Decentralized finance explained

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Learn more about the hottest topic of 2020 so far

Decentralized finance or DeFi as it has become known has been a hot topic in 2020. The protocols within this category contain many components that can be confusing for people new to the sector. 

Furthermore, at this stage in its early history, there is also some debate over what categories specific dapps should sit within i.e DeFi or Decentralized Exchanges or DEX, as they are known. Both categories are crucial to the overall decentralized finance ecosystem so here we will explain both. 

Find out more about the rapidly expanding movement toward financial independence and how to benefit.

Centralized Finance (CeFi)

The traditional finance market is centralized. Central authorities are responsible for issuing the currency that drives our economy and that same currency is used for every trade executed by the government and banks. 

This means the power to manage and regulate the flow and supply of such currencies in the market sits wholly with them. We, as financial customers also pass the control of our assets to various financial organizations like banks in expectation of getting higher returns. 

The major problem with this way of working is since all the control and money is centralized, the risk is also centralized. 

2020 provides a case in point for how the government alongside banking corporations acts to ease financial frictions. The Covid-19 outbreak being an example of how world economies suddenly had to react. 

Recently central bodies decided to print currency to tackle the financial crisis, but what if it backfires? Central bodies consist of humans and mistakes can and do happen in their judgment.

Take the case of the Venezuelan government – their poor monetary policies, including printing huge amounts of money amid oil price drop – resulted in inflation exceeding 1,000,000% as per IMF data. This has destroyed its economic balance.

Decentralized finance
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The big swindle

As people and financial customers, we give our money to banks and other financial institutions in order to save and often deposit fixed or recurring deposits to earn profits. Those organizations you trust your money to invest that money in share markets as well as give loans at high-interest rates earning huge profits. 

But only a small fraction of that is returned to us. With the global inflation rate vacillating around 3.64% (2% in the US), the actual value of this return becomes even less. So some of us choose to invest.

Again, we put our trust in financial advisors to advise on schemes, mutual funds, and share markets in exchange for a cut of your returns. The return here is increased but it’s risky as the advisors can also make mistakes or fail to see market risk. So you receive just a fraction of the money from the investment. In the case of the share markets, many think and talk about them, but how many of us are actually invested there.

The introduction of easy to use applications offering one-click investments and an increase in overall education have certainly added pace to the financial independence movement. Compared to 2017, more and more middle-class people own more stock but it’s still widely disparate to what the upper classes hold. Simply put, it is very difficult for ‘normal’ people to benefit from shareholdings. 

Decentralized finance

NYU economist Edward Wolff’s research showcases that the top 1% of households by wealth owned nearly 38% of all stocks shares. While the top 10% of Americans have investments in stocks over $1,000,000, the next 40% have an average of $100,000, with most of the rest having none.

Furthermore, there are people in countries where they don’t even have access to a trustworthy bank account, let alone the stock market.

Zero control

One major factor to consider here is that we as customers have very little to zero say in where and how our money gets invested and handled by these corporations. The movie The Big Short did an excellent job of breaking down complex financial issues for the average joe and explaining that it is intentionally designed to confuse and scare people. 

All these issues arise because of the centralization of the finance that underpins the world economy, but as you can hopefully understand it is definitely not an open system. One possible solution is to decentralize the system and put power back into the hands of users.

Enter decentralized finance

Bitcoin, Ethereum, Cardano, and other early crypto coins offered a way to secure peer-to-peer trading without the need for middle-men like banks for trade settlements. This ‘upgrade’ has given users complete control over their assets. That said, some people are not ready for this total control and there is definitely a degree of education required.  

However, it is also important to recognize that cryptocurrencies have not really decentralized the financial system. They have just decentralized the issuing of money and its storage. As mentioned,  at this early stage we could consider most of the applications and protocols operating inside the space as still in their ‘Beta’ test stage. There are a couple of pertinent problems that exist hindering blockchain from making the financial system genuinely decentralized. 

  • While cryptocurrencies are decentralized, they are mostly accessed via centralized access points such as exchanges.
  • Most crypto projects are managed through centralized companies that lack accountability or transparency.

What is DeFi?

DeFi is a shortened term for Decentralized Finance. Decentralized Finance includes digital assets, protocols,  smart contracts, and dapps built on a blockchain.

Think of DeFi as an open financial ecosystem where you can build various small financial tools and services in a decentralized manner. Since these are applications built on a particular blockchain, they can be combined, modified, and integrated according to your needs. Just like lego!

Decentralized finance

What are DEXs

DEX is a shortened term for a Decentralized Exchange. DEX’s operate without a central authority thus allowing peer-to-peer trading of cryptocurrencies. 

Furthermore, because users do not need to transfer their assets to the exchange. Decentralized exchanges reduce the risk of theft from the hacking of exchanges. Decentralized exchanges can also prevent price manipulation or false trading volume through wash trading. Plus they are more anonymous than exchanges that implement know your customer (KYC) requirements.

As mentioned, a decentralized exchange can still have centralized components. Meaning that some control of the exchange is still in the hands of a central authority. A notable example being the IDEX protocol blocking New York State users from placing orders on the platform.

What can DeFi do for me?

DeFi is offering people the chance to take total control of their own assets. You may think that new-age banks with their creative marketing spin promise to provide more control to users. In reality, you are still trusting them completely to manage your funds. 

The objective of DeFi is to give users back full control of their assets. Something which has been made completely possible by decentralization and blockchain technology. 

The fact that all protocols are open-source allows anyone to build new financial products on top of them. Developers across the globe can collaborate with each other to create new products. Leading to faster innovation and a secure network. 

It is also allowing crossover between separate and previously disconnected categories. At DappRadar we are seeing a big movement by developers to incorporate these decentralized financial services inside dapp games, for example. Creating full-scale internal economies. 

Users can store, trade, and invest assets in the blockchain securely and earn a much higher return than from the traditional financial system. The major advantage is that since there are no intermediaries, you have complete control over your investments.

We’re just getting started!

Now you have hopefully gained a foundation to what the decentralized finance movement looks like in the real world. Its time to look at the separate products and services you as a customer can utilize.

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