What is DeFi? How does it work? & Need for Decentralized Finance [For Beginners]
Trust plays a critical role in finance.
In our day-to-day lives, we transact with people we don’t know or trust, and hence we carry out such transactions through mutually trusted third parties like banks and other financial institutions.
Nick Szabo in a paper published in 1997, explained this trust factor in finance as “The God Protocol”.
The third party is expected to act like “God”, who is fair to everyone, unbiased, and can be trusted by everyone.
However, as humanity has experienced over the years, financial institutions certainly don’t act like “God”, at least the instances of banking frauds say so.
Blockchain technology and decentralized finance (DeFi) offer to replace the third party in the equation with what is called a ‘Trust Protocol’.
In this post, we delve deep into what is DeFi?; how DeFi works? and most importantly why do we need decentralized finance?
Also Read (opens in a new tab): DeFi vs. State: Regulation of Decentralized Finance (DeFi)
“Trust Protocol”
The ‘Trust Protocol’ is basically defined by a set of computer codes that determine the functionality of a blockchain network.
These are rules that define and characterize the blockchain itself.
It lays down everything from what the network is, how transactions are recorded, how they are verified, who can verify and record these transactions, and who can access them.
Ideally, in a decentralized setup, these rules can neither be reworked nor deleted to favor any one party.
For public blockchains like Bitcoin and Ethereum, these sets of rules are publicly available for developers to build software applications on the respective blockchain.
The idea is to facilitate rules-based transactions between two unknown parties, without the involvement of any third party with a profit mentality. Rather computer codes defining irreplaceable, or unchangeable protocols will do the job.
Thus the blockchain itself acts as the ‘Trust Protocol’ and terminates the need for an intermediary through mass collaboration, cryptography, and distributed computations.
Throughout the history of finance and money, there has always been an intermediary involved that is mutually trusted.
However, these third parties have proven to be vulnerable to bias, fraud, security breaches, information leaks, identity theft, etc.
Blockchain technology for the first time offers a solution to remove the third party from the equation and enable peer-to-peer transactions based on the blockchain network, making the process “decentralized”.
Why do we need DeFi?
Over the last three decades, the internet has changed the way businesses operate and has influenced our personal as well as professional lives.
A report by Ericsson ConsumerLab states that Indians now spend an average of 3.4 hours per day online. And the pandemic has resulted in students and the remote workforce spending around 5 hours and 24 minutes daily on the web.
However, the internet hasn’t been able to change how the financial system works at its core.
Although it has enabled digital transactions and has brought the bank to our fingertips, it hasn’t changed the fundamentals of how we transact and interact financially on the internet.
We still need government or banks to establish and verify our identity in the digital world, and we need these intermediaries to interact with others.
The internet that we have today is regarded as the ‘internet of information’ designed to store and exchange information among users.
“for nearly four decades, we’ve had the Internet of information. It vastly improved the flow of data within and among firms and people, but it hasn’t transformed how we do business. That’s because the Internet was designed to move information—not value—from person to person.”
Blockchain Revolution: How the Technology Behind Bitcoin and Other Cryptocurrencies is Changing the World
We cannot yet own anything on the internet except for a domain name, for example, fedupchronicles.com.
The social media accounts that we operate belong to the service providers, and everything you express through such platforms is vulnerable to hacking and complete loss on the failure of the providers.
The internet has been designed to enable users to exchange information, however, it hasn’t been designed to transfer value directly between the end-users.
We cannot use the internet as a store of value, nor can we use it for peer-to-peer payments and transfer of value like land rights, gold, etc.
The major disadvantages associated with the traditional financial system and the internet’s inability to transform the way financial transactions work on it have led to the development of what we call the ‘internet of value’.
The modern phase of the internet, popularly regarded as the ‘internet of value’ or ‘web 3.0’, is likely to enable end-users to own ‘digital assets’ on the internet.
These digital assets can be cryptocurrencies, which are native coins of a blockchain network, like Ether and bitcoin of the Ethereum and Bitcoin blockchain networks respectively.
They can be tokens, like NFTs (non-fungible tokens) issued by known users on some blockchain network. These tokens can represent underlying legal agreements,
products, and services, both tangible and non-tangible.
For example, a token can represent a unique digital art or it can also represent a smart contract for land rights.
The basic idea is to enable digital ownership of valuable items, that can be accessed throughout the internet, provided they are on the same blockchain network.
For instance, owning an NFT art on the Ethereum network, allows one to use it across different applications made on the Ethereum network.
Compare it with the currently popular usage of the internet where even if you own something digital on the internet like an avatar on an application or game, you cannot use it across different platforms.
For example, if you own a ‘Hero Skin’ in the popular game ‘Clash of Clans’, you can only use it on that specific game, however, NFTs will have utility across platforms on the same blockchain.
This is just an example. NFTs of course have much more significant implications than just making games more awesome!
Now since the idea of digital assets is the backbone of the ‘internet of value’, it is very much obvious that the need for a system would arise that would enable the transfer, exchange, trading, storing, lending, and borrowing of such digital assets. And since blockchain technology is at the core of such digital assets, all these developments, along with drawbacks of traditional finance led to the need for blockchain-based fintech or decentralized finance (DeFi).
Decentralized finance (DeFi) provides a financial system without a central authority, or intermediaries, where peer-to-peer transactions can take place between the users, and such transactions are verified and recorded by millions of computers doing distributed computations on the blockchain network.
Bitcoin & the Idea of Cryptocurrencies
Amid the 2008 collapse of financial markets, Satoshi Nakamoto, the anonymous creator of Bitcoin, published a paper called “Bitcoin: A Peer-to-Peer Electronic Cash System”, in which he outlined the protocol for the Bitcoin network, giving way for a new electronic cash system, which enabled peer-to-peer transactions, replacing financial intermediaries with coded protocols.
This was seen as a viable technological solution to Nick Szabo’s “God Protocol” problem, and thus the idea of blockchain being a “trust protocol” gained prominence.
Satoshi’s paper also introduced the concept of cryptocurrency and gave birth to bitcoin (BTC), the native cryptocurrency of the Bitcoin blockchain.
Cryptocurrencies are digital assets native to a particular blockchain network, that acts as the currency used for transactions within that blockchain network.
For example, bitcoin (BTC) is the native coin of the Bitcoin network, and it can be used for all transactions that take place in applications and software developed on the Bitcoin blockchain network.
Similarly, Ether (ETH) is the native coin for the Ethereum network that can be used for transactions within that blockchain.
An example of use cases of cryptocurrencies, currently in prominence, would be buying and selling of NFTs (Non-fungible tokens).
OpenSea is one of the largest NFT marketplaces currently in operation with a valuation of around 13.3 billion US Dollars as of January 4, 2022, and in order to buy or sell an NFT art or a digital piece of land in the form of a token on OpenSea, you will need ETH (Ether), MATIC (Polygon), KLAY (Klaytn), or SOL (Solana) as the currency, as the platform supports only these four blockchains.
Unlike fiat currencies, cryptocurrencies are not issued or regulated by a central authority or government, instead, they are created and governed by a set of coded protocols that define a blockchain.
However, what is important to note here is that these protocols are different for different blockchain networks, and are usually laid out in the ‘whitepaper’ issued by the developers.
For example, there can be private blockchains where there is a controlling authority that determines who can access their network, and then there are public or permissionless blockchains like Bitcoin and Ethereum where anyone can participate in the process of verification and recording of transactions, and the distributed ledger is publicly available.
For transactions using cryptocurrencies, there is no need for a mutually trusted third party, like a bank, to verify and record the transactions as all these processes are carried out by millions of computers across the globe, carrying out distributed computations as per the protocol, using Proof of Work or Proof of Stake consensus algorithms, thus verifying and then recording the transactions into blocks that form a chain of transaction records.
All these processes take place as per coded protocols that cannot be deleted or edited, and with no human intervention.
This mechanism of distributed computation for verification and recording of transactions eliminates the need for a bank and makes the process peer-to-peer.
Peer-to-peer verification and mass collaboration remove the chances of human error and also solves the problem of ‘double-spending’ of cryptocurrencies, where the same coin can be used multiple times.
This is because once a transaction is verified by distributed computations and recorded on blocks, that transaction becomes irreversible and the record can neither be deleted nor edited.
This ensures full transparency in terms of the flow of assets, as all transaction records are accessible on a public blockchain.
Blockchain technology thus removes the need for a trusted third party by means of codes, and collective self-interest of millions of miners (those engaged in blockchain computations) rather than a company’s quest for profits. It provides a globally accessible solution for peer-to-peer transactions.
All this makes blockchain technology a revolutionary technological feat that can and is already changing how finance and money work.
What is DeFi? Understanding Decentralized Finance
We have seen the utility of blockchain technology as a currency solution in the form of cryptocurrencies.
Now once a cryptocurrency and the respective blockchain network gains prominence in terms of the number of applications and software being developed on that network, the need for multiple financial solutions arises that can be used to store, trade, exchange, lend and borrow these cryptocurrencies and tokens.
This gives rise to a whole new ecosystem of decentralized finance solutions, that removes the need for banks and financial institutions and gives a mechanism for peer-to-peer transactions, saving, lending, borrowing, and a plethora of financial activities.
Decentralized finance or DeFi is a rapidly evolving financial technology that provides peer-to-peer financing solutions, that are based on coded protocols and blockchain technology-driven software applications. DeFi has the potential to do away with centralized control over financial products and services like lending and borrowing.
Blockchain technology of collaborative verification and recording of transactions is used to facilitate financial activities such as lending and borrowing.
The end users have more control over their digital assets like cryptocurrencies and tokens, etc., and depending on the security protocols, DeFi has the potential to completely eliminate the chances of banking fraud.
Read (opens in a new tab): DeFi vs. State: Regulation of Decentralized Finance (DeFi)
How Does DeFi Work?
If you look at how the traditional financial system works, then you’ll notice that it always involves a mutually trusted third party that has three main jobs.
Firstly, it is supposed to provide a secure and smooth mechanism to facilitate transactions between two parties, that is to say, it provides a medium of exchange. This they do in the form of cheques, credit and debit cards, etc.
Secondly, these third-party financial institutions also act as an intermediary that balances the need for resources of borrowers and the willingness to save, of the savers.
That is to say, they connect those who have excess and hence wish to save, and those who have a deficit and need to borrow. Simply put, a bridge between lenders and borrowers.
And last, they maintain the records of these transactions. This is why you are able to check your account balance and transaction history.
Decentralized finance or DeFi solutions take care of all these three functions without the need for a third party.
Firstly, the medium of exchange that banks and other financial institutions offer is replaced with decentralized applications (dApps) built on a blockchain network, that facilitates transactions and financial activities of all sorts on that blockchain.
Anyone with internet connectivity can use these applications. Unlike the traditional banking setup, these applications don’t need any of the traditional verification processes, like KYC, rather everything is based on technology-driven collective verification.
Secondly, the functionality of banks as a bridge between lenders and borrowers is effectively replaced by DeFi which provides peer-to-peer financial solutions, thus directly connecting the lenders and borrowers.
If you wish to earn a fixed interest amount on your crypto assets you can simply use a suitable decentralized financial application (dApps) to lend your assets to some other user in need of them.
And third, distributed ledgers are at the very core of blockchain technology. These ledgers are publicly accessible (for public blockchains) and are maintained through collective verification of transactions by millions of computers employing a particular consensus mechanism, for example, Proof of Work, where mathematical computations are done to verify transactions and record them on the blockchain.
This ensures complete transparency, privacy, accuracy, and efficiency in maintaining the transaction records. As a result, the flow of assets can be monitored, curbing money laundering and banking frauds, once proper regulations are in place.
While all transaction records are publicly available, they cannot be linked to individual users as user identities are kept obscure by keeping public keys anonymous. This ensures privacy of those transacting.
The best part, there is no chance of human error or embezzlement of your money by shady bankers!
DeFi uses blockchain technology to verify and record transactions. Once transactions are verified through computations, they are recorded into blocks and encrypted.
Each succeeding block has information from the previous block, forming a chain of transaction records and hence these records cannot be altered or deleted, as changing one transaction record would require changing the whole ledger.
In short, there is no way to alter a blockchain.
Conclusion
Once a complete ecosystem is formed around blockchain technology, with services, products, cryptocurrencies, tokens, digital assets, etc. it is theoretically possible to completely replicate the traditional centralized financial system into a decentralized setup.
However, DeFi is still in its early phase of development, with research and development work going on as we speak.
If you are here already, you are still early in realizing the vigor and flair of this revolutionary tech.
Traditional financial institutions, governments, and regulatory bodies are all jumping in. In fact, Deloitte’s 2018 global blockchain survey with 1000 banks, revealed that 95% of the responders are working on blockchain and distributed ledger technologies.
At this moment, you and I might be witnessing the future of money and finance in the making!
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