Everything you need to know about the financial system powering Web3.
The first time Erin Holloway encountered the world of decentralized finance, she had the same question as almost everyone else: What exactly is it?
Even with nearly 20 years of financial experience working for JP Morgan, the industry puzzled her at first and piqued her curiosity. On the one hand, DeFi — as it’s called for short — is a field brimming with promise, envisioning a more egalitarian financial future run on blockchain . In it, anyone — especially those underserved by the banking industry — can take out a loan or invest in a company without going through a financial institution. What Is DeFi?
Decentralized finance is cryptocurrency’s answer to the traditional financial system. It ecnompasses any blockchain-based application that facilitates peer-to-peer financial transactions, allowing users to trade digital assets on crypto exchanges, lend and borrow crypto, purchase goods and more. Transactions are then registered, encrypted and stored across a distributed ledger, thus preventing centralized control over assets.
On the other hand, one of the more popular cryptocurrencies — the blockchain-based digital currency that DeFi depends on — started as a joke (Dogecoin) and there are countless stories of coins that could portend the future or descend into scandal.
So, which is it? The reality is somewhere in the middle. It’s still considered the Wild West of technology and finance, but its future potential also can’t be ignored.
“I did have that healthy sense of skepticism, but at the same time, I could also see what was happening,” said Holloway, who now works for Prime Trust, which provides the financial infrastructure for DeFi applications. “It was a revolution, and there were things about the traditional finance world that needed to change and change for the better.” What Is DeFi?
First, let’s take a step back and define what DeFi means.
DeFi is a broad term used to describe any blockchain-based application that allows users to process a financial transaction outside of a traditional financial institution. It’s the backbone of Web3 , and allows users to take out a digital loan, lend cryptocurrency, buy an NFT, invest in other cryptocurrencies, become a voting member of a decentralized company or dive into one of the many play-to-earn blockchain-based games .
Since it’s blockchain-based, data is stored across a distributed network of systems, what’s known as a distributed ledger , and can’t be updated, deleted or controlled by a central entity. How Does It Work?
Traditionally, any financial transaction you want to complete — from buying a cup of coffee to taking out a loan — has to go through an accredited institution like a bank. They’re there to confirm that your account exists and that you meet the rules necessary to complete the transaction.
Decentralized finance changes that equation. Instead of banks storing and controlling your funds, you store your digital assets (cryptocurrency, tokens and NFTs) in a crypto wallet, which you have complete control over. This means anyone can open an account and no entity can freeze your funds or charge you for failing to maintain a minimum balance.
Decentralized apps (known as dApps) built on the blockchain then facilitate peer-to-peer transactions thanks to what’s known as smart contracts , self-executing code that ensures a fair transaction. Smart contracts are the key behind DeFi. Just as the bank needs to verify that your account has the funds necessary to execute a transaction, smart contracts do the same thing.
If you wanted to borrow $50 in a token, for example, the smart contract would contain the parameters to receive those funds, setting the interest rate and collateral required to borrow the cryptocurrency. When the code runs, it verifies that those conditions are met and then releases the loan. And once the loan is repaid, the code will execute again and release the collateral assets back to the borrower.
In essence, it operates as a third party governing a peer-to-peer transaction, creating trust in the transaction. Where Did DeFi Come From?
If it feels like DeFi came out of nowhere in 2020, that’s because it sort of did.
The basic ingredients of DeFi can be traced back to the foundation of Bitcoin, which was created to facilitate safe, peer-to-peer financial transactions without bank involvement. Its goal was to replace traditional fintech payment systems that connect bank account to bank account to transact, like PayPal or Venmo.
Ethereum, an open-source blockchain platform and the second most popular cryptocurrency, took it a step further, providing the infrastructure for programmable smart contracts. Because […]
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