What we’ve been thinking: We’ve spoken at length about fintechs launching DeFi services—but until now, we haven’t zoomed in on how DeFi actually works, what it’s trying to solve, and how it may develop in the coming years.
Here’s how it works: DeFi stands for decentralized finance. As its name suggests, it aims to remove traditional intermediaries like banks from financial services processes by using blockchain technology.
This is not Bitcoin. The Bitcoin blockchain—the first blockchain to be launched in 2009—is used to accurately and securely record Bitcoin transactions, creating an alternative payment system that doesn’t need to be validated by going through traditional players like banks. DeFi services run on other blockchains, primarily Ethereum, and these take the idea of removing intermediaries from transactions to a much wider range of applications.
Who runs it? Voluntary groups of people often with no connection to one another power DeFi services across thousands of computers. These volunteers are rewarded with Ether for providing the processing power.
How do you use it? On the user side, one needs a crypto wallet to interact with DeFi. The wallet is protected by a private key—a random string of numbers and letters, much like a strong password—and is used to access and move crypto funds to pay for these services.
What problem is it trying to solve? DeFi attempts to overcome the shortcomings of running financial services on centralized platforms.
The traditional system can be cheaper to operate and supervise than a decentralized group of people. But large financial institutions can also engage in monopolistic behaviors—as seen with the recent spat between Visa and Amazon over transaction fees. Big players can also slow innovation from smaller aspiring competitors and even potentially act against customer interests, epitomized in the 2008 financial crisis.
Blockchain-run services, by contrast, distribute power across the network of participants, which in theory prevents monopolies from forming. Here are three DeFi use cases that aim to improve on centralized counterparts:
The challenges ahead:
What's next?These barriers won’t slow DeFi adoption over the long term due to three trends.