Finance and Accounting

Rise of DeFi: How decentralized finance is revolutionizing the landscape

Decentralised Finance (DeFi) uses blockchain technology to provide lending, investment, or swapping services for digital assets without the need for conventional facilitators as the transactional hub. Centralised financial systems are run by governing bodies that manage banking, lending, and trading. End consumers must go through several intermediaries for any financial need, from home loans to bonds. DeFi runs on peer-to-peer relationships, providing a complete set of financial services from everyday banking, loans, mortgages, and asset trading to complex contracts. DeFi has grown due to its potential to transform the financial system with significantly more accessibility, transparency, and security. Around 6.6 million unique addresses had bought or sold a DeFi asset by January 2023.

How does the DeFi system work?

DeFi protocols encapsulate the logic of financial operations in the form of smart contracts to operationalise financial services. Smart contracts are software programs within the blockchain that run when predetermined conditions are met. Studies attribute the following four qualities to DeFi: competitiveness, contestability, composability, and non-custodianship. The DeFi ecosystem does not assign miner or validator nodes to execute transactions. The nodes vie against each other to be the executor. Users can choose from several available protocols as protocol implementation is open to all. DeFi allows the merging of existing protocols to create more sophisticated protocols. Ownership of assets in DeFi is a straightforward custodianship without any go-between entities.

DeFi systems have a settlement layer, an application layer, and an interface layer. The blockchain provides the settlement layer’s functionality. The settlement layer implements the consensus protocols and replicates the state across all the nodes. It is responsible for the completion of financial transactions and the fulfilment of obligations. Smart contracts implement the crypto assets, primary protocols, and the combined secondary protocols that make up the application layer. Crypto assets reflect the financial value that a user holds and uses in transactions. Protocols use crypto assets and provide financial services like lending protocols, derivatives protocols, and decentralised exchanges (DEXs). The interface layer has the DeFi applications’ front-ends that facilitate user interaction with the smart contract code. The front-ends are usually web-based or mobile device applications.

Oracles are smart contracts that connect the DeFi blockchain and the external world. They are used to obtain and incorporate off-chain and external sources of information into the DeFi protocols, such as real-time asset prices. Prices of cryptocurrencies like bitcoin and ether are volatile and fluctuate wildly. A stablecoin is linked to gold, national currencies, and other assets to maintain price equilibrium. Stablecoins are growing in use in DeFi systems.

How are DeFi services implemented?

A decentralised exchange (DEX) enables the trading of cryptocurrencies, and the transactions are settled directly on the blockchain. DEXs are implemented by smart contracts that algorithmically set the prices of various cryptocurrencies against each other. They use liquidity pools, where investors lock funds in exchange for interest-like rewards, to facilitate trades. Lending protocols have smart contracts that hold the crypto deposit of the lenders. The lenders earn an annual interest, which rises with the growth in borrowing. DeFi borrowing usually involves high collaterals due to the volatility of cryptosystems. Smart contracts act as intermediaries, dealing with the borrowers on behalf of the lenders.

Why is DeFi growing?

Globally, approximately 1.7 billion adults do not have access to a bank account. DeFi is an opportunity for financial inclusion and the erasure of geographical barriers, with participation requiring only internet access and a crypto wallet. DeFi replaces conventional intermediaries and mechanisms with automated processes, decreasing the costs associated with services and enabling peer-to-peer transactions.

The DeFi ecosystem is interoperable, with varied protocols and applications co-existing and interacting seamlessly. It is also open-source, with protocol and application code available for inspection. Openness and interoperability are catalysts for ongoing experimentation and innovation. The composability fosters the creation of new DeFi services by using existing ones as building blocks. DeFi is permissionless, and developers do not need approval from a central authority to deploy new products, speeding up advances and breakthroughs. DeFi allows users complete access to funds, minimising the risk of centralised control and asset seizure. DeFi is attractive for investors as it provides higher yields on assets.

DeFi faces many challenges, like fraud, money laundering, and lack of protection for consumers. In 2021, more than ten billion dollars were lost to DeFi scams. Tax payment is problematic as reporting the transactions is difficult, with DeFi being built on permissionless and pseudonymous blockchains. DeFi systems need to be regulated in a way that preserves blockchain architecture but ensures accountability and regulatory compliance. Before processing transactions, there should be checks to ascertain that addresses belong to certified entities. Infrastructure for collaboration between decentralised entities and regulators should be set up to prevent money laundering and terrorist transactions.

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