What's Driving Decentralized Finance?

For those new to blockchain and crypto, you may have heard the term decentralized finance, or DeFi for short. What exactly does DeFi mean, and what’s driving its rise? A little context on both the business and technology side will help to explain it.

An alternative to 'trusted third parties'

If you want to pay someone for an item or service and that person is in front of you, you can just take money from your wallet and pay the other person directly. In technical terms, this is a “peer-to-peer” payment. There is no other person involved. Just the two of you.

On the other hand, if you and the other person (or party) are some distance away, or even halfway across the globe, in general, you want a trusted third party such as a bank, wire service or retailer (e.g., Amazon) to handle it for you.

From just $107.88 $24.99 for Kiplinger Personal Finance

Become a smarter, better informed investor. Subscribe from just $107.88 $24.99, plus get up to 4 Special Issues

CLICK FOR FREE ISSUE

Sign up for Kiplinger’s Free Newsletters

Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.

Profit and prosper with the best of expert advice - straight to your e-mail.

Sign up

However, some computer scientists have been working on ways to go back to a peer-to-peer payment or exchange method, where it would feel like you were transacting directly with another person without that “trusted third party.”

These initiatives are driven by the prevalence of bank frauds, theft and scams or even government intervention (e.g., debanking). These computer scientists wanted a system that no single “trusted” party controls, but is controlled by a global community at large.

In 2008, someone published a blueprint — a white paper for a decentralized cryptocurrency on the blockchain. The author, writing under the pseudonym Satoshi Nakamoto, published the white paper for Bitcoin. (Note: I am currently not an investor in nor own any of the blockchains and crypto mentioned in this article.)

Although bitcoin (and succeeding cryptocurrencies) solve the problem of a trustless peer-to-peer way to send value over the Internet without requiring a bank or wire service, blockchain’s use cases don’t stop there.

After all, finance is not just about sending payments to and from parties.

Enter DeFi

The summer of 2020 is often called “DeFi Summer.” Because of the pandemic, applications such as Uniswap and Aave suddenly garnered more users and allowed other aspects of finance, not just value remittance (such as what bitcoin does), to be transacted on the blockchain (on-chain).

These applications run on smart contracts, which initially ran only on another blockchain, ethereum, but have since spread to most new blockchains such as Solana and others.

DeFi allows users to transact with these smart contract decentralized applications (apps) without the need for banks.

They also are an alternative to third-party centralized crypto exchanges, such as Coinbase and Binance, which although they offer good service, especially to newcomers, are not the ethos of decentralization if you ask the hardcore crypto enthusiasts.

DeFi is a catch-all term that encompasses everything from token swaps (e.g., ethereum ERC20 tokens); intra-chain bridges (e.g., from ethereum to Solana and vice versa); yield and liquidity farming, which is like earning interest from a time deposit; and so on.

I cannot discuss all the possible applications that DeFi encompasses here, especially since more are in development.

The pushback

When you deal with a bank, you normally deal with a layer of people such as tellers, bank managers, customer service agents and the like. Even if you do electronic banking, this is simply automating part of your bank account. There are still people who work in the bank who handle your money.

DeFi is different. Basically in DeFi applications, bankers are replaced with software smart contracts running on blockchains. Because these are software smart contracts, there is not much room (if at all) for human discretion.

If you have deposited the payment, the smart contract should remit that payment to an intended recipient as defined in the code. Basically, if one party has satisfied the requirement, the transaction should be processed.

Once the transacting parties have done the required deposit, payment or task, then the smart contract ensures that this transaction proceeds, with no “trusted human third party” to exercise discretion on whether to stop it or not.

Of course, this technology does not win fans in the traditional banking and finance space.

For example, the European Central Bank (ECB) opposes many of Trump’s pro-crypto policies. Instead, they are advocating for central bank-controlled digital currencies (CBDCs).

Although this would use blockchain technology, it is important to note that their vision of blockchain-based finance is that they would centrally control all the aspects of the network, so ownership would not be decentralized.

The takeaway

DeFi is probably the future of blockchain and crypto. It allows for peer-to-peer financial transactions even at long distances, not encumbered by bank and government restrictions to some extent, thus regaining some of our financial freedom and privacy.

We pay someone in cash when we are face-to-face with them without any other party involved; DeFi advocates want the same for sight-unseen transactions, because the “trusted third parties” who are supposed to ensure these transactions happen smoothly have not always lived up to that task.

Related Content

• Is Your Cryptocurrency Safe? How to Shield Digital Assets
• Digital Asset ETFs: A Less Risky Way to Invest in Crypto?
• Heirs Inheriting Crypto? Don't Make It a Headache for Them