Last editedMay 20213 min read
Decentralized finance is quickly rising as a more secure, more transparent, and more efficient alternative to traditional financial services. By eliminating the need for centralized financial institutions, we create a more open and trustworthy financial system, and one that’s far more accessible.
Secured by blockchain technology, decentralized finance will reduce the risks of fraud, corruption and mismanagement of your assets. It will also make managing finance far more cost-effective and efficient, with no more overdraft fees, no costs for wire transfers, and no waiting on banking hours for a transaction to be verified.
Understanding decentralized finance
The term decentralized finance, or DeFi for short, describes a financial system that operates without the need for traditional, centralized intermediaries. We’re used to everything going through a bank and other financial institutions like a global exchange, but DeFi creates a system that can function on its own.
Perhaps the most well-known application of decentralized finance is online transactions through DeFi cryptocurrency, but decentralized finance allows us to handle a number of financial applications – like investing, insurances, exchanging, borrowing, and lending in a more efficient and transparent way.
How does decentralized finance work?
Rather than a bank facilitating transactions and services between parties, DeFi uses technology. A number of open-source protocols are being developed alongside public blockchains, forming a framework for decentralized finance to operate on.
There are two core components that allow a finance system to work; it needs an infrastructure to operate on, and a currency to operate with. In a centralized system, banks and financial institutions act as that infrastructure, while fiat money, like the US dollar, acts as currency. Decentralized finance must replace these components in order to offer a full range of financial services.
Ethereum is a platform for writing decentralized programs. Through Ethereum, we’re able to create smart contracts – automated code that can be used to manage financial services. Through smart contracts, you can establish a set of rules for how a financial service will work, and deploy those rules to Ethereum. Once a smart contract has been deployed, it cannot be altered.
Users can build decentralized apps on Ethereum to establish any financial service, and allow smart contracts to manage those services autonomously.
In order to create a reliable, secure decentralized finance system, you need a stable currency. Bitcoin is not compatible with the Ethereum platform, and Ether – Ethereum’s own programmable cryptocurrency – is highly volatile.
A stablecoin is a cryptocurrency that matches its value with a fiat currency. DAI is a decentralized stablecoin that’s pegged against the US dollar – meaning 1 DAI is equal in value to $1 USD. DAI’s value is backed by cryptocurrency collateral, rather than being backed directly by US dollar reserves. Because of its stability, DAI is the ideal currency for decentralized finance.
Decentralized financial services
The benefits of a decentralized finance system stretch beyond online payments. Money transfer is just one aspect of the traditionally centralized financial system, but decentralized finance looks to replace every aspect, including exchanges, loans, insurance, and saving plans.
Smart contracts on Ethereum are what allow these decentralized services to exist, and what allow them to operate fairly and securely.
Below are some of the financial services already supported by Ethereum:
Decentralized borrowing and lending
You could, through decentralized finance, secure a loan in a matter of minutes, without having to go through a complicated or restrictive application process.
Compound is an Ethereum-based app that facilitates decentralized, peer-to-peer borrowing and lending. Compound automatically connects lenders with borrowers, and autonomously manages loans using smart contracts. This has led to a rise in popularity of what is known as ‘yield farming’, as anyone is able to lend their crypto assets and earn interest in the process.
You can also use Compound to deposit your cryptocurrency as collateral and borrow fiat money against it.
The decentralized exchange (DEX) allows us to buy, sell, and trade cryptocurrencies on the Ethereum platform, without having to go through an exchange operator; without the need for sign-ups or ID verification; and without any fees for withdrawing funds. Furthermore, exchanging with DEX doesn’t require any initial deposit, unlike centralized exchanges.
Trades are executed autonomously, with the terms and process guided by smart contracts.
Smart contracts in the decentralized finance system make peer-to-peer, decentralized insurance possible too. In a decentralized finance system, you can connect with anyone around the world who is willing to insure your assets, and on the other end, you can insure other people’s assets at a premium, without ever having to go through an insurance company or agent. Everything happens autonomously, with smart contracts ensuring a fair, secure, and trustworthy process.
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