Decentralized finance, or DeFi to the cool kids, is the core program used to operate the cryptocurrency phenomenon. It provides the security, applications, and functions needed to create this newest financial system.
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A New Financial System
When terms like “finance” and “system” come into the discussion, pictures of The Wolf of Wall Street, crazed stock quotes, and bulls and bears may come to mind. However, crypto is nearly anything but.
No Single Authority
Without a single bank entity or a government at its center, one of the key concepts of cryptocurrency is a shared digital ledger. Instead of a single bookkeeper, or even a team of accountants within a business, the crypto world relies on blockchain technology.
A blockchain, as the name implies, is a series of blocks, or “containers” of data. These blocks are strung together (in a chain-like series) and shared across the entire system. Each and every user on the blockchain has access to this public ledger.
It is shared across a peer-to-peer network, forming the foundation of decentralized finance. Crypto such as Bitcoin and Ether rely on this style of decentralization. Financial products are able to be bought, sold, traded, created, and tracked via the blockchain.
Blockchain Technology
The public recording ledger is known as blockchain technology. It is the DeFi core, necessary to track the financial transactions occurring on the web. Transactions must be verified, recorded, and tracked in order for the system to have order and consistency.
To do so securely, decentralized apps operate without the use of a centralized system. Instead, there is not a single server, single institution, or single overseer that controls the financial institution. A decentralized exchange system means one that is scattered, spread about, and distributed amongst its users.
Decentralized exchanges can occur with the safety of knowing that an entire group of blockchain users is keeping an eye on it. This public digital ledger is shared, immediately and simultaneously with all users. It is copied to all, and it is immutable.
Once data is a part of the chain, it cannot be altered by any one individual. There is no advisor or bank in control. The group monitors and verifies the transactions. It is a “power of the people,” and not the authority of banking institutions watching these funds.
Streamlined Processes
Another major pro when it comes to the use of decentralized finance is the use of technology. Eliminating third parties and authority figures are great, but the workflow needs to find some way to operate. Thankfully, decentralized finance platforms use automation to make this possible.
No human, authority or third party needs to monitor the exchanges on a DeFi system. This skips a step, shortening the process by eliminating another involved party.
The system also uses smart contracts, or “If/Then” programming, to automate processes. This streamlines things by cutting costs (no person once again to push a button, review a transaction, or approve any changes) and also by allowing for a smooth and error-free flow.
Computers only know that if X goes in, Y must come out. It is programmed to do so. With the elimination of a human or the need for several rounds of approvals, it isn’t just a shorter process, but a more accurate one.
Decentralized vs. Centralized
To understand the similarities and differences, it is key to understand both a centralized and decentralized finance transactions process. To begin with, the two models share one goal: to facilitate users’ use of cryptocurrencies for all of their financial needs and services.
How the two go about that goal is not similar.
Centralized Financial Institutions
Centralized financial operations are the way in which many financial services operate in the global economy. CeFi depends on an intermediary to manage the transactions and activities of its users.
Traditional banks, for example, operate under a centralized exchange. It is a form of centralized finance (CeFi) that has typically multiple intermediaries.
When money moves hands, it is the bank itself that oversees the transactions. In the United States, the US Dollar is the “token” of choice, and assets are a part of investing, lending, and storing that is handled entirely by a bank.
The bank is the center. It has its rules. Financial institutions must follow the laws of the land. They must oversee their banking clients and their actions with the money in that bank’s accounts.
Most of the United States’ banking systems rely on some sort of centralized power or authority. Data is stored, most typically, on a centralized system of servers. You cannot log into your bank’s servers as a single client. You cannot create accounts, verify them, or view a public ledger of the comings and goings of funds in the bank.
Money can move across a bank, be exchanged, moved, and invested, much like a cryptosystem (which allows for buying, selling, and trading). However, it is the centralized authority that has the final say in these processes.
In a CeFi system, the decision-making abilities are housed in the central “office.” While it does not matter how this central authority is physically stored, it is the power that matters. Think of centralized exchanges as requiring a hierarchy. A central authority is the boss of the land. They make the decisions, they oversee the products, and they make the last calls.
In that system, others must adhere to the final say, the rules, the projections, the applications, the processes … nearly anything that the boss decides. A central bank (think the HQ) tells its subsidiary locations (think your local bank and its tellers) how things will operate. From transaction fees to interest rates are decided by the main office.
Decentralized Financial Institutions
In a decentralized financial system, there is no single authority. The DeFi system operates independently instead of on technology. It is not relying on a centralized office, server, or “boss” of any sort.
The concept of decentralized finance operates on this pillar, to lack a single authority. Instead, financial transactions operate using the digital universe. These entities are not tied by a hierarchy of power, office, and authority. These connections are made via an Internet connection.
A peer-to-peer network operates, registering and tracking digital assets typically, and not US dollars. Tokens, Bitcoins, Ether, and similar crypto products often use this blockchain technology, focused on decentralization. There is no third party involved. There is no “boss man” setting the laws of the land.
The users of the blockchain agree to the system and typically operate in one of two manners: Proof of Work or Proof of Stake.
Proof of Work
Some blockchains rely on a proof of work model, which means that those wishing to “mine” the blocks must prove themselves via work. Actual electrical power, computational power, and human capacity all are provided by the miner.
Miners often charge gas fees to cover transactional costs, but overall, the power required, or the work put forth, is the way one participates in the decentralized ledger.
Proof of Stake
In a proof of stake model, the decentralized finance system operates as users post a stake or a sort of collateral. This pay-to-play model is more like a casino. Participants will post tokens at a chance to “win” a randomized chance to mine.
In this model, the DeFi apps focus on users posting money. If they are selected to mine, they “win” the chance to create a new block and reap the benefits.
Something Old, Something New
When it comes to crypto assets, it is not just as black and white as centralized versus decentralized. Crypto truthfully uses both types of financial institutions.
Decentralized finance is a relatively new term. Decentralized applications only make up a small percent of today’s crypto market, but are seeing massive growth. From June 2018 to June 2020, the decentralized finance market went from $4 billion to $93 billion in DeFi assets in the crypto market.
Defi applications such as Bitcoin, the Ethereum network, and Solana operate on a decentralized blockchain.
A Bit of Both
Some people think that CeFi is old and DeFi is new. And, while that may be true of the age of the exchanges, it is not true about how the two are currently being used in cryptocurrency. Both types of systems are frequently used for digital assets.
One Major Difference
Though they have similar goals, there is one major difference between decentralized finance and centralized finance. Decentralized finance allows parties to directly interact with one another. There is no intermediary. There is no third party.
The transactions are recorded on a public ledger. They are monitored and secured in a peer-to-peer, shared network.
However, a centralized exchange relies on the oversight of an authority. There is a centralized business.
Applications Using CeFi
Some examples of cryptocurrency platforms using the CeFi exchange include:
- Binance
- CoinBase
- Libra
Applications Using DeFi
Some examples of cryptocurrency platforms using DeFi exchanges include:
- Kyber
- Totle
- MakerDAO
The Benefits of CeFi
A major plus of the centralized finance system is that it supports cross-chain exchanges for multiple cryptocurrencies. Typically, these cryptos are generated on individual blockchains and work within an individual network. A Bitcoin isn’t traded from its DeFi app for an Ether on its Ethereum platform. These blockchains operate independently from one another.
But, with a CeFi exchange, users are enabled with the ability to access the conversion of fiat currency to cryptocurrency and vice-versa in an easy and seamless manner.
The Benefits of DeFi
Because DeFi operates with technology on its side, another basic pillar of its entire existence, there are some major pros. In short, the decentralization process is already a pro in and of itself for many. They appreciate the lack of a single authority, the exclusion of a third party, and typically the fees and costs associated with those extra steps.
Smart Contracts
Smart contracts have been created to automate systems. They are “If/Then” programs, which allow that “if” X occurs, “then” Y can happen.
This eliminates the need for oversight and human interaction. Technology makes the workflow smoother, more efficient, and more effective. Fewer errors occur since a digital contract must have X to have Y occur. This streamlined and cost-effective method is very appealing to many.
The Future of Finance
At the end of the day, the world is full of the unknown. While trends can be monitored, statistics analyzed, and critiques discussed, there is no crystal ball that shows us what will be coming in the crypto world.
DeFi may be the “new kid on the block,” but this kid is pretty cool. He’s making new friends. He’s gaining popularity. He’s spreading his name around. And he is getting attention.
Decentralized finance has already seen amazing growth, and most wager a bet that it will continue to do so. While governments and the traditional finance world may not be big fans, the crypto users “bet” with their cryptocurrency. And they sure seem interested.
DeFi is one of the building blocks in crypto circles, to say the least. In order to trade cryptocurrencies, financial services need many of those blocks. Will DeFi be the one that stays? No one can say for sure.
This is a method still in its infancy. So much about digital asset collecting, buying, trading, and selling still is. It is still an emerging technology. Much remains to be seen, but it is certainly a method to keep an eye on for the months and years to come.
