The past year we saw and continue to see a surge in the popularity of decentralized finance, or DeFi for short. The sector is young, innovative, and the technology that has the potential to disrupt finance as we know it.
So what is Defi and how does it compare to the traditional financial system?
Decentralized Finance is any financial application that runs on a smart contract in the blockchain. Today, the majority of DeFi activity happens on Ethereum, the 2nd largest blockchain. The innovation from Ethereum is the creation of smart-contracts that run on the blockchain, coupled with a complete programming language. This allowed the creation of complex applications that can be not censored or shutdown.
What is Traditional Finance
The traditional finance system is the financial system we are all familiar with on the surface. Beneath the surface, traditional finance encompasses a large network of companies engaged in investing, credit, debt, money markets, lending, insurance, and anything that has to do with managing money. These traditional finance systems are heavily centralized, and usually run by for profit companies.
Today, traditional financial systems across the world operate on fiat. In fact, the word fiat comes from latin, meaning “let it be done”. The central banks print money that is backed by no real asset, and lend it to banking institutions. The banks are at a huge advantage, because they receive loans directly from the central bank at a low rate. The banks then turn around and lend that money for a higher interest rate, and collect the difference.
Wouldn’t you like to be able to receive loans from the central bank, and then lend it out at a higher interest rate and pocket the difference? And even if you make risky moves with your money, the taxpayers of your country will bail you out? Seems like a sweetheart deal, right?
How DeFi is different
You can view DeFi, as if programmers decided to build the world financial system on the blockchain, and make everything open to everyone at every level. DeFi opens up the world of finance and puts it in the hands of the people.
Decentralized finance shakes up this system of money by putting the business logic of financial institutions into smart-contracts. Smart-contracts automatically execute the code when conditions are met. For example, if a traditional finance lender were to give loans of $10,000 USD to anyone with a 720 credit score, that business logic can be put into a smart-contract that will deliver $10,000 loans to anyone with a 720 credit score.
The Trust Factor
DeFi is succeeding in part because it solves the problem of trust. A big part of traditional finance is the trust factor. If you deposit money into the bank, you inherently trust that the money will be there. This trust is backed up by the government, which will enforce laws if the financial institution does something illegal.
In DeFi, the trust comes from the open source code in the smart-contract. Smart-contracts allow developers to create financial applications with rules written in code. Since the smart-contracts run on the blockchain, they are always active, and follow the rules no matter what. Since the code is open source, anyone can look under the hood and view how the contract works. If you have programming skills, you can even work on improving the code and contributing to the platform. The collective efforts of hundreds of developers brings the trust factor to the community.