Unlocking the Future of Finance: Exploring Decentralized Finance (DeFi)

Decentralized finance, or DeFi, is a financial product built on blockchain technology characterised by the fact that financial users themselves offer and demand these products and services. DeFi can be understood as financial products and services provided through the new Decentralized Ledger Technology (DLT).

They are called finance because they cover a range of financial products and services, such as deposits, investment and credit instruments for Immediate Edge clients, insurance, and derivatives. They also offer financial infrastructure for negotiating, custody, and administrating securities. They are called decentralized because they operate on DLT technology, characterised by decentralized consensus mechanisms. These mechanisms are responsible for validating the legitimacy of the transactions carried out on the blockchain, which is why intermediaries are necessary.

Blockchain is one of the most disruptive technologies of recent years, leaving its transformative mark on many sectors. One of them is the financial sector, which is accustomed to centralising its systems and working methods and where DeFi emerges, bringing new rules.

DeFi (Decentralized Finance) is the concept used to designate an entire ecosystem of financial applications and services built on blockchain networks and operating on a decentralized infrastructure, allowing user interaction without intermediaries. While it is true that as solutions grow, some introduce a certain degree of centralisation, we can define decentralisation as the main characteristic on which the DeFi universe began to be created.

This decentralisation allows DeFi applications to be free of the need for intermediaries. Through technology and code, the resolution of any potential conflict or dispute is specified, while users maintain control over their funds at all times. This reduces the cost of providing and using such products while enabling a frictionless system. Due to their deployment on Blockchain networks, the potential failure points of DeFi applications are reduced and, depending on the case, even eliminated. The data is recorded on the Blockchain network and spread across thousands of nodes, making it very difficult for service problems to occur.

Another essential feature of DeFi is that it is an open ecosystem. Because the traditional financial system relies on intermediaries seeking to generate profits, its services are often not available in places with low-income communities. However, with DeFi, costs are significantly reduced, allowing any community to benefit from a wide range of financial products and services.

Remember that Bitcoin is a payment system that works on its cryptocurrency. However, the introduction of Ethereum was a turning point in DLT technology because, more than a payment system, it is a virtual machine/computer that allows programming within the blockchain. Ethereum is the first blockchain of this type and the largest. Still, after it, different similar solutions have been created that compete with each other by offering added values such as costs, computational capacity, and speed, among others. Among the main “programmable” blockchains, in addition to Ethereum, there are Tron, BSC, Arbitrum, Avalanche and Solana, among others. Smart contracts are arguably the skeleton on which DeFi is based, as it is through these contracts that financial products are presented within a “programmable” blockchain. Developers program protocols that, together with user interfaces, allow access to a financial product to be automatically fulfilled once certain agreed conditions are met. Szabo clarifies that smart contracts generally require interaction with other contracts and user interfaces. These interactions can be within the blockchain or even outside of it, which can make the implementation of these contracts complex.

Key principles of decentralized finance

Below is a list of key principles when incorporating decentralized finance into your organisation or company.

• Decentralisation: In DeFi, no central authority or intermediaries controls or manages financial services. Decentralization means that transactions and contracts are executed automatically.
• Accessibility: No additional accessories are required. All you need is a digital wallet and an internet connection.
• Transparency: Transactions are recorded on the blockchain in a public and transparent manner. Anyone can consult and verify them.
• Interoperability: DeFi applications feature high compatibility, making maintaining an interconnected financial ecosystem possible.

Top DeFi Products

Since financial products and services are defined in detail in contracts, in theory, most of them could be replicated using smart contracts. However, there are different limitations of various kinds for this transition to be made. Currently, the DeFi ecosystem has as its main products the issuance of tokens, decentralized trading platforms, decentralized credits and derivatives. However, as we already mentioned, the range of products also includes custody, compliance, external information verification services (oracles) and liquidity providers, among others. Below we will make a brief description of the most important ones.

• Tokenizations: The asset layer contains the blockchain’s native asset and other assets created in a non-fungible or fungible manner. Non-fungible tokens, or NFTs, have been traded with a sense of investment for collectors as they are unrepeatable. Such is the case of the Bored Ape Yacht Club collection that includes 10,000 NFTs issued, traded and held in the Ethereum ecosystem. Among the fungibles, on the other hand, the best known are stablecoins, which generally seek to facilitate transactions between smart contracts that are part of the same blockchain ecosystem. However, one of the main problems that has been evidenced with the issuance of fungible tokens is the quality of the issuer of the same since their value depends on the fulfilment of the promise made that these tokens represent obligations that will be duly fulfilled. Unfortunately, the collapse of the Terra blockchain and the FTX trading platform were linked to the lack of credibility and convertibility of its stablecoins TerraUST and FTT when their holders realized that the issuers were not solvent, recalling what happens in a typical “run on deposits” in a financial system without prudential regulation and a lender of last resort. Among the possibilities of tokenization is that of “real” assets (real-world assets or RWA), which include the digital representation of ownership of financial or real assets such as securities, real estate, metals, precious stones, pieces of art, watches or even wine vintages. In all these cases, the promise is to redeem the tokens for the respective physical asset under the defined terms.

• Decentralized trading (DEX) – These are decentralized cryptocurrency trading platforms. Most trading of these assets takes place on centralised platforms such as Binance, where traders must first deposit their cryptocurrencies to trade, trusting in the seriousness of the management of these platforms, which is known as the principal-agent problem (it is not entirely clear to the owner of the assets what the platform administrator does with the deposited resources, as was seen during the FTX collapse). DEXs, on the other hand, seek to reduce the principal-agent problem by allowing the trader to maintain full control of their crypto assets until the transaction agreed upon within the platform is fulfilled. The execution of the transaction is done through a smart contract that simultaneously exchanges the agreed assets between the buyer and the seller, reducing the risk of default between the parties. The main DEXs are Uniswap, Pancakeswap, Curve, Balancer and THORNchain.

• P2P lending: A wide variety of platforms allow crypto-asset lending transactions between two parties without the need for an intermediary ( Peer-to-peer or P2P). Therefore, it could be said that any participant in a “programmable” blockchain can lend or borrow resources at an agreed interest rate. Loans are designed using at least one of two approaches to prevent the lender from defaulting on the contract. The first is flash credits, in which the disbursement, interest payment and capital payment are programmed in a single smart contract. If the lender does not pay, the contract is declared invalid, and the entire process is reversed, including the disbursement. This approach is very useful for obtaining liquidity, for example, in the recomposition of managed portfolios, since the resources are used for very short periods, even just a few hours. In the second approach, use is made of collateral that is kept in a smart contract until the moment in which the credit is paid.

• Decentralized derivatives: These derivatives, like their financial counterparts, are characterized by the fact that the behaviour of an asset defines its values, the materialization of an event, or the evolution of a variable that can be observed. Decentralized derivatives generally require an oracle that follows the behaviour of the underlying variables, which is why they generate certain dependencies and centralizations of information in their development.

• Oracles: Oracles are smart contracts that allow other smart contracts to communicate with the world outside the blockchain. While there are many types of oracles, one can generalize that their function is to find, verify, and authenticate sources and information outside the blockchain and make it available to the blockchain for use by smart contracts that need this information. The main oracles are Chainlink, WINkLink, Chronicle, and Pyth.

Advantages of DeFi

In terms of technology, DeFi’s promise is the same as that of DLT technology: transparency, traceability, efficiency, interoperability, platform immutability, and universality. However, the use of this technology is still too recent to confirm that these promises are satisfactory in all cases and that they can be more efficient than solutions presented by the traditional financial system.

A very important niche of DeFi is the creation of stablecoins, which can have technological advantages over other existing payment systems to improve the efficiency of transfers at a local and international level. Private and public proposals are central bank digital currencies (CBDCs) in this niche.

• Open and global access. DeFi allows access to a broader global market, reaching customers who do not have access to traditional banking services.
• Transparency and security. Transactions are recorded in a public and verifiable manner, which increases confidence in the system. In addition, the records are immutable and resistant to alterations or fraud.
• Investment opportunities. These allow for the generation of investment opportunities and additional cash flows. This includes lending and stacking.
• Savings by eliminating intermediaries. The nature of Decentralized Finance allows for the elimination of the need for traditional intermediaries, such as banks or financial institutions. This way, users interact directly with each other.

Furthermore, the Bank for International Settlements has highlighted the composability feature of programmable blockchains, which allows exploring the idea of a “unified ledger” in which both participants in the traditional financial system and new agents can participate in a “monetary framework” that facilitates financial operations at an international level.

On the other hand, a high proportion of DeFi development has been directed towards providing alternative infrastructures in the capital markets. As we have already seen, decentralized trading platforms, decentralized derivatives, liquidity providers, and third-party portfolio managers are among the main applications of DeFi. These businesses exist in traditional capital markets but are supported by an extensive financial infrastructure that includes brokers, clearing houses, and custodians, which DeFi promises to complement or even replace.

DeFi Volume

Both Bitcoin (BTC) and Ether (ETH) hit new all-time highs at the start of 2021, causing the total value locked (TVL) in DeFi to also increase. This triggered optimism and participation across various decentralized exchanges (DEXs) and lending platforms.

To give you an idea of the numbers, in the last six months, DeFi’s total market capitalization has grown to 45 billion ($), and in January 2021, DeFi platforms collectively saw the total value locked (TVL) in DeFi increase from about 15 billion (USD) to 25.36 billion (USD).

Use Cases in DeFi

Decentralized Exchanges (DEX)

Decentralized exchanges (DEXs) are cryptocurrency exchanges that operate without a central authority. They allow users to conduct peer-to-peer transactions while maintaining control of their funds. DEXs reduce the risk of price manipulation, hacking, and theft because crypto assets are never in the custody of the exchange itself.

Loans

Peer-to-peer lending protocols are some of the most widely used applications in the DeFi ecosystem. They use smart contracts to replace intermediaries such as banks that usually manage loans in the traditional environment.

Asset Management

With DeFi protocols, we are the custodians of our crypto funds. Crypto wallets help us easily and securely interact with decentralized applications to buy, sell, or transfer cryptocurrencies or generate interest in our assets.

Decentralized Autonomous Organization(DAO)

A DAO (Decentralized Autonomous Organization) is a decentralized autonomous organisation that operates according to transparent rules encoded into the Ethereum blockchain network, eliminating the need for a centralised administrative entity. Several DeFi protocols have launched DAOs to raise funds, manage financial operations, and decentralise governance.

DeFi and Ethereum

Most applications in the DeFi universe are built on the Ethereum public blockchain network. This is because the Ethereum network allows the development of smart contracts, which enable transactions to be executed automatically if certain conditions are met and offer great flexibility.

Prediction markets

Due to the transparency around transaction data and network activity, DeFi protocols offer unique advantages for data-driven analysis and decision-making on financial opportunities and risk management. Numerous tools help users track the value locked in DeFi protocols, assess platform risk, and compare performance and liquidity.

The list of possibilities and use cases is extensive and continues to grow as new applications and platforms emerge:

• Tokenized derivatives
• Gaming
• Insurance
• Margin Trading
• Decentralized Marketplaces
• Stablecoins
• Synthetic assets
• Tokenization

Top DeFi Platforms

The growing interest in decentralized finance also includes knowing the main DeFi platforms. Although new platforms and applications are constantly emerging, we highlight the following as a small sample:

Uniswap

Uniswap is a decentralized exchange focused on offering the exchange of ERC-20 tokens, which can be stablecoins such as DAI or Tether or other projects such as TRON, EOS, and ETH.

Maker

MakerDAO is a decentralized lending platform on Ethereum that supports Dai (its stablecoin), a stablecoin whose value is pegged 1:1 to the dollar’s value.

Aave

Aave is an open-source, non-custodial protocol on Ethereum for people who want to lend or borrow money. It’s a lending platform where someone puts up money for interest, and someone else uses it by paying interest. Interest rates are algorithmically adjusted based on supply and demand, and borrowers can opt in or out at any time.

Things to keep in mind in DeFi

Although the DeFi universe offers many new and interesting options and is generating increasing interest, it should be noted that its appearance is very recent, and there is still a long way to go and things to improve. Below are some aspects to keep in mind about DeFi today:

• As mentioned earlier, most DeFi platforms and applications use the public Ethereum network, which is currently experiencing some scalability issues and increased transaction costs, the latter due to the progressive increase in the price of ether. Although the migration process to Ethereum 2.0 has already begun with changes that will improve this situation.
• Before investing in or using DeFi platforms or tools, it is advisable to be well-informed about the project, its security, the development of the Smart contracts it uses, etc. There have been cases of scams in projects that promised high returns and also cyber attacks due to poor programming in Smart contracts that have caused the loss of investors’ money.

In conclusion, the financial universe that DeFi offers offers many new features and very interesting applications and will probably continue to grow over the years. However, it is advisable to be well-informed and contact companies and professionals to be safe and minimize the risks of our investments.

What services does DeFi offer?

While traditional finance covers a wide range of services and products, from mortgages and consumer loans to fixed-income investments, currencies, and equities, DeFi finance is still in its early stages of development. Among the most notable services of the Defi ecosystem are the services for accessing the interest generated in cryptocurrency pools, a practice known as staking or yield farming, depending on the case. Users can also access the tokenization of assets from the virtual or real world.

However, there are still major barriers to the mass adoption of decentralized finance: the absence of regulation and standards, and the standards associated with Know Your Customer (KYC) to prevent money laundering.

How does DeFi work?

Let’s take as an example the oldest and most in-demand financial service in the world: loans. In the relationship between lender and client, there are three key elements to set the transaction terms: the loan amount, the interest, and the guarantee in case of default. In the case of decentralized finance, any user could turn to these cryptocurrency pool services to obtain liquidity. The terms of the cryptocurrency loan would be set in a smart contract, which would establish the amount, interest, and liquidation threshold.

For example, some platforms offer a net credit value of around 75% of the collateral, with a liquidation threshold of 80%- 83%. This means that if the value of the crypto assets you put up as collateral trades below this limit, the smart contract will automatically liquidate the transaction. Few users have found in this type of service an alternative financing vehicle to the traditional one. In most cases, this type of loan from decentralized finance has served as a leverage formula for investors.

Challenges of the DeFi ecosystem

Among the main challenges facing the DeFi ecosystem, in addition to those directly related to its technological implementation, are the limited knowledge that still exists about this technology, consumer protection, corporate governance of DeFi, supervision of smart contracts, prevention of money laundering and terrorist financing, and the generation of systemic risks, among others.

One of the main problems with this technology is that it is a complex innovation whose understanding is still dominated by a small group. Therefore, this knowledge must be more widely disseminated and studied from a multidisciplinary perspective to better elucidate its advantages and risks. The lack of agreements and understanding on these issues among national regulators also limits the ability to adapt regulatory frameworks to respond to the new challenges posed by these solutions.

Several authors have highlighted the paradox that automating processes to gain efficiencies can lead to a loss of control in platform management. The various cases of fraud that occurred last year show that technology is not enough to guarantee the proper functioning of these services; it must be accompanied by structured corporate governance within the entities that offer these services.

Among the systemic risks, a very important source would be the creation of stablecoins and the tokenization of other “real” assets since they imply an interaction between the current financial system and the crypto world in cases where collateralization is outside the blockchain. Stablecoins backed by deposits in financial institutions could generate alterations in the liquidity of monetary markets in the event of liquidity problems in the negotiation of these instruments and even what is already known as “digital deposit runs.”

Another important challenge is the possibility of offering transnational services. Although technology could make this possible in the not-too-distant future, it requires a significant change in the local regulatory frameworks of the countries involved and harmonization in international regulation not only in what is inherent to the operation of transfers but also in everything related to the control of illicit operations.

Finally, a fundamental piece in the development of DeFi is the protection of financial consumers, both in terms of their personal information and their transactions, as well as the ability to enforce contracts outside the blockchain. The importance of regulation and supervision to guarantee the proper functioning of smart contracts is fundamental since there may be execution errors that generate changes in the expected results of the contract or even make them vulnerable to attacks that lead to the loss of resources.

Risks of DeFi or decentralized finance

The world of decentralized finance is currently one of the most well-known among computer and cryptocurrency users. The DeFi ecosystem is one of the fastest-growing areas in the crypto industry, and it offers investors numerous attractive and high-yield opportunities. However, it also has some risks that users should be aware of. Let’s briefly review what the DeFi ecosystem is. In a nutshell, this ecosystem is a decentralized financial system in which numerous assets and financial products are available on a public network of the decentralized blockchain so that all users can use them without intermediaries such as banks or brokers.

The difference between a DeFi and a bank account is that in a DeFi system, the user is generally not required to provide any form of identification or other proof to use the system. DeFi is characterised as a system where buyers, sellers, lenders, and borrowers can interact with each other directly through blockchain or software.

Unlike conventional credit institutions, the decentralized finance system does not have a central office or a service employee to turn to if a problem arises.

Errors in smart contracts

DeFi applications or dApps operate on what we know as smart contracts. These are automated digital contracts (if you want to know more about them, we offer all the necessary information here ). The more advanced a smart contract is, its source code will be more extensive. The more extensive the source code is, the greater the risk of errors.

Smart contract security has improved significantly in recent years. However, errors can still occur and have serious consequences. In addition, we must remember that hackers will always benefit from finding and exploiting network vulnerabilities. Currently, insurance companies cover smart contract vulnerabilities and errors created due to these problems.

Despite all of the above, the future is unpredictable, and a bug in a smart contract can affect users in many ways. Therefore, it is advisable to take all necessary precautions to minimise the risk of failures in the DeFi system.

Below, we will see some risks that represent a clear threat to the users of a smart contract:

• Timestamp dependency. This occurs when miners seek to change the timestamp of a block.
• Front-Running. This is when a hacker can use mempool transactions to modify an unlisted block.
• Integer Underflow and Overflow. These are cases where the code cannot limit the value of the unit variable to 2256. When this happens, the consequence is that the value is automatically reset to zero.
• Forced transfer of ETH to a smart contract. This causes the smart contract to be prone to self-destruction.

Based on all the data studied above, it is important to verify whether the application we want to use has been subject to an audit, and if so, we should know what conclusions it has shown.

Hardware risks

Another of the most well-known errors in the DeFi ecosystem is hardware errors. dApps’ software runs on hardware, so damage to the hardware also affects the software. Therefore, we must be cautious when entrusting our assets to DeFi applications.

Regarding the risks of DeFi applications, there are some that we must take into account. We will see them below:

• Incompatibility. This risk occurs when hardware devices are not configured to work together or do not have the correct drivers to allow them to work together.
• Power fluctuations. These fluctuations can have detrimental consequences for application users. Power problems occur when, for example, electrical outlets do not provide a constant power supply.
• Sensitivity to moisture, dust, wear and tear, and improper storage. These defects can cause errors or failures in the system.
• Voltage glitches. With these glitches, an attacker can manipulate the hardware so that the software does certain things that are usually malicious.

Software risks

Other significant technical risks in decentralized finance are software risks. These risks include DDoS or Distributed Denial of Service attacks, injection or overflow. Among its main risks, we find:

• Dedicated Denial of Service (DOS or DDOS) is a common technique for disrupting a website or service. An example is when a website or application is filled with meaningless queries.
• Injection. This occurs when software that allows users to manage data from the command line has certain vulnerabilities that could allow a hacker to access commands and modify data.
• Overflow occurs when data buffering or integer calculations are carried out in a way that produces undesirable results. For example, if the software tries to insert too much data beyond the accepted storage capacity into the buffer, it could corrupt the data or even allow malicious code to be executed.

Influence of developers

Another risk often overlooked in this ecosystem is the possibility of a project having potentially malicious developers influence the code. Therefore, we must ask ourselves questions such as: What influence do developers have over the funds stored in the DeFi application? And could they freeze or move our capital?

Many dApps in the DeFi ecosystem employ time blocks for some changes, such as to prevent code changes from being made without access by multiple parties or a DAO. Additionally, we should investigate potentially unfavourable or controversial changes to a dApp’s protocol. If that change is related to a cryptocurrency, we should investigate how much control the developers have over the code.

What the future of DeFi looks like

The future of DeFi looks promising, with increasing interest from individuals and businesses to explore and adopt these decentralized financial technologies. As new solutions are developed and current challenges around scalability and security are addressed, DeFi is expected to grow and expand.

Furthermore, regulations around cryptocurrencies and DeFi are expected to become clearer and more consistent worldwide, which could further encourage their widespread adoption and acceptance. In short, DeFi has the potential to revolutionize and democratize the global financial system, and its future is undoubtedly exciting and full of opportunities.

Frequently Asked Questions

What is Decentralized Finance (DeFi)?

Decentralized Finance, or DeFi, refers to a system of financial products and services built on blockchain technology. Unlike traditional finance, which relies on central authorities like banks, DeFi uses decentralized ledger technology (DLT) to enable peer-to-peer financial transactions without intermediaries.

How does DeFi differ from traditional finance?

DeFi operates on decentralized infrastructure, meaning no central authorities or intermediaries exist. Transactions are validated by decentralized consensus mechanisms on the blockchain, providing transparency, security, and reduced costs. Traditional finance relies on intermediaries such as banks to manage and control financial services.

What risks are associated with DeFi?

Risks include:

• Smart Contract Vulnerabilities: Errors or hacks in the code can lead to significant losses.
• Hardware Failures: Physical damage or power issues affecting DeFi applications.
• Software Attacks: DDoS attacks, injection, and overflow issues.
• Developer Influence: Risk of malicious developers manipulating the system.

How does DeFi work for loans?

DeFi loans involve peer-to-peer lending where terms are set in smart contracts. For example, a user can borrow crypto using their assets as collateral. The smart contract automatically liquidates the loan if the collateral value drops below a set threshold to prevent defaults.

What is the future outlook for DeFi?

With increasing adoption and technological advancements, the future of DeFi looks promising. As scalability and security challenges are addressed and regulations become clearer, DeFi has the potential to revolutionize the global financial system, offering more inclusive and efficient financial services.