With adequate checks, balances, and regulations, DeFi may bring a positive revolution in the world of decentralized finance
Technology in the last decade has radically transformed the dynamics of the global financial system. Slowly but steadily, the world of centralized finance is making way thorough decentralization.
Decentralized Finance or DeFi, at its outset, is a promising ecosystem of financial applications and protocols built using blockchain technology. It is a developing field at the intersection of blockchain, cryptocurrencies and various decentralized financial services.
Let’s first talk briefly about blockchain and cryptocurrencies before delving deeper into the captivating world of DeFi.
Read: Indian American indicted in cryptocurrency money laundering scheme (March 11, 2022)
Cryptocurrencies & Blockchain
A cryptocurrency is basically a collection of digital data which is designed to work as a medium of exchange. The term is broadly used to refer to all forms of decentralized digital money.
First introduced in 2009, Bitcoin cryptocurrency became popular in the early 2010s and were largely looked upon as a speculative opportunity. Soon, many companies started Initial Coin Offerings (called ICO) through their private exchanges for crowdsourcing and crowdfunding. The process is simple.
A hype is created through social media and other platforms about such crypto projects using celebrities and influencers for promotions, and thereby money flows in from various anonymous sources globally.
Around the same time, the blockchain was slowly getting into the arena of application development. But many problems arose during blockchain development as it was a heavily loaded and extremely slow process.
Unlike traditional systems, it was not possible to have accelerated transaction processing for the blockchain. Traditional systems process over 200,000 TPS, (transactions per second) for MasterCard, while the Bitcoin can only process about 10 TPS. Ethereum, the second-most popular blockchain platform has about 20 TPS.
Additionally, there were serious concerns about the increased danger of ransomware and security threats due to denial of service that accompanied the acceleration of transaction processing.
Malicious attacks for stealing data and exposure of system vulnerabilities enhanced the apprehensions around the internet ecosystem. It wasn’t until the evolution of next-generation technology, that all these concerns were finally being addressed.
Read: As Bitcoin loses steam, blockchain moving into next generation (September 10, 2021)
In the new blockchain ecosystem, interoperability, scalability, data privacy, and network security issues could not be resolved as the individual platforms were all standalone.
This motivated several groups of young enthusiastic engineers to come forward for the development of blockchain platforms and devise innovative solutions to the existing constraints. Blockchain platforms generally can be categorized into public, private, and permissioned networks.
The first generation of blockchain technology was basically a cryptocurrency mining process like Bitcoin, while the second generation is Ethereum, a new development platform built by people who initially worked in the Bitcoin community.
They had their ideas to improve the blockchain system and started their own development process. Many computer scientists of high calibre joined Ethereum and made innovative financial products.
Thus, Ethereum which first came out in 2013, became the most popular and technologically advanced platform in the blockchain ecosystem. Today, Ethereum II is being developed to support a wide range of financial services such as lending, borrowing, crowd farming and insurance.
Read: Lure of Bitcoins: Greed blinds even the wise to risks (February 24, 2021)
Blockchain ecosystems
Many blockchain ecosystems are currently under development and are expected to bring about revolutionary changes to the world of finance and trade. Some of them have already been released.
Recently, Bitcoin has upgraded its capability by using an additional network infrastructure or software enhancement layer called Lightning Network. MIT is speculated to be closely associated with the enhancement of blockchain development, maintenance and promotion.
Ethereum Foundation is a Swiss foundation, started by Vitalik Buterin (b. 1994), who was a college student back then. He, with the help of a few other scientists and cryptocurrency experts, started Ethereum. Today, they have a net worth of about $50 billion.
There are other major blockchain platforms like Avalanche ($AVAX) which is a Cornell Lab-based software platform, Polkadot ($DOT), Solana ($SOL), Cardano ($ADA), Aion ($AION), ArcBlock ($ABT), Corda, Ardor ($ARDR), Eosio ($EOS), etc.
Most of them are essentially created with a smart contract implementation capability. In addition to money exchange functions, asset management can also be done using smart contracts.
IBM also came up with its own concept for blockchain implementation. They are not considered as DeFi. With the Linux Foundation, which is an open-source foundation, IBM developed the Hyperledger Fabric. Hyperledger Fabric is a kind of blockchain adaptation, and its fabric is essentially a software development assistance tool.
All these are publicly available systems and there are no regulations for cryptocurrency as of now. However, two mandates have been put by various governments on blockchain technology – KYC and AML.
KYC refers to “Know Your Customer”, i.e. cryptocurrency exchanges are required to obtain full knowledge about the customers and verify and document customer data before initiating financial transactions. AML is anti-money laundering instructions that every exchange needs to follow.
Read: Digital assets management poses global challenge of the decade (February 10, 2021)
Most of the blockchain ecosystems are developed using three or four major languages like C++, Java, Python, JavaScript, Haskell, Solidity, Smalltalk, and Pascal. Solidity is practically a software development language for smart contracts on Ethereum.
Ethereum II is now the most popular blockchain smart contract development platform. Along with Ethereum II, additional blockchains called “parachains” can be created that run in parallel within the Polkadot ecosystem to enable inter operability.
Parachain is nothing but an extension of the existing platform to do specific tasks. This allows developers to build their application system on Ethereum by building an additional virtual machine that runs independently.
Read: Cryptocurrency: A serious threat; Blockchain: A revolution underway (July 6, 2021)
DeFi: Decentralized finance
Now, let’s understand what DeFi all is about. Decentralized Finance or DeFi is a blockchain system with no central control. In other words, a decentralized system does not have any intermediaries, banks, brokerages, or money exchanges.
Instead of these central controls, the smart contract autonomously executes all binding contract terms on the transactions. All the contractual obligations are identified in advance and coded properly into the smart contract package, which is a software module that is utilized for the processing of specific transaction.
Today, DeFi has become a buzzword for evolving distributed ledger and autonomous network of systems and procedures dealing with financial services and products.
The major building blocks of DeFi are:
• Blockchain’s distributed ledgers, serving as the settlement layer for transactions
• Digital assets in the form of coins and tokens that can be traded or transferred
• Wallets software interface to manage assets stored in the blockchain
• Smart-contract blockchain based software that performs all terms and conditions stipulated in transactions
• Dapps software application module that contains smart-contract program codes
• Governance systems software-based consensus mechanism using POW / proof of work, or POS/proof of stake algorithms
• Decentralized Autonomous Organization (DAO) Entities whose rules are defined and enforced in the form of smart contract
• Stable-coins, digital assets whose values are pegged to fiat currencies
• Oracle external data feeds from outside of blockchain such as LIBOR rates, currency rates, stock prices etc. that are integrated into DeFi services.
The fundamental difference between CeFi and DeFi is that CeFi stands for Centralized Financial system while DeFi stands for the Decentralized Financial system with no central control.
Control in DeFi is exercised by the software system autonomously. There are no specific instructions to be given, as it’s an automated process. On the other hand, in the centralized finance system, most transactions are visually verified and processed, before transferring the money.
This leads to delays in transactions and sending or receiving money takes several hours or even days altogether, due to the separate manual processing required to ensure that the money is sent to the correct place.
DeFi essentially uses smart contracts to process financial transactions. According to the Wharton School, DeFi service categories are: Stable-coins; Exchanges; Credit; Derivatives; Insurance; Asset management; Wallets; Oracle services.
As of now, Ethereum has the most effective implementation of DeFi and its token is called ETH. Additionally, there are hundreds of crypto coins or tokens available that are all transacted through exchanges.
Read: Is cryptocurrency the next Internet Bubble waiting to burst? (October 16, 2021)
One of the coins, called a stable coin, is backed by the USD in theory, and can be bought in order to participate in smart contract transactions in the place of tokens issued by other platforms. Every time a transaction is processed within the ecosystem, there is a cost associated with it that is paid by these tokens.
This is a self-supporting endeavor even though all the hardware and communications infrastructures are initially built and funded by the developers, eventually it will be paid up by the transactions directly as transaction fees.
Hence, it’s considered an self-supporting automated process. Everything is automated including the cost of the entire infrastructure, it is envisaged, and the venture will become profitable in due course of time with a reasonable transaction processing fee.
This innovative idea of cryptocurrencies using DeFi is rapidly transforming the entire global financial paradigm and is slowly constructing a parallel economy worldwide.
Enthusiasts are certain that DeFi has the potential to become a huge financial system outside the control of any sovereign government. It has a host of advantages in terms of execution, cost, financial inclusion and reliability.
Moreover, most financial institutions and big money tycoons are wary of governmental interference in their financial maneuvers. Thus, sceptics allege that the establishment of a decentralized financial system is in their interest, as it enables them to operate in the dark. Only time will tell its efficacy.
DeFi applications
Currently, there are many well-acclaimed DeFi applications in the market. Aave, a multi-chain lending and borrowing platform and Curve finance, a multi-chain exchange liquidity pool designed on Ethereum, are two popular examples. These are basically exchanges, called DEXes (decentralized exchanges).
Apart from the common applications mentioned earlier, DeFi is also used for lending and borrowing. Members and wallet holders can borrow crypto investment from the crypto exchange for a small fee and can even lend, to get a better return than the current bank interest.
All these operations take place not in fiat currency like USD or GBP, but in one of the cryptocurrencies. These products have been developed using Decentralized Applications or Dapp.
Dapp is the common method of interface between these applications. It is nothing but a blockchain-based APP. However, the coding procedure, protocols, and details of a Dapp are fundamentally different from a conventional app.
Decentralised Autonomous Organization – DAO is the entity that stipulates and enforces smart-contract terms. It’s a self-governing application system.
In the next few years, there will be much demand for developing Dapps for financial, insurance, and healthcare applications as well as asset-based applications. Dapp developers are in high demand now.
Dapp can provide liquidity to Non-Fungible Tokens (NFTs). NFTs are kinds of cryptographic assets on blockchain with unique identification codes and metadata that distinguish them from each other. Hence, they are undestroyable or non-fungible.
On the other hand, cryptocurrencies pegged tokens are fungible and can lose their value. Alarmingly, if the private key to one’s wallet is lost, the entire money is lost and cannot be recovered. Many people are said to have lost millions of dollars in cryptocurrency that way.
Blockchain challenges
Blockchain is a cryptographically secure transactional singleton machine shared state. Although hundreds of thousands of computers are networked together through the blockchain, only one program transaction takes place at a time on each of the machines.
Once the transaction is processed, the new state is updated and distributed to every computer in the blockchain. Thus, it’s called a singleton machine shared state.
Despite all the rapid technological innovations made in the blockchain paradigm, a lack of technical perfection is considered its biggest drawback.
There is a lot of enthusiasm around the revolutionary idea of decentralized finance, but the hardware deployment is overly redundant, and scalability often becomes a major issue, due to incredibly poor TPS (Transactions Per Second) output.
High infrastructure costs and poor transaction processing speed have also slowed down the rate of adoption of cryptocurrencies. Security protocols are still questionable and regulations inevitable.
Blockchain is an open-source software platform that performs operations automatically. Though its evolution determines the future of cyberspace, blockchain is not a panacea for all internet problems.
Promising technology
DeFi, undoubtedly a promising technology, promotes efficiency, transparency, innovation, and financial inclusion. Its long-term governance requires a well-informed understanding of its opportunities, risks and challenges.
Like any other innovative technology, it is also prone to malicious use in the wrong hands. With adequate checks, balances, and regulations, DeFi is expected to bring a positive revolution in the world of decentralized finance.
(Krish Pillai is a former business owner and Information Technology consultant for over thirty years. A former IIT Delhi student and IIT Madras staff member, he lives in Washington DC metro area.)
