The beginners guide to decentralized finance
Casual cryptocurrency users tend to think of crypto in terms of using something like Bitcoin to play online slot games or buy a cup of coffee. It is so much more to blockchain developers and institutional investors. To them, cryptocurrency is just one small part of the much broader concept of decentralized finance. And by the way, decentralized finance is where all the action is taking place right now.
Also known as DeFi, decentralized finance is more a concept than anything else. It is a concept that takes the fundamental principles of cryptocurrency and applies them to the entire spectrum of financial transactions. It relies on public blockchains to produce monetary systems that are completely free from government and central bank control.
"But wait," you say. "Doesn't Bitcoin already do that?"
Yes, it does. What makes the DeFi concept different is scale. Bitcoin is just one cryptocurrency among thousands. Its worldwide network, as big and robust as it is, constitutes just one of many others all vying for the attention of users and traders. DeFi takes what exists on the Bitcoin network and scales it up to include every other alternative monetary system based on blockchain technology.
Cryptocurrencies are networks
If you are having trouble wrapping your brain around the DeFi concept, consider this: Bitcoin, Ethereum, and all the rest are not really currencies. We call them currencies only because we do not know of any other way to describe them to users and traders with no computer software development experience.
'Cryptocurrency' is a term that easily encapsulates what you can do with something like BTC or ETH. As a user, you understand that you can buy BTC for any number of purposes. You can treat it as an asset similar to stocks and shares, or you can spend it like cash. At any rate, referring to it as 'currency' makes such concepts familiar to your brain.
In reality however, these digital monetary systems are nothing more than networks. Remember, buying BTC does not give you access to tangible, minted coins you can carry in your pocket. Cryptocurrencies are not even digital representations of hard assets in the same way that fiat is represented by digital transactions on bank and credit card networks. In short, there is no currency you can actually possess when you buy something like BTC.
This is not meant to scare you. Rather, this explanation is given only to help you better understand that cryptocurrencies are really just computer networks capable of facilitating transactions between multiple parties and keeping records of said transactions. When you see cryptocurrency in that manner, it is easier to understand the DeFi concept.
The DeFi concept seeks to bridge the divide between cryptocurrencies. For example, the Bitcoin network cannot interact with the Ethereum network very easily. As such, transactions on the two networks are kept entirely separate out of necessity. Moving between the two requires a transaction similar to what we currently do with fiat.
Let's say you live in Hong Kong and are planning a holiday trip to Europe. Your native fiat, the Hong Kong dollar (HKD) will not be usable as a day-to-day currency on holiday. So what do you do? You convert HKD to EUR at the airport. Whatever travel money you have left is converted back to HKD upon your return.
The same sort of situation occurs in the crypto universe. If you only possess ETH and want to play online slots at a casino that only accepts BTC, you have to make the conversion. The only way to do that is on a cryptocurrency exchange. It works well enough, but there ought to be a better way to do things.
This is one of the basic tenets of DeFi. One of its primary goals is to create a system of cryptocurrency interoperability that erases the lines between different digital tokens. That interoperability will eventually extend to payment processing systems and decentralized apps that will allow financial institutions to effectively hold and utilize digital assets.
More access to more people
DeFi's ultimate goal is to give access to financial services to more people. As things currently stand, there are nearly 2 billion people worldwide without easy access to financial services. Many of these same people have been shut out from wealth-building opportunities as a result. DeFi seeks to change that.
Because DeFi is built on blockchain monetary systems, it has the advantage of permissionless and fault-resistant technology that overcomes many of the limitations of the traditional financial system. A permissionless system is open to anyone because there is no central authority excluding people who do not fit a particular mold.
Centralization also makes it nearly impossible for a single entity to take control. That is where fault resistance comes into play. We can look to the way Bitcoin is structured as an example of how this works. Remember that Bitcoin is essentially a computer network that performs the function of an alternative monetary system.
The Bitcoin network is controlled by a series of computer nodes located around the world. Each node has a copy of the Bitcoin ledger and the software necessary to build new blocks for the chain. Before any new blocks can be officially added, consensus must exist. In other words, all the computer nodes on the network must agree. This consensus prevents a single entity from taking control of the blockchain.
How does this help the average consumer who doesn't have access to financial services? It prevents a government or central bank from taking over. Decentralization keeps government and central banks out of the arena and allows private citizens to conduct business among themselves without interference.
When you understand the basic tenants of DeFi, you begin to understand all the practical applications. One of the most easily understood applications is that of remittances. What is a remittance? Think of it as sending money to family members who live overseas. DeFi makes sending that money a lot easier and secure.
This is something that happens routinely in Venezuela. Former Venezuelans who have fled the country routinely send money back to relatives via electronic remittances. Handling remittances through traditional financial networks can be quite expensive. In some cases, the fees charged by transaction processors are considered extortionate. Once again, DeFi could be the answer.
Cryptocurrency transactions tend to be available with lower fees. If sender and recipient both possess digital wallets and do not need to go through payment processor, remittances are completely free of all fees. Money goes from one wallet to the next without any third-party interference.
Another practical application of DeFi is consumer lending. This is especially important to people who do not have bank accounts and credit histories. Banks will not lend to them, which is completely understandable. But that does not give disaffected consumers much hope.
A lending system structured around the DeFi concept connects borrowers and lenders directly without any banking institution or credit bureau interference. Lenders can choose to vet borrowers in any way they see fit because DeFi is not regulated by central bank authorities. Furthermore, borrowers can use other digital assets as collateral for their loans, thereby reducing the risk to lenders.
Two things holding DeFi back
With so much going for it, it is a mystery to some as to why DeFi has not exploded around the world. It's no mystery to others. Those who truly understand the inner workings of cryptocurrency and DeFi recognize that there are two things holding it all back: infrastructure and volatility.
In terms of infrastructure, it is just not there yet. Before DeFi is worthy of competing with the world's financial systems, it has to be able to at least match capacity. That is something you cannot do right now. Just compare Visa's worldwide network with Bitcoin's and you will learn everything you need to know.
The Visa network can complete a transaction in mere seconds. It is generally not affected by heavy traffic either, as network capacity almost always outpaces demand. Things are different with the Bitcoin network. A typical Bitcoin transaction takes at least a couple of minutes to finalize. When traffic is heavy, a transaction could take up to 10 minutes to complete.
As for volatility, it speaks for itself. Anyone who follows Bitcoin knows that its price could drop hundreds of dollars in mere minutes. Even casual followers know that Bitcoin opened the year at around $3,500 before briefly eclipsing $13,000 over the summer. It is now trading in the $9,500 range.
That sort of price fluctuation scares markets. And by the way, it should. Such volatility makes it too risky to use cryptocurrency as a monetary system for day-to-day business. Imagine taking out a BTC loan when the price was at $3,500. Now that it is hovering around $9,500, you suddenly owe a whole lot more than you borrowed.
DeFi is a phenomenal concept with a lot of potential. Once all the kinks are finally ironed out, it could provide a viable alternative for businesses, consumers, and financial institutions looking for a decentralized way of doing things. Until that day arrives, we will have to be content with the only other system we have to work with.