Decentralized finance: Decentralized finance (DeFi) offers financial instruments without relying on intermediaries such as brokerages, exchanges, or banks by using smart contracts. - Wikipedia.
Decentralized finance is a new type of financial service that uses blockchain technology to create a decentralized network to trade digital assets. DeFi aims to make money available to people without having to go through an intermediary and wait days or pay high fees. These transactions are made possible by smart contracts, which allow users to transact funds directly from each other. Distributed financial databases collect and aggregate data from everyone who participates and use a consensus protocol to verify the transactions, completely removing the need for third party verification.
Breaking down the definition you could argue that Bitcoin itself was the first application of a decentralized finance protocol. It is indeed the safest and most decentralized of all the crypto assets. However, it really only has the one use case, buy and hold. DeFi is based on the use of smart contracts which can be programmed for a multitude of difference use cases. Bitcoin was origially unable to facilitate this. This is the whole reason Ethereum, the first blockchain with DeFi smart contract functionality, was created.
Traditional Finance (Centralized finance) has historically been the most efficient method of moving money around. Banks, corporations, and networks such as VISA are the entities that traditionally move money around with these big merchants receive payments for clearing transactions. Defi allows users to avoid fees charged by traditional financial institutions. Users can also choose to store their funds in a digital wallet instead of a bank account. Anyone with an internet access can use this service. However, these decentralized systems do not provide anonymity. Transactions can be traced back to the owners of the wallet.
This new financial system hasn't been tested by long or widespread usage. Governments are starting to take a closer look at these systems, with the intention of regulating them. One of the main risks of DeFi include no consumer protections. You don't have any consumer protections when using decentralized finance which means users may not be able to get their money back if something goes wrong. Consumers do have some protections in centralized finance. Banks are also required to hold certain amounts of capital as reserves. These safeguards help prevent future banking crises. There are no such safeguards in DeFi. Hackers are also a serious threat to DeFi. Blockchain technology like Bitcoin is nearly impossible to hack, but the other parts of DeFi are vulnerable to hacking.
In 2016 a Decentralised Autonomous Organisation called The DAO launched on the Ethereum Blockchain and proceeded to crowdfund over $150 million dollars. The DAO had plans to take funds and invest on behalf of the members and return the proceeds to the stakeholders. However, a flaw in the code enabled it to be hacked and about $50 million dollars was stolen. This is what led to the controversial fork of Ethereum and Ethereum Classic, with the majority voting to roll back the transactions and those who didn't agree continuing with the classic chain.
DeFi's future looks very bright. Investors will soon be able to deploy assets in creative ways that seem unimaginable today. DeFi also carries huge implications for the big data industry as it matures to allow new ways to commodify and monetize data and we can see this today with the evolution of play to earn and move to earn in the defi space.
Defi has a lot of promise, but it still needs work before it can be used by more people. To educate people about the potential of Defi, we need to keep building better tools.