While information technology advances unceremoniously over most areas of daily life, finance and commerce are their great patrons. In the case of so-called decentralized finance, it is a market that in 2020 exceeded 14 billion dollars and that promises a lot. However, first, we must know its operation and characteristics.
What are we talking about when we talk about Decentralized Finance?
Finance is a field in which investors and savers allocate their capital to finance third-party activities and continuously grow that capital. Decentralized finances share this purpose, although they pursue it by implementing IT solutions and applications; blockchain technology and smart contracts are a fundamental part of its computing architecture.
The abbreviation De-Fi comes from the agglutination of the terms Decentralized and Finance; In short, the resulting term refers to the ability of these computer elements to automate most of the known operations, transactions, and investment instruments.
Analogous to the creation of cryptocurrencies, decentralized finance recognizes the usefulness of tools such as the blockchain to reduce the influence of third parties in the supervision and execution of financial operations, which effectively means opening up the activity to a greater number of users. In this way, the orders and operations are usually executed when certain circumstances or conditions occur that are previously incorporated into computer language.
In short, this decentralization does depend on applications that allow the creation of exchange platforms, exchanges, cryptocurrencies, and predictive markets whose activity is carried out through the implementation of data mining and the collective registration of users. As for the object of its activity, it is the same as in traditional finance. The only real difference is that it is developed thanks to blockchain technology.
This idea of a decentralized financial system was born with the very idea of economic liberation that predicted the creation of bitcoin and chain mining technology, in mid-2009. At that time, cryptocurrency was only talked about as a payment method, an attempt to replicate the workings of cash.
However, blockchain technology had much more interesting applications. One of the first firms to tap into its true potential was Ethereum, an open source platform that launched its cryptocurrency, ether, in 2013 to finance its operations. This platform, by having an open code, allows the modification of said code and allows users to create smart contracts, essential for the DEFI.
The network was launched in the market in 2015, to develop better features for blockchain networks. Although smart contracts are user-programmable computer products, the first products created by Ethereum were stablecoins —stable cryptocurrencies—, which, unlike bitcoin and other cryptocurrencies, are backed by a foreign value, such as the dollar. In this way, uncertainty and volatility, common in other cryptocurrencies, are reduced, and a less erratic market is established.
Stablecoins were a first step in the development of Ethereum’s activities as a leader in smart contracts. For 2018, its developers are especially focused on production for liquidity and crypto exchange markets. In 2019, this financial area channeled around 500 million dollars a year. By 2020, the investment methods and lending platforms that implemented this technology registered a value of 14 billion dollars thanks to the smart contracts created by Ethereum. Today the need for smart contracts is growing rapidly, and with just a few clicks, one can hire a top smart contract development company.
Operation of decentralized finance
We know that DEFI applications and platforms use smart contracts as a fundamental architecture. These contracts are self-executing and can be programmed by anyone with computer skills. They allow transactions to be carried out automatically when certain previously specified conditions are reached; for example, the liquidation of an asset upon reaching a certain price or date.
Thanks to this, it is possible to speak of a decentralized financial market, since the execution of transactions is not human. Smart contracts also record the data of the operation in the permanent list of the blockchain. However, this operation is not entirely independent of the participation of third parties: precisely, a fundamental characteristic is the intervention of the so-called blockchain oracles; these are agents that record information that comes from outside the blockchain.
Thanks to this mechanism, contracts and tools can be developed by anyone who has the necessary knowledge in programming and blockchain technology, while operations can be owned by anyone regardless of their banking or financial affiliation.
This new area, although decentralized and open to the general public, depends on the development and operation of computer products and applications —and obviously on a telecommunications infrastructure such as fiber optic cables.
For info, today there is a parallel market for financial services such as loans and credits, savings accounts, digital banking, and many more.
Advantages and disadvantages of the model
There are many considerations surrounding a new technology that is growing so rapidly. We will mention only some of them: among the most optimistic proposals, it refers to the always-weighted economic liberation and financial autonomy; on the other hand, from a somewhat more apocalyptic perspective, all kinds of reservations and fears emerge regarding fraud, embezzlement, and lack of control resulting from the indiscriminate opening of this market. Making mistakes in a transaction represents a great risk since no organization or entity guarantees the funds and that can force restitution.
Power and economics go hand in hand, and for a long time—and still today—large financial institutions and organizations have dominated the creation and exchange of value globally. Information technology, the internet, and DEFI platforms and applications represent a democratization of the economy and the individual ability to independently control and manage personal wealth. Blockchain technology favors transparency and limits centralized power over markets.
For the same reason, the traditional financial market was accessible only to those who had large sums of capital whose investment and management justified the cost of intermediaries and institutions such as stock exchanges. By automating operations and simplifying platforms, today the average user can invest relatively small sums of capital without this producing a detriment in the return on said capital.
In principle, it should be noted that, like many of the technological advances of recent times, the implementation and popularization of this technology and its effects on society are still too young to be analyzed in depth. However, some well-founded criticisms can be mentioned.
First of all, it is a market that carries a much higher financial risk. The user, exposed to it indiscriminately by unknown developers and economic agents who must not respect a code of conduct, much less legislation that regulates their activity, finds themselves at the mercy of certain operations about which they may know very little. There are countless frauds and embezzlements in the last couple of years that can be cited as examples.
Second, smart contracts become a technological product in development that can have design flaws and become the target of criminal organizations. It doesn’t help that these are instruments that represent huge sums of money.
In short, decentralized finance represents a new and exciting market that is still under construction. The smart contract specialists are optimistic about it; There are many ways to stay up to date and learn what the most reliable developments are and what benefits they represent for this new financial ecosystem.