The Next Revolution of Finance is Decentralization
Imagine all of the finance service you need is run by code
Cryptocurrency has decentralization concept at heart. Crypto is born to give power back to people, not giving it up to people in Wall Street. It is true that crypto today is used to speculate and making some profit. But, we can’t deny the bigger vision of it is to provide money accessible for all people from around the world, no matter where they are.
After crypto, some people take a step further toward decentralization, and introduce the concept of Decentralized Finance (DeFi) or Open Finance.
Today, such concept is gaining more and more popularity among crypto users. Imagine a global, open alternative to every financial service you use today — savings, loans, trading, insurance and more — accessible to anyone in the world with just a smartphone and internet connection, no middle man needed.
The Idea of DeFi
Decentralization Finance is now possible because of smart contract blockchains, like Ethereum and Binance. “Smart contracts” are programs running on the blockchain network that can execute automatically when certain conditions are met. Unlike Bitcoin, These smart contracts enable developers to build far more sophisticated functionality than simply sending and receiving cryptocurrency. These programs are called decentralized apps (or dapps for short).
You can think of a dapp as an app that is built on decentralized technology, rather than being built and controlled by a single, centralized entity or company. While some of these concepts might sound futuristic, such as automated loans negotiated directly between two strangers in different parts of the world, without a bank in the middle, many of these dapps are already live today.
You may have used it even though you don’t know it is a dapp. There are dapps that allow you to create stablecoins (less volatile cryptocurrency), lend out your crypto and earn interest in return, take out a crypto loan, exchange one crypto asset for another, go long or short crypto assets, and implement automated, advanced investment strategies.
By far, DeFi dapps are mimicking what traditional bank and other traditional financial institutions. The difference is the process is not managed by an institution and its employees — instead the rules are written in programmed smart contract. Once that smart contract is deployed to the blockchain, dapps can run themselves with little to no human intervention. Developers only maintain the dapps, fix dapps or add some new features.
The code is also transparent, hence anyone on the blockchain network can audit. This builds a different kind of trust with users, because we have the opportunity to understand the contract’s functionality or find bugs. All transaction activity is also public for anyone to view. This may raise privacy questions, but don’t worry, the transactions are pseudonymous by default, i.e. not tied directly to person’s real-life identity.
Dapps are designed to be global from day one. They are available anyone with an internet connection. However, some local regulations may strictly limit dapp’s functionality.
Why is It Gaining Such Popularity?
Dapps built on the basis of “permissionless” smart contracts, meaning anyone can create and use dapps without paying any penny. The user interaction within the network is also anonymous, no KYC or such identity approval needed like what we have in traditional financial system. Say no more to lengthy opening account forms because user interact programmatically from their crypto wallets.
Permissionless is not the only reason why DeFi and dapps are gaining some buzz for the past few months. There are other reasons like below.
- Flexible user experience — don’t like the interface to a certain dapp? No problem — you can use a third party interface, or build your own. Smart contracts are like an open API that anyone can build an app for.
- Interoperable — new DeFi applications can be built or composed by combining other DeFi products like Lego pieces — e.g. stablecoins, decentralized exchanges, and prediction markets can be combined to form entirely new products. DeFi is now one of the fastest growing sectors in crypto. Industry observers measure traction with a unique new metric — “ETH locked in DeFi” because of it.
DeFi and dapps is still in their early days. End-users should do their research on new products and services before using real money. Why? Simple, people can lose money on it. Not all dapps is legit. Like any computer code, smart contracts can be vulnerable to both unintended programming mistakes and malicious hacks. Not to mention the risk of developers doing fraud and rugpull.
Real-world Practice of DeFi
Like what mention above, DeFi by far is mimicking the traditional financial system, adding the decentralization concept at the base. Thus, the real-world practice is basically like these:
Stablecoin
Simply put, stablecoin is a kind of crypto currency with less volatility, and price fluctuations can be minimum.
Stablecoin does it by backing its value to some collateral, which can be in the form of fiat currency, other crypto currency and algorithm. But, since it is built as dapps, we can take out fiat currency from the list of coin’s underlying.
One of the most well-known is MakerDAO. It is a stablecoin project where each coin, DAI, is backed by collateral in the form of crypto. MakerDAO is more than just a stablecoin project. The bigger vision is to be a decentralized reserve bank. That’s why they made other token, called MKR. People who hold a MKR can vote on important decisions like the Stability Fee. This concept is very similar to how the FOMC (Federal Reserve’s Federal Open Market Committee) votes on the Fed Funds rate!
Lending and Borrowing
Compound is made to be a decentralized version of a traditional bank. It is blockchain-based borrowing and lending dapp, enabling people to lend crypto out and earn interest in return. For the perspective of borrower, people can use Compound dapp to deposit their crypto and borrow some fiat money with that cryptos as collateral. Compound contract will then automatically matches borrowers and lenders, and adjusts interest rates accordingly based on supply and demand.
There is also dapp acting like aggregator, called LoanScan, that track borrow/lend interest rates across the various Compound-like dapps, so you can shop around for the best rates.
Decentralized Exchange
Exchange like Binance, Gemini, Houbi, etc. are the party also benefiting from rise of crypto currency trading. The more people doing transaction in the exchange, the more money they generated from fees. It’s totally fine, of course, since that is how it is. But, the thing is they are centralized exchange, meaning they are backing by companies. How if those companies go busted or commit some fraudulent activities? Is there any decentralized option for it?
Yes it is, and one of them is Uniswap. Uniswap is a cryptocurrency exchange run entirely on smart contracts blockchain, letting you trade popular coins directly from your wallet.
In Uniswap, you store your coins in your own wallet, not in the exchange, for safekeeping. The pricing mechanism is also different from centralized exchange which usually used last price. Instead, Uniswap uses an innovative pricing mechanism known as Automated Market Making. Because of it, the trades are settling “near” the market price, and that’s why you need to set a slippage in every trades you make. In addition to trading, trader is not trading against other trader, but a liquidity pool. Anyone can participate in the pool by supplying crypto to the Uniswap contract and earning a share of the exchange fees.
Other popular Decentralized Exchange platforms (DEXes) include 0x, AirSwap, or PancakeSwap.
What’s the Next Big Thing of DeFi?
DeFi today is still in infancy stage. It is safe to say that all the dapps mentioned above is still in the first generation. Dapps was built by blockchain enthusiasts for blockchain enthusiasts. These dapps did a great job of demonstrating exciting new DeFi possibilities, but the usability left something to be desired. The next iterations of DeFi apps are prioritizing design and ease of use in order to take open finance to a wider audience.
In the future, crypto wallets might be as important as your bank account since they hold all your digital complete asset activity. Imagine a dashboard that shows you not just what assets you own, but how much you have locked up in different open finance protocols–loans, pools, and insurance contracts. Imagine your crypto holding can be one of the important factor to build credit score. That will be a game changing features.
Something magical is happening in the our financial system — crypto is bringing money online, and DeFi will someday revolutionize the financial infrastructure we used to have. It’s a rare opportunity to see an entirely new industry blossom from scratch. But, at first, the DeFi space should catch up with today’s financial services industry.
