blockchain dictate the terms. The contract terms (code) are publicly available. Transaction participants agree to the terms before any financial exchange. The terms of the deal are not enforced by human or platform oversight. Enforcement occurs automatically, by the code. Smart contracts do not require a lawyer.
Smart contract platforms are prompting innovation for secure transactions beyond financial services. Ideas include transforming the American voting system, supply chain management, and clinical trials. Blockchain brings a new level of security for proprietary data.
Another differentiator of a smart contract account is the ability to hold a balance or payout assets over time. The code sets the parameters for the release, so the terms are always honored.
A common example of a smart contract is rental arrangements. You want to rent a vacation property for a set date and send payment. The payment is held until the key to the property is delivered within the specific time frame in the terms. If the key is not submitted or not submitted on time, the rent payment is automatically returned.
This example raises some of the practical issues of smart contracts. Once both sides honor the terms, the contract is closed. Arrangements get made in the virtual world but delivered in the real world. If the rental space has squatters or a hurricane is happening, you have no recourse. On a smart platform, once a contract is complete, it’s unchangeable.
It’s exactly this provision that makes it popular for capturing proprietary data, like medical records or votes. Once the transactions are captured, the blocks and their chronology can’t be changed.
Mining is the way cryptocurrencies generate new coins and verify the transactions on the blockchain. Mining requires vast amounts of computer power as the blockchain grows. Most mining happens in specialized companies or mining groups that use distributed computing.
The Proof of Work methodology creates a blockchain consensus algorithm. Miners compete with each other to verify transactions on the network to earn coins. The verification process happens at the miner’s expense. That means the value of the coin must be sufficient to cover costs. Bitcoin and Ethereum’s smart contracts platform use the same process.
Mining is an essential component of blockchain security. Without it, the continued growth of a blockchain is impossible. The minors secure the blockchain by verifying transactions and earn coins. Exchanges hold lotteries to incentivize their efforts.
Scarcity will be a growing factor for miners. For example, the number of available Bitcoin is 21 million. As of 2021, 2.632 million coins remain. When those coins are fully mined, miners will receive fees for conducting verifications.
Wallets are apps that store cryptocurrency. They are necessary to participate in decentralized finance. When you purchase or receive cryptocurrency, it goes in your wallet. Each wallet has a unique cryptographic address. Users share their addresses to transfer funds. Gifts, purchases, and sales of products or services go to your wallet. The wallets are housed in the blockchain itself.
You can purchase cryptocurrency on several platforms. Some accept credit cards and most accept electronic fund transfers for your purchase. Despite the decentralized system, the original purchase is trackable. Once you transfer your purchase to your wallet, it’s hidden from an outside entity. Investing, lending, buying, or selling are typical transactions.
All revenue from your transactions is private. There is no way for anyone, including the government, to know how much you have in your wallet.
The underlying infrastructure for DeFi depends on blockchain. A blockchain is a decentralized, distributed record of transactions conducted on a Peer-to-Peer (P2P) network. A P2P network is a group of computers linked together that share data.
For DeFi, P2P architecture frees cryptocurrencies for transfer anywhere in the world. These transfers occur without the need for a central server or third-party intermediaries. This structure also prevents denial of service (DoS) attacks from threatening the network. Without a central server, each user in the network operates from a single machine. To take out the network, a DoS attack would need to take down every computer on the exchange. It’s virtually impossible to do.
Blockchain is a distributed computing model. Users share equal permission and responsibility for sharing and protecting data. Consensus is the key to its governance. Any attempt to modify a closed block on the chain requires consensus from every user on the network. Another impossibility. Blockchains may have thousands of users. It only takes one to say no.
Explanations on the blockchain are often very technical and hard to understand. This video simplifies how the technology works.
DeFi Advantages & Concerns
The concept of decentralized finance receives a lot of hype, from supporters and detractors. Cut through the rhetoric to make informed decisions about the system
- Traditional finance infrastructure is fraught with human error and mismanagement. DeFi removes control from those institutions. The decentralized, consensus-based exchange gets its governance from technology.
- Users no longer need permission from a bank or other third parties to access their own funds. Crypto-wallets are individually owned – funds are always available.
- Loans between individuals don’t require the involvement of third-party underwriters. Borrowers can use their funds as collateral in place of a credit score. Money becomes more accessible. Systemic barriers of race, gender, age, and religion do not apply to the transaction.
- Purchasing power without third-party fees or contracts. Smart contracts codify the deal between two parties – the only money spent is between the two parties.
- Access to a wallet is global – no borders or fees for international commerce. Money moves from one wallet to another, no matter where the parties’ location.
- As blockchains continue to grow, it takes more time for transactions to be confirmed. The more traffic on the system, the more expensive the transaction verification becomes. Scalability is a rising concern.
- DeFi blockchains offer none of the protections from a traditional financial system. There is no insurance against fraud or hacking. If something in the system causes users to lose currency – it’s gone.
- Anonymous transactions open the door for illegal activities. It’s impossible to tell the white hats from the black hats. An unintentional transaction with the wrong party will lead to trouble.
- Cryptocurrency is remarkably volatile. The value of a particular asset revolves around the volume of interactions. The result is uncertainty about the systems. Uncertainty negatively affects interaction.
- DeFi is drastically underfinanced compared to traditional systems. Though cryptocurrency is becoming more mainstream, its liquidity is just a fraction of centralized systems.
The appeal of DeFi is apparent to many. But for others, the complexity of cryptocurrency is an obstacle. It’s difficult to translate the value of an internet currency without any relation to a familiar unit of exchange, like USD. Efforts to explain the systems rely too strongly on technical jargon.
DeFi itself is simple to understand. It’s a marketplace for cryptocurrency to be sent, received, and gifted without the involvement of a middleman. The confusion lies with the pieces – not the whole.
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