Decentralized finance, or, in short, DeFi, is a financial-technological phenomenon that is increasingly noticeable in a number of new ways of providing financial services outside the banking system.
The access to financial instruments provided by DeFi refers to smart contracts, peer-to-peer and blockchain protocols, mainly Ethereum.
All transactions that take place in this alternative financial ecosystem are beyond the direct control of financial institutions and legislative actors.
In the complex word DeFi, the abbreviation for the word “decentralized” refers to the basic principle of blockchain technology in which each protocol transmits a multitude of servers for performing transactions in such a way that any of the performed transactions can no longer be changed or deleted, as it remains recorded so that all processes are transparent and instant.
The word “finance” on this complex word refers to common tools and instruments, such as money transfers, payments, loans, currency exchanges, insurance, or everything that has existed in traditional, centralized systems since ancient times.
The reason for the emergence of DeFi
DeFi arose from the need to eliminate some of the key problems that appear when conducting financial transactions in the international financial system. One of the key problems in this area is the settlement of financial instruments, which is very slow and takes several days to execute, clear and settle.
Also, the verification, execution and validation of transactions in financial markets often require human intervention, which drastically slows down all these processes.
The liquidity of certain financial instruments and access to them are two components that are affected by the traditional financial system due to its centralization between different actors that are in commercial relations with each other, which is why the end-user usually bears the costs of maintaining liquidity of a certain financial instrument.
In addition, it is important to take into account the fact that a number of citizens do not have access to bank services, i.e. do not have a bank account or for certain reasons (no ID, no income).
All these are the reasons why many companies, organizations and individuals see the advantage of decentralized finance, which should not be seen as a need to end existing practices and abolish control and supervision systems, but as an additional tool that can accelerate, improve and expand the range of financial service to those who do not have access to banking services, as well as to speed up certain processes and thus eliminate unnecessary costs.
Decentralized financing is, therefore, an ecosystem in which everyone could benefit from a variety of financial services and products without controlling bodies. In this sense, each beneficiary could, for example, have access to credit without discrimination and without the decision of the human factor used to assess one’s creditworthiness, mainly based on past indicators that may not be relevant in the financial world.
The idea and the goal
Decentralized finance is one of the key reasons for using the ethereum network. It is, therefore, a much broader and more complex process than blockchain, in which, for example, the value is transferred using a cryptocurrency transaction. In this sense, DeFi refers to much more complex processes than it is the case with the one that simply means the transfer of funds from person A to person B.
The aim is to offer various forms of decentralized financial services that would be accessible to all. DeFi is designed to be a financial ecosystem without control bodies and completely free to use.
The main goal is to completely remove the barriers that prevent some people from accessing financial services, including all the reasons why a large number of people around the world still do not have a bank account but have access to the Internet.
In the current circumstances, the liquidity of financial markets is often not guaranteed in peer-to-peer exchange, given that there is always the possibility that the entity selling something will not find a buyer due to the fact that the offered price does not match what the buyer is willing to pay.
This means that the desire to be “fairer” towards those who are discriminated against in the banking system is not the only guiding principle of DeFi advocates, but that the goal is to eliminate other problems, either financial or technological, that now arise as a result of asymmetric actions.
Initially, the DeFi concept can act as an attempt to develop the system “on its own”. This, of course, is not the case, as transactions can only take place on platforms that have the technical predisposition to do so and that would meet those customer expectations that existing services do not meet.
In this sense, DeFi requires pooling the skills of a number of actors around the world to make the scope of joint action broader, rather than trying to create its own DeFi ecosystem on each platform that would compete with the ecosystems of other platforms.
Inclusion of the marginalized
DeFi should not be idealized, nor imagined as a concept that will completely eliminate the need of entities for banking services. On the contrary, the idea of developing this concept is, among other things, based on the inclusion of a large number of individuals in the financial system, which increases the amount of money in circulation in accordance with applicable regulations.
The simplest way to illustrate this is to imagine a worker doing a job who can’t open a bank account because he7she doesn’t have a valid document – someone who can’t prove their identity, who doesn’t have citizenship, and so on.
Such an individual is being paid in cash, which further deprives him/her of money – he/she has money, but his/her earnings are not recorded anywhere, which deprives him/her of access to pension insurance, loans and many other rights that other individuals have.
The problem is especially noticeable among the minors who perform various tasks – voluntarily, but also forcibly. They are paid cash for their work, mostly informally, without any guarantee, completely marginalizing them and eliminating any possibility of having legal proof of their income.
So, if we enable people who do not have access to banks to become users of financial services, this act will not reduce the number of bank clients, nor do anything to their detriment, but will introduce into legal flows those entities that are marginalized in existing systems.
In the financial-technological sense, the advantages that DeFi provides are related to the possibility of individual asset management at any time, according to market rates created in real-time by an active group of actors.
All processes take place entirely uncensored and without the operation of banking or government institutions, with the possibility of auditing visibility and control in relation to the offered and executed contracts.
Increasing transparency is one of the key imperatives brought by DeFi, with a non-discriminatory or restrictive approach.
DeFi applications for decentralized lending work in a way that there is no user rating or transaction history, however, this does not mean that loans are given unconditionally. The protocols use the principle of guaranteeing for granting a loan, and for each amount borrowed in cryptocurrency, it is necessary to pledge collateral, also in cryptocurrency, where the ratio of the size of the collateral exceeds the loan amount.
On DeFi platforms, there are different mechanisms for connecting lenders and borrowers, and the process can take place through a peer-to-peer concept.
DeFi also has several characteristics that, compared to the traditional form of transactions, require additional adjustment and adoption of different habits. First of all, there is no possibility to cancel any transaction and all transfers are immutable.
Also, in the case of decentralized lending services, which are performed in cryptocurrency, the loan is approved with crypto collateral deposited. In case the loan is not repaid or if the value of the cryptocurrency decreases, the collateral is spent without further negotiations.
If the borrowing capacity decreases due to the fall in the value of collateral, liquidation occurs, and the guarantee is then sold at a unit price, which is lower than the market price.
In the case of capital withdrawals, the process may depend on liquidity to a much greater extent than is the case with traditional finance. In the end, the responsibility for all transactions and asset management is merely personal.
In other words, the ideal concept does not exist, so DeFi is not designed to be the one. As many projects that will complete it are just emerging, we will see the real scope of this approach in the future, and for now it is important to understand the concept and not to equate it with any previously known processes in the financial market, as well as not to observe it as a competition to banks.
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