DeFi 101: How Blockchain changed the world of finance

If you’re reading this article, you have surely noticed something is changing in the world of finance. Cryptocurrencies like Bitcoin have been around for a long time but their use cases have been limited and of a speculative nature.?

We are now, however, experiencing a paradigm shift within the financial industry which is being propelled by the same technology on which cryptocurrencies stand.?

Blockchain technology allows for value to be created and transacted in a completely trustless manner and with no counterparty risk. While this is an incredible step towards financial liberty, privacy, and ownership, we are only scratching the surface of what can be achieved with the help of an immutable and distributed ledger.?

The decentralized nature of blockchain allows for a whole new set of financial services to flourish without the need to trust a centralized agency like a bank or government. We have dubbed this phenomenon as Decentralized Finance (DeFi). As so, the crypto-community has now coined the traditional financial sector as Centralized Finance (CeFi).?

As CEO of Coinchange, I want to take some time to share what I’ve learned on my journey throughout the cryptosphere and on my previous positions as an advisor at Wattum, and general partner at BGS. By the time you finish reading this post, I want you to understand the differences between CeFi, DeFi, and the role of blockchain in this new economic model.

The old way: Fallible trust

There’s an old saying: “Trust makes the world go round.” We need to trust a bank to hold our funds for us and that same trust comes from the reputation and capital that has been established by the aforementioned institution.?

This is the way it has always been because there was no alternative. Centralized finance is characterized by the involvement of a third party and by the associated trust one deposits in a third party as the intermediate for financial transactions. This system is the traditional finance model we all know, which is built on the old foundations of borrowing and lending money from banks, insurances, mortgage companies, and other financial institutions.?

Something to keep in mind is that in a CeFi setting, business ethics and trust between the involved parties are fundamental.? All financial activity (be it trading, lending, transacting, etc) will need to go through an intermediary, which can be considered as a single point of failure. Said ethics and trust can sometimes go out the window when corruption or even sheer incompetence comes into the mix.?

Put shortly, trust is fallible and comes at a high cost: The fees paid to banks, insurance companies, exchanges, and all other venues. However, this cost can sometimes multiply when the “trusted” party behaves in an unexpected way. We’ve observed this in the 2008 financial crisis and in many other fractional reserve banking situations. So, if we can’t rely on trust, what should we do?

DeFi: In code we trust

Decentralized Finance or DeFi is the answer to these issues. Technology has allowed us to remove trust from the equation and to automate certain tasks where mankind tends to stave. So how does it work?

The advent of Bitcoin brought along blockchain technology. A distributed ledger in which no centralized party is in charge of keeping records. Secured by a massive amount of energy and hashrate, the blockchain ensures that all financial transactions and records are legitimate and immutable without the need to trust one single party. Instead, we trust the thousands of “peers” spread out throughout the world who are monetarily incentivized to behave in a predictable manner.

This model opens the door for what is now known as “Smart Contracts”. These are self-executing clauses that do not require any human input in order to perform their task. If properly programmed, smart contracts are infallible as they are not subject to the typical pitfalls of the human condition: greed, incompetence, and so forth.

Moreover, these smart contracts eliminate the middleman fees that incur in traditional financial services which is why DeFi has been gaining so much traction. Trading, Lending and borrowing, insurance, etc, all of this can be automated without the need to pay for someone who can ultimately be the biggest pitfall in the entire system.

With that said, it’s easy to understand why DeFi is essentially faster, cheaper, and more permissive than the traditional financial system. It is nothing short of a revolution. Without the involvement of intermediaries, this model can operate at a faster pace, improving traditional services and even creating completely new ones.

Let's cut to the chase?

1 - The main difference between CeFi and DeFi is not the type of money used, but the involvement (or not) of a third-party in financial transactions;?

2 - In CeFi, we trust people. In DeFi, we trust technology;?

3 -? DeFi is a power to be reckoned with and it’s growing fast.

4 - Blockchain is safe. Very safe.

5 - Blatantly, without blockchain tech, decentralized finance doesn't exist.

Where are we headed?

I believe Decentralized Finance is here to stay. However, there are many regulatory hurdles and technological and scalability pitfalls to be dealt with. For DeFi to become a fully-fledged industry within the financial realm, it needs to be appropriately regulated and structured. This can only happen when both worlds come together to adapt and evolve.

While decentralization can be seen as a positive element, it can also be used for nefarious purposes. Therefore, we need regulators, governments, and banks to understand DeFI and know how to incorporate it within their systems to avoid a figurative “bloodshed.” This is why I wanted to give you this brief introduction to the CeFi and DeFi concepts, as it all starts from the bottom: the more people know about DeFi, the easier it will be for it to become mainstream.

To continue moving forward on your crypto journey, keep an eye on our blog. You can read more here.?