Satoshi Nakamoto's original Bitcoin whitepaper described removing financial intermediaries to improve micro-transaction economics. While high gas fees have kept these goals out of reach, Ethereum's smart contracts have continued to advance Satoshi's goals by promoting the decentralization of financial services.
In this article, you'll learn about the rise of decentralized finance (DeFi) platforms, why they're becoming so popular, and potential challenges.
What is DeFi (Decentralized Finance)?
Most traditional financial services rely on trusted intermediaries. For example, depositors rely on a bank's loan officer to lend their money to borrowers and generate interest income. However, these intermediaries add cost (e.g., a bank's profit) and biases (e.g., creditworthiness).
Decentralized finance, better known as DeFi, refers to financial applications built atop blockchains. These applications seek to remove intermediaries (e.g., banks or brokers) from financial transactions and democratize access to financial services.
Under the hood, DeFi platforms rely on self-executing smart contracts, where a transaction's terms are written into code. For example, a borrower can request a loan, deposit collateral via a smart contract (at rates set in code), and repay the loan upon maturation.
Benefits of DeFi
- Inclusion – Traditional banks rely on credit scores and other metrics that exclude many individuals and businesses. But DeFi's code-based approach lets anyone participate in the system if they meet collateral or other requirements.
- Permissionless – DeFi participants don't need permission from a centralized authority, which means they don't need to provide income verification or other documents. Instead, they require little more than a digital wallet and internet connectivity.
- Transparency – DeFi platforms rely on smart contracts and public blockchains, enabling anyone to see transaction terms, fees, and other aspects of the system. As a result, there's less room for fraud and fewer security vulnerabilities.
- Lower Cost – DeFi platforms have the potential to significantly lower transaction costs by cutting out intermediaries, particularly as the Ethereum blockchain moves toward a proof-of-stake (PoS) consensus mechanism to lower gas fees.
Early DeFi projects targeted lending and borrowing. For instance, the first recorded DeFi project was MakerDAO, which enables anyone to lend themselves DAI stablecoins by locking up ETH in a smart contract. But since then, the DeFi ecosystem has dramatically expanded to include everything from exchanges to insurance schemes.
Example of DeFi
- Lending – DeFi platforms enable users to lend and borrow crypto without using a centralized authority. Lenders can earn interest and borrowers can access funds by providing digital collateral.
- Exchanges – Decentralized exchanges, better known as DEXs, facilitate peer-to-peer crypto trades without relying on a centralized authority, enabling users to maintain control over their assets.
- Stablecoins – Stablecoins provide a digital alternative to fiat currencies by tying their value to a basket of cryptocurrencies, fiat currencies, or hard commodities (e.g., gold).
- Insurance – DeFi platforms can help decentralize risk management and protect users against smart contract failures, market volatility, and other risks while enabling underwriters to earn income.
The Rise of Decentralized Exchanges (DEXs)
Cryptocurrencies operate on different blockchains, making them challenging to trade and convert. As a result, centralized exchanges like Coinbase and Binance emerged to serve as intermediaries. They would accept fiat currency and cryptocurrencies and convert them into any supported cryptocurrency or back into fiat currency.
By 2014, decentralized exchanges began facilitating peer-to-peer transactions. Using smart contracts, they match buyers and sellers or use liquidity pools to facilitate trades without a central authority. They also determine the price of a token based on supply and demand. However, they were difficult to use and often lacked liquidity.
Still, they provided several critical benefits:
- Security – DEXs enable users to maintain control of their assets and private keys, making them less susceptible to hacks and theft. However, that cuts both ways if you lose your keys!
- Privacy – DEXs do not require any personally identifying information, providing users with far more privacy than centralized exchanges that may need to comply with government regulations.
- Censorship – No single entity owns a DEX, making them harder for governments to censor or shut down. Users also maintain control over their assets, limiting any government seizures.
These days, DEXs are easier to use, with better liquidity and a more approachable trading interface. For example, Nash offers a mobile app that rivals most established centralized exchanges, enabling users to buy and sell popular cryptocurrencies with full custody of their assets. And bisq offers even more decentralization via a MacOS app.
DeFi Growth & Challenges
Decentralized exchanges and other DeFi platforms could experience significant growth over the coming years.
Ethereum's recent upgrades have addressed scalability and transaction fee concerns, paving the way for more cost-competitive financial services. Meanwhile, decentralized identity solutions could help DeFi platforms comply with government regulations (e.g., KYC) while preserving their privacy and decentralized nature.
Traditional financial institutions are also starting to dip their toes into the market. With deeper integrations, DeFi platforms could integrate hybrid approaches combining elements from DeFi and conventional finance. As these lines blur, the industry could reach a broader customer base and achieve more mainstream consumer adoption.
Despite these trends, the DeFi space also continues to struggle with challenges that could derail its growth, such as:
- Security – Smart contracts help enforce transparent rules without bias but may also contain vulnerabilities and errors. For instance, the Nomad Bridge hack resulted in the loss of $190 million in funds.
- Regulations – DeFi platforms have caught the attention of regulators and policymakers worldwide. For instance, mixers like Tornado Cash have seen sanctions from the U.S. Treasury.
- Centralization – DeFi platforms may have decentralization in their name, but some concerning centralization elements exist. For example, some platforms use centralized data sources or have centralized governance structures that undermine their goals.
- Manipulation – The open-source nature of DeFi protocols opens them up to price manipulation. For example, oracle manipulation has reportedly cost protocols nearly $400 million in 2022 alone.
As the DeFi industry evolves, new technologies are emerging to address these challenges and increase security and compliance. Decentralized autonomous organizations (DAOs) are addressing centralization concerns, decentralized identity is helping compliance challenges, and more secure approaches could address smart contract security concerns.
The Bottom Line
Decentralized finance (DeFi) has become a $50+ billion industry since its modest beginnings in 2014. But these figures could just be scratching the surface of the multi-trillion dollar global financial services industry. While challenges remain, DeFi continues to push the boundaries of what's possible and take on new use cases.
If you participate in the DeFi space, ZenLedger can help you organize your transactions and compute your tax obligations each year. By connecting with your exchanges and wallets, we can automate a process that typically takes hours or days to accomplish. And we provide an audit trail to ensure that you're accurate and compliant.