Decentralized finance: what it is and how it works

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Decentralized Finance – DeFi is a new technological and financial ecosystem, formed by a set of IT protocols that develop on the basis of decentralized networks that exploit blockchain technology . Its purpose is to make people and businesses recover their trust in traditional finance, making it transparent, secure and democratic. In this guide we will discover the main characteristics of decentralized finance, and we will analyze the main advantages over traditional finance and fintech .

What is decentralized finance?

The peculiarity of decentralized finance is the lack of censorship , both from the point of view of the technology you choose to use and from the regulatory point of view. The creatives and geniuses of our time, the developers , have the opportunity to give free rein to their creativity by using open-source technologies, without bureaucracy and resistant to censorship by governments or financial market supervisors. The problem is to agree on which technology to use, the parties that are currently facing are different: those of Bitcoin and the Lightning Network on one side and Ethereum lovers on the other.

Developing a DeFi solution allows developers to worry about bureaucracy only a posteriori and not a priori, one should not have to ask anyone’s permission to write computer code. It is a bit as if before doing a search on Google, you had to check the civil or criminal code. The internet does not work that way nowadays.

Decentralized finance is in its infancy, some projects and startups have been launched in 2019. The first investors began to take an interest in the issue, it is a few months ago the news that the famous venture capital fund Andreessen Horowitz (also known as a16z) invested $ 25 million in compound finance .

Decentralized finance: how it works

Blockchain technology is part of the wider family of Distributed Ledger Technology (DLT) to which they add some typical features. A Distributed Ledger is a database shared between multiple participants. Most companies currently use a centralized database. DLTs store data on independent synchronized computers, increasing security and interoperability. A Distributed Ledger eliminates the need for a central authority or broker to process, validate or authenticate transactions.

Main advantages of decentralized finance

Among the aspects on which it is important to pay attention to assess the effectiveness or not of decentralized finance solutions, one must not focus on their performance, in fact currently the main fintech solutions (apps, platforms and marketplaces) guarantee superior performance compared to the solutions DeFi but on trust .

Fintech startups develop predominantly proprietary or private software, in short, not open-source, which cannot be modified by users except if requested and authorized by the company. Software always runs the risk of being censored by an authority.

DeFi allows the creation of new markets. But decentralized markets present the same problem as all-new markets: adoption is necessary to generate liquidity and liquidity allows for increased adoption. While decentralized finance can create new markets and allow new users to access them, it does not automatically create liquid markets.

Decentralized finance: the risks

In a decentralized financial system, internet connection would be the only prerequisite for accessing financial services. A reduction in the centralization of those controlling the current financial infrastructure would increase transparency, reduce costs and censorship. Unbanked people who do not have a bank account or do not use the services offered by banks would gain access to financial services. In fact, ” open finance ” is often used as a synonym for DeFi .

The main problem is that technology is not the only factor limiting access to financial services. It is unreasonable to believe that retail investors understand the risk profile of simpler DeFi products and solutions, when they often and willingly do not fully understand traditional financial instruments and products.

Another problem is the product-market fit (PMF) currently limited to early adopters and experienced users of cryptocurrencies who are comfortable with the current interfaces and interactions offered by DeFi. Furthermore, the lack of education and developer tools are limiting the growth of the industry. If current limitations on the adoption and growth of decentralized finance are to be overcome, developers, regulators, investors and users will have to talk and work together. Breaking the conceptual barriers.

What do the banks of decentralized finance think?

The Financial Stability Board is an international body responsible for monitoring the financial system globally. The main central banks are part of it and in June 2019, they published a report on decentralized finance .

The report states that decentralized finance can be effective especially in terms of payments and trade finance. Trade finance concerns national and international commercial transactions and includes lines of financing, the issuance of documentary credits, solutions for the management and coverage of the risk on export credits, etc.

Among the most interesting points:

• Decentralization of the decision-making process. Moving away from a single financial intermediary or infrastructure and adopting systems in which a large group of users is able to make decisions on whether and how to carry out financial transactions.
• Decentralization of risks. Moving from risk retention on the financial statements of a single financial intermediary to more direct correspondence between individual users and financial service providers.
• Decentralization of record keeping. Removal from centrally stored data and transactions, towards systems where the ability to store and access data is extended to a larger number of users. Verification of data and transactions can be distributed, for example through consensus mechanisms.

In conclusion

Before deciding whether to opt for a DeFi service or product, a fintech or a traditional financial service, it is advisable to carefully evaluate the advantages and disadvantages. First of all it is important to understand how it works , whether or not it presents a guarantee in the event that something should go wrong so as not to be found unprepared. Subsequently, it is essential to evaluate the associated costs and the convenience to find the solution that best suits your needs.

Finally, a tip: it is essential to have a good basic financial education , regardless of whether someone has to deal with decentralized finance, fintech or traditional finance solutions.

Subsequently, if you want to understand more fully the functioning of decentralized finance products and solutions, you will need to deepen some technical and IT aspects that will help to better understand topics not accessible to most of the population. In this way, you will avoid bad surprises and you can make the most of the opportunities of techno-finance . For more technical readers who want to learn more, on GitHub there is a repository with a curated list of decentralized finance projects .

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