The future is here, and while the flying cars that were promised haven’t arrived yet, the finance world is speeding full-force into the future with everything from wireless payment apps on our phones to entirely decentralized finance systems.
Decentralized finance, known as DeFi for short, is a fundamentally new financial system that moves monetary control away from centralized banks and towards public blockchains.
Put more simply, DeFi has the potential to change the underlying mechanics of financing and banking, as well as how people access financial services, by using the internet and smart devices instead of going through a centralized bank.
What Is Centralized Finance?
In order to understand DeFi, it is helpful to understand how the traditional financial system works. In general, the current US financial system is largely controlled by central authorities.
For example, some aspects of the financial system are controlled by the Federal Reserve (sometimes referred to as “The Fed”). The Federal Reserve, which serves as the nation’s central bank, was created in 1913 after several financial panics caused people to withdraw their money from decentralized banks.
Mass withdrawals of money caused banks to fail and incited more financial crises.
In response to these crises, the US government created the Federal Reserve, which acts as a centralized banking system and attempts to stabilize the economy through means such as managing national monetary policy and regulating banks. Banks, which are regulated by the Fed, also have their own controls and regulations on how finances are conducted.
For example, a bank might require a driver’s license to open a checking account or a certain credit score to take out a loan.
Simply stated, whether buying groceries with a debit card or saving for retirement, most of our financial transactions go through a bank, lender, investment company or financial institution that is highly regulated.
While centralized banking was created in order to foster economic stability, it has come with restrictions on how people can access financial options, and with criticisms that putting financial control in the hands of a central body can create more risk if that central body gets it wrong.
For example, what if the Fed decides to print too much money and inflation explodes or interest rates shut out people from accessing credit lines?
Or what about credit rates in general — if people take financing out of regulated contexts, could consumers see higher interest rates on their investments?
For example, as discussed above, most financial transactions take place through intermediaries: A bank account is required in order to use a debit card. An account at a financial institution is required in order to earn interest on money.
A broker is required in order to invest in the stock market. Each of these intermediaries is a product of the centralization of the nation’s financial system — and each intermediary potentially minimizes consumers’ financial earnings.
In the most elemental way, when money is deposited in a savings account, it earns interest. The interest that money earns is funded by the financial institution where the account is located. That financial institution earns money by lending depositors’ money to borrowers, who pay interest to the financial institution.
But the interest rate earned on a savings account is not the same as the interest rate the financial institution charges the borrower. Because it is acting as an intermediary between saver and borrower, the financial institution controls both interest rates.
But would both savers and borrowers get a better deal if it was possible to make secure financial transactions without an intermediary like a bank or other financial institution?
These are some of the questions about centralized finance that supporters of decentralized finance think that DeFi can answer without necessarily losing the stability created by a centralized bank.
What Is Decentralized Finance?
At its most basic, the idea behind decentralized finance is that it would truly put money in an individual’s control.
While it might seem like there is individual control over money though robust banking options, cash management accounts, financial management apps and ATM access, each of those things actually requires turning over that money to an institution and trusting that intermediary to manage it.
The underlying goal of DeFi is to give actual control by using blockchain technology and open source coding to do the same types of transactions that currently take place largely through financial institutions.
Blockchain technology is a term commonly used in relation to cryptocurrency. At its most basic, blockchain can be thought of as a secure logbook that records transactions but is not controlled by a centralized institution.
Rather, accountability in the blockchain is ensured because the “chain” is not editable and is stored in many places instead of in one centralized institution.
If this sounds familiar, it may be because blockchain serves as the “building blocks” of cryptocurrency like bitcoin.
To understand DeFi, however, it is only important to understand that blockchain is secure, automatically generated, and able to be examined and tracked, just like a physical ledger. And unlike banks, blockchain is stored on users’ computers, which means that it’s not controlled by a central authority like the Fed.
In order for cryptocurrency like bitcoin to exist, it needs a secure ledger to track it — that’s blockchain. So is DeFi just a synonym for bitcoin and other cryptocurrencies? Not exactly. While cryptocurrencies are decentralized when it comes to issuance, transfer, and storage, they are still centralized when it comes to access and management.
Specifically, you still need to access cryptocurrencies through centralized exchanges, and many cryptocurrency projects are managed through companies which functionally act as that intermediary that DeFi seeks to eliminate. Some cryptocurrencies even tie their worth to physical currencies like the US dollar to attempt to provide stability.
DeFi takes crypto to the next level by attempting to give the benefits of cryptocurrency without the need to tie access and management through centralized access points or companies, which can obscure the open nature of these transfers and potentially lead to abuse of the system.
DeFi is a network of open-source apps based on blockchain that allow users to engage in financial acts in an entirely peer-created, peer-reviewed, open-source world, which is all based on the security of blockchain.
Because everything within the DeFi crypto universe is open source, users theoretically have the control to engage in a wide variety of financial transactions with the assurance provided by the underlying blockchain technology.
How Can Decentralized Finance Be Used?
There are many ways that DeFi crypto is and could be used. One popular way that it is being used currently is with open lending protocols. While the name sounds complicated, open lending protocols essentially seek to eliminate the centralized middleman between lenders and borrowers.
For example, instead of one person putting their savings in a bank and another person applying for a loan from that bank, two people could use a DeFi open lending protocol to lend and borrow money with open-sourced, agreed-upon contracts created by the DeFi system and stored in unalterable public blockchains.
DeFi can also be used for things like international and peer-to-peer payments. Currently, if one person wants to send money to another person, options may be limited to a third-party service or a bank in order to transfer the funds.
Currently, these services take time — it may be hours or even days between when a sender transfers money and when someone else receives it.
Additionally, these services can be expensive. Whether paying a fee to a bank for a money transfer or paying to use wire services, sending money from place to place can add up.
DeFi is one possible answer to routing money from person to person because it allows individual people to transfer money to each other securely and instantly without relying on centralized third-party providers.
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