What is Decentralized Finance?

Decentralized finance or DEFI, refers to the application or use of Distributed Ledger Technology (DLT) in finance. It involves offering financial products or administering financial services such as money transfers and loan acquisitions, without any intervention from traditional systems such as banks.?

Besides the omission of central authorities, decentralised finance goes further to involve: the provision of financial services to highly remote regions, increased accessibility of persons with different statuses to financial services, and access to financial services without internet connectivity.?

Elements of Decentralised Finance

There are several unique elements of decentralised finance. Each of these nine elements either plays a role in the overall success of decentralising financial services and products or creates an edge for the concept. Below, we list out each of these different elements and explain what they are:

Token Transfers: Native Blockchain Transactions:

This is more or less the most widely recognized element and use of decentralised finance: being able to carry out native blockchain transactions. A token, here in our context, refers to an asset that stores value or information and also acts as a means for the transfer or verification of such value or information.?

Decentralised finance effectively allows the transfer of tokens from one digital wallet to another. As the Law Insider explains, this token transfer is “any direct or indirect offer, sale, contract to sell, assignment, pledge, grant of any option to purchase, any short sale or other transfer (voluntarily and involuntarily), or other disposals of any of the Purchased Tokens or the private key(s) to any digital wallets containing any Purchased Tokens.”?

The transfer of tokens in a native blockchain transaction is exactly similar to electronic money transfer services offered by today’s financial institutions. However, being decentralised, blockchain transactions are visible to all and sundry. The moment a transaction happens, it is irreversibly documented on the blockchain.?

Market Making via Smart Contracts:

Market making is a long-existing property of traditional financial markets. It entails market makers providing liquidity and creating the right conditions for sales and trades to take place. In decentralised finance, market makers bring together crypto exchanges, investors, and projects. Most of their work is facilitated using smart contracts.?

Smart contracts are computer programs developed as a protocol for implementing automated transactions. They are fulfilled or executed on the basis that a preset condition is met.?

Smart contracts effectively promote market-making in cryptocurrency exchanges. They work by monitoring a blockchain for instant trading values and cryptocurrency prices, analysing this information using pre-programmed algorithms, and determining when best to execute market trades to reduce volatility and increase market efficiency.?

Oracles: Importing External Data:

We have just mentioned that market-making smart contracts need to monitor the blockchain for instant trading values and cryptocurrency prices. A technology referred to as oracle plays a key role in this.?

Oracles bring off-chain, real-world data onto a blockchain environment to facilitate the work of smart contracts. They more or less source and import external data, for application within a blockchain. Oracles could also be used to deliver blockchain data to outside web3 environments.?

Borrow/Lending: Banking Functionality:

Similar to traditional finance, decentralised finance possesses banking functionalities such as borrowing and lending. This is once again made possible through smart contract operations. In this case, smart contracts use pre-set rules to match borrowers with lenders and then employ algorithms in determining interest rates, repayment terms, and loan expiration periods.??

The role of decentralisation here is that no one authority is responsible for dictating interest rates and other loan conditions.?

Cross Border Finance: Bridges, Wrapped Tokens:

Cross-border finance naturally refers to the operation of financial products or services between two or more countries. Within the deFi ecosystem, the cross-border concept is not about physical transaction locations. Instead, it is about the digital location - that is, the specific blockchain from which a transaction occurs and the number of different blockchains involved in a transaction process.?

This infers that digital asset transactions might entail moving tokens from one blockchain to another. Transactions that take this route are complex and they are impossible unless facilitated by bridges and wrapped tokens.?

A bridge is a special software that connects different blockchains and enables the transfer of data between them. Since all blockchains usually have their own unique protocols, consensus mechanisms, and native tokens, assets transferred from one blockchain must be aligned with the parameters and properties of the destination blockchain. This is where wrapped tokens are needed.

Wrapped tokens simply help in modifying assets or native tokens from the sending blockchain to resemble assets or native tokens on the receiving blockchain, to facilitate the transfer process and ensure a smooth operation.?

Stable Coins: Tying Tokens to Fiat:

Stablecoins are digital asset mimics of real-world currencies. They are close and highly similar to the fiats they represent, so much so that they are described as being tied to these fiats.?

The relationship between stablecoins and fiat currencies is linear and it is often focused on their prices. What it means is that the price of a stablecoin increases and decreases in accordance with real value fluctuations of the currency it is pegged with. Ideally, this gives stable owners the benefits of fiat and cryptocurrencies.?

Synthetics and Perpetuals:

Synthetics and perpetual are important trading and exchange elements existent within the decentralised finance ecosystem. Synthetics refer to assets that collateralize cryptocurrencies by cloning real-world assets and replicating their values. On the other hand, perpetual are a type of derivative product trading synthetic assets that are margined.?

NFTS: Digital Collectibles

Blockchain was designed to promote the use of cryptocurrencies for decentralised finance. Today, the idea of decentralised finance remains the same but the world of digital assets has changed greatly. In addition to cryptocurrencies, digital assets have grown to include collectables known as non-fungible tokens or NFTs.??

NFTs are unique digital identifiers stored on a blockchain and employed to certify the ownership and authenticity of a specific digital or physical asset. While they are more popularly used to represent digital artwork, NFTs can also represent images, music, and many other forms of data. They can be sold and traded for money.

The noble NFT technology was developed in 2014 but a recent boom in 2021 brought the digital asset to light, disrupting the global art industry and leading to sales of up to 17.7 billion.?

DAOS: Tokenized Governance:

DAOs or Decentralised Autonomous Organisations constitute what is known as tokenized and decentralised governance. A DAO is a system that promotes decentralised decision-making and, at the same time, represents a member-owned community.

DAOs are built after specific tokens. Their members are holders of the DAO token and these individuals are responsible for casting votes in decisions regarding the token and the community itself. Since DAOs push the idea of tokenized and decentralized governance, their votes, decisions, and activities are published on a blockchain to provide visibility to the public.?

Conclusion

Decentralised finance operates parallel to traditional financial systems but significantly improves processes, outcomes, and benefits to users. The ecosystem combines the use of blockchain technology with concepts like decentralisation to offer financial products and services which are transparent - through visibility on blockchain transactions, accurate - through smart contracts executions, secure - through consensus, and efficient - through distributed efforts and decision-making.?

As a financial institution or innovator in this sector, you can consult Convexity([email protected] ) to guide you in the implementation of blockchain infrastructure to give you leverage in the evolving financial landscape.