Decentralized finance (DeFi) is a blockchain-based form of finance that does not rely on central financial service providers such as brokers, exchanges, or banks to offer traditional financial instruments, but instead uses smart contracts on blockchains. DeFi uses a multi-layered architecture and flexibly composable building blocks.
What Are the Advantages of Decentralized Finance (DeFi)
The exclusion of central middlemen from all types of transactions is considered a significant advantage of DeFi.
DeFi revolves around decentralized applications, also known as DApps, that perform financial functions on distributed ledgers called blockchains. Instead of transacting through a centralized intermediary such as a crypto exchange or a traditional securities exchange on Wall Street, transactions are conducted directly between participants mediated through smart contract programs. These smart contract programs, or DeFi protocols, are usually run using open-source software created and maintained by a community of developers.
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DApps are usually accessed through a Web3-enabled browser extension or application, such as MetaMask, which allows users to interact directly with the Ethereum blockchain through a digital wallet. In addition to the Ethereum blockchain, other blockchain ecosystems are increasingly developing services that offer DeFi services and can be used with dedicated wallet applications. Many of these DApps are able to work together to create complex financial services. For example, stablecoin holders can lend assets such as U.S. dollars or euros in a lending protocol such as Aave to a liquidity pool and allow others to borrow these digital assets by depositing their own collateral that exceeds the loan amount in value. The protocol automatically adjusts interest rates based on the current demand for the asset.
In addition, Aave introduced “flash loans”, which are unsecured loans of any amount that are taken out and proven to be repaid within a single blockchain transaction. While there may be legitimate uses for flash loans, such as arbitrage, collateral swapping, self-liquidation, and the liquidation of leveraged positions, several exploits of DeFi platforms have used flash loans to manipulate the low prices of cryptocurrencies.
Another DeFi protocol is Uniswap, a decentralized exchange, or DEX, that runs on the Ethereum blockchain. Uniswap allows trading of hundreds of different ERC20 tokens issued on the Ethereum blockchain. Instead of using a centralized exchange to execute orders, Uniswap incentivizes users to form liquidity pools in exchange for a percentage of trading fees earned by traders who exchange tokens in and out of the liquidity pools.
These liquidity pools allow users to move from one token to another in a completely decentralized manner while maintaining control over their funds. At the same time, liquidity providers are encouraged to deposit tokens for a portion of the fees generated by exchanges. Liquidity providers can remain completely passive after pooling their tokens, as the smart contract ensures the automatic adjustment of the liquidity provision logic to the current market price.
Therefore, DEXs are operated by automatic market makers based on mathematical formulas that make it possible to estimate the exchange rate between two assets, taking into account the liquidity present in the protocol.
Since no centralized party runs Uniswap and any development team can use the open-source software, there is no entity to verify the identity of the people using the platform to comply with KYC/AML regulations. It’s not clear what position U.S. regulators will take on the legality of a platform like Uniswap.
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