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How decentralized finance is changing the economy and cryptocurrency ecosystem

Franklin Izuchukwu
By Franklin Izuchukwu

Decentralized finance or DeFi forms a new financial infrastructure for the cryptocurrency world. DeFi provides services on borrowing, lending, cryptocurrency exchange, etc. Read on about DeFi and its effect on the world economy and cryptocurrency ecosystem.

Candlestick trade on cryptocurrency.

The current world economic system has left many 'wanting for more. Countries have seen economic upticks and downturns. A 2019 report by world vision has revealed that 689 million people in the world live in poverty.

The 2008 economic crisis could precipitate the current situation; The government was responsible for these actions.

Duly elected government officials and dictators have been making decisions that affect all humankind because each political policy or decision affects the economy. In a standard economy, the government can decide to:

  • Print more paper money (which undervalues savings of the citizens)
  • Increase taxation for the middle-class to get more revenue
  • Lower corporate taxes in a bid to create more jobs
  • Increase the interest rate to deter borrowing and halt inflation
  • Reduce interest rate to favour whoever suits the state

In most cases, the populace is not part of the decision-making. It has led individuals to sort for alternative means of proffering economic solutions.

The possible answer was bitcoin and cryptocurrency.

The idea behind cryptocurrency and bitcoin was to create an economical solution that takes power away from a few middlemen and give it back to the people ( in essence, it removes the middlemen in its entirety).

Clacified has a detailed article on how Satoshi Nakamoto created bitcoin and how the blockchain system works.

The creation of bitcoin as a digital currency may serve as a source of alternate economic power to the world. Still, it fails to offer more products readily available in a traditional economy.

The traditional world economy offers eligible individuals loans, insurance, portfolio management, and trading; bitcoin lacked in most of these services - the new role of Decentralized finance or DeFi.

A 2017 report by Globalfindex has shown that over 1.7 billion adults do not have access to banking institutions even mobile money. The same report claims that the number was about 2 billion in 2014.

This disparity is one of the many solutions that decentralized finance wants to solve. With decentralized finance, anyone from around the globe and can log online and access financial services.

DeFi seeks to offer limitless possibilities in the area of finance. It aims to act as a broker between the ordinary person and accessibility to financial tools.

Users can use Defi to get cryptocurrency loans, insurance services and even exchange one cryptocurrency for another.

At the end of this article, readers would understand:

  1. The basic concept and definition of DeFi
  2. The services and applications of DeFi
  3. The effect of DeFi in the cryptocurrency and economic ecosystem
  4. Some of the platforms where users can access some of the DeFi services
  5. The risks that are associated with DeFi

After the 2008 economic crisis, the US government had to bail out banks and other financial companies to save the world economy.

The definition and concept of DeFi

DeFi is a blockchain-based financial technology that does not depend on known financial intermediaries like banks, insurance companies and brokers but instead uses smart contracts (most likely ethereum) to execute transactions.

Some DeFi platforms allow users to borrow and lend funds to each other (P2P lending), earn interest throughs savings accounts, insure against risks, speculate and place bets on prices, events etc.

DeFi offers an entirely new world of finance to users in the cryptocurrency ecosystem. The goal is to create alternate finance where anyone with an internet connection can access funds and experience bank-like transactions.

The 4 basic foundations of DeFi are:

  • Cryptography
  • Decentralised Infrastructure
  • Smart contracts
  • Digital currency

Cryptography and Decentralised Infrastructure:

Cryptography and cryptocurrency are the foundation of DeFi. Cryptography gave birth to the idea of decentralised infrastructure.

The decentralised structure would act as a record book, database or ledger for recording cryptocurrency transactions.

The bitcoin blockchain is the first primary decentralised ledger; it is responsible for authorising, authenticating, verifying and recording all bitcoin transactions with the help of individuals known as Miners.

The Miners are responsible for certifying bitcoin transactions; the miners receive bitcoin for each successful block of transaction they process.

This singular action limits the application of bitcoin blockchain as default in DeFi because the need for miners to verify transactions betrays the whole idea of decentralisation and the effect of intermediaries in traditional finance.

Also, the bitcoin blockchain features basic programming functionalities that limit additional features and are not compatible with DeFi - the Ethereum network solves these problems.

Vitalik Buterin created the Ethereum network to solve the problems associated with bitcoin's blockchain. The ethereum blockchain:

  • Is Programmable
  • Is a 'Do-it-Yourself' service (DIY)
  • Allows the implementation of Decentralised apps (Dapps)
  • Permits the use of Smart contracts

Smart contracts:

Another basic foundation for DeFi is Smart contracts; Smart contracts are self-executing programs that implement a transaction according to the terms of agreement or contract.

They are codes meant to execute a set of actions between a buyer and seller after meeting some conditions.

Smart contracts take over intermediaries, banks, and the government to make a financial transaction.

The populace buys into the world economy and makes investments because of the trust placed on the government and other corporate bodies.

Smart contracts assure DeFi users of that trust because smart contracts are automated and cannot execute when a condition fails.

After deploying a smart contract code, the owner will lose control because smart contracts are immutable.

Smart contracts enable DeFi by delegating the role of the government or corporate bodies to immutable lines of code.

Digital currency:

Every financial infrastructure needs a currency or money as a medium of exchange for transactions.

Though the whole idea of DeFi erupted from the creation of the Ethereum network, common sense would require that Ether (the default currency in the ethereum network) should be the default currency in DeFi.

The above cannot be the case because Ether is very volatile. A very volatile currency would not ease the fear of investors and future DeFi users.

Stable coins like USDT, USDC, DAI etc., are the default currencies in DeFi because their value is pegged to the US dollar and are less volatile.

DAI is the common cryptocurrency used. Unlike USDT, DAI is over-collateralised with other cryptocurrency assets in reserve.

On the contrary, USDT maintains its value with USD cash reserves; thus, the government reserves little control over the value of USDT.

Smart contracts are lines of codes that validates transactions on DeFi.

Applications and uses of DeFi

As stated earlier, DeFi seeks to take over the role of traditional finance. In the journey to achieve such fit, potential users would always ask about the benefits, uses and applications of DeFi.

DeFi offers loads of opportunities and benefits to users.

Some of the applications and uses of DeFi competes with traditional finance is, being a bank for the everyday person, with the only difference being the foundational infrastructure and architecture.

A whole lot of research, testing and developments are underway to create more opportunities with the use of DeFi, but some of the known services and applications of DeFi are:

  • Anonymity and less regulation
  • Decentralized applications (Dapps)
  • Borrowing and lending of cryptocurrencies
  • Insurance
  • Decentralized exchange
  • Flash loans

Anonymity and less regulation:

Today, the government dictates policies either to impact the economy or to abuse its power. The government determines the total amount of transactions a citizen can perform daily. They also limit access to foreign investment whenever they deem fit.

In some cases, the government prevents forex transactions while giving access to only a handful of people. DeFi gives everyone access to a wide range of financial benefits devoid of regulation.

Users are allowed to move an unlimited amount of funds in cryptocurrency assets while using DeFi. DeFi does not promote the KYC policy because the government does not regulate it.

This advantage ensures that users are not over-taxed for performing simple transactions.

Decentralized applications (Dapps):

Decentralized applications or Dapps is are one of the core uses of DeFi. The ethereum network allows Software developers to create decentralized apps on the ethereum chain.

All decentralized apps have no central authority but rather use smart contracts to execute actions and validate transactions.

Dapps are broadly used in DeFi to provide financial services to users. Traditional finance services like borrowing, lending, margin trading, exchanges, etc., are accessible to users through Dapps.

Uniswap is one of the most popular Dapps hosted on the ethereum network. Uniswap automates exchange of cryptocurrency based on the smart contracts model. Users could also use the Pancake application for the same purpose.

Borrowing and lending of cryptocurrencies:

Traditional financial institutions like banks and other fintech companies keep the economy afloat by lending money to individuals and companies.

These loans often come with a high interest rate. Many a time, only a few individuals are eligible to get loans from banks.

DeFi, on the other hand, has opened a new space for users without prejudice or bias on gender, age, race or social class. With DeFi, users can easily take loans on stable coins to make a trade and other transactions.

DeFi also allows users to earn interest on their cryptocurrency assets by lending to other users. AAVE is one of the known platforms that seeks to connect the borrower and the lender.

The interests on DeFi loans are low because of the competitive market - many users are willing to loan their crypto assets and earn in the process.

DeFi offers a platform where uses can lend and borrow funds.

Insurance:

Daily activities come with risks, which is why people opt for or buy insurance packages to mitigate unforeseen circumstances. Insurance payments are by premiums.

DeFi has delved into the insurance niche to offer insurance packages in the real world. With platforms in DeFi, users can buy insurance packages to protect their farms etc.

For instance, Software developers could deploy smart contracts codes to make insurance payments to a user if the temperature in a particular region is above a chosen degree Celsius. Oracles determine this decision.

Some DeFi insurance providers like Nexus mutual, Opyn and others offer coverages against market volatility, wallet hacking, etc.

Decentralized exchange:

As noted earlier, Dapps accesses borrowing, lending, insurance and other services. Some Dapps offer services in cryptocurrency exchanges.

In traditional finance, Forex is the transfer of foreign currency from one point to another. Decentralized exchange (DEX) offers a platform for exchanging or swapping cryptocurrencies.

For instance, a user can exchange ethereum for bitcoin in Uniswap or Pancake applications. DeFi offers DEX to allow interaction between the different coins and tokens available.

Flash loans:

Flash loans are one of the most innovative applications of DeFi. Flash loans are the first uncollateralized loans in DeFi.

At the moment, flash loans are accessible to only developers. Smart contract protocol is the foundation of flash loans. It allows developers to borrow millions of dollars worth of crypto assets and repay within seconds.

For example, if Ethereum is sold for $1 on Binance but sold for $1.2 on Coindirect. smart contracts can allow a developer to borrow $10 million worth of ethereum from a DeFi platform to buy ethereum on Binance and sell it instantly on Coindirect for a higher price.

If inadvertently, the price in Coindirect slips below the proposed order, the transaction would fail, and the loan returned instantly to the DeFi pool - that is, smart contracts in play.

Flash loans does not require any collatral.

The economic effects of DeFi

The goal of DeFi was to revamp the current traditional financial structure. DeFi seeks to creep into every part of the economy, to be part of the daily lives.

The different applications and uses of DeFi have been instrumental in achieving the goal of financial restructuring.

Anyone can access the services offered by DeFi, thereby creating a platform devoid of discrimination. More accessibility to financial infrastructure equals poverty alleviation.

P2P lending in DeFi is a crucial advancement in the world of finance. The advantage of this application is, it offers low-income earners a platform to earn interest with their savings rather than depositing money in the bank with little or no returns.

Small business owners can access loans on DeFi with very little interest because the free market determines the rate and not a few intermediaries or government bodies.

The insurance service offered by DeFi gives users an alternative to traditional finance. More advancement might lead to solutions for more coverage in people's daily lives.

The whole system and infrastructure offered by DeFi create more opportunities via software development. Software developers are responsible for creating Dapps, API and algorithms needed to fuel the advancement of DeFi.

On the other hand, DEX also offers more options for liquidity, thereby making cryptocurrency exchange more feasible with fewer hassles. The implication is a reduced cost and fees.

Unlike DeFi, Banks and the government may work together to keep the price steady in traditional finance, thereby promoting monopoly and less competition.

For DeFi, the endpoint is to create a free and robust market accessible to everyone independent of creed or class.

Decentralised apps are software used for accessing numerous services in DeFi.

Conclusion

DeFi offers financial options for users. Notwithstanding, there are many cons associated with DeFi. For some individuals, DeFi is nothing more than a revolution. Others see DeFi as the future and plan to stick with it.

DeFi is a new project; thus, uncertainty is one of the risks associated with it. Many users are sceptical about the future and sustainability of DeFi. The instability and volatility of the cryptocurrency market is a deterrent for many people.

Another primary concern in the world of DeFi is the lack of 'shared responsibilities. DeFi takes away the middlemen; therefore, any mistake encountered in the transaction process is the user's sole responsibility.

In a nutshell, flash loans are often tagged as unsecured because some unscrupulous developer can fork the system into thinking the loan has been repaid - thereby leading to loss of funds.

DeFi is new but has gained popularity; cryptocurrency enthusiasts looking for new opportunities should research before making any DeFi transaction.

Nevertheless, DeFi is an innovative revolution that will tap into the space occupied by traditional finance.

The past may not have anything to do with DeFi, but DeFi will affect the future economic ecosystem positively or negatively.