Out with the old and in with the new! It seems like there’s always a more recent version of something coming out, and in many cases, new is better—the latest smartphone, gaming console, and in this case…a new kind of…finance?

Yup, you read that right. There’s a new kind of finance out there and it’s rocking the foundation of the industry: decentralized finance.

What is it and how does it work? What does it mean for finance to be decentralized? We know you’ve got a lot of questions, so let’s break it down.

What is DeFi and how does it work

Decentralized Finance (DeFi) is like blockchain technology and traditional bank services put into a big pot and stirred for several hours—it’s the perfect blend of the two. Because of its inclusive format, it’s also often referred to as Open Finance.

Think of every traditional financial service available now—savings and checking accounts, insurance, asset trading, loans, and more. The main goal of the DeFi community is to create open-source, transparent, and permissionless alternatives to these services.

To achieve that goal, decentralized finance heavily relies on decentralized applications (DApps). To fully understand how DeFi works, you’ll need a working understanding of the concept behind DApps.

What are DApps? To put it simply, they’re programs designed to work within the decentralized networks. The networks can be blockchains, distributed ledger technologies (DLTs), or Tor networks. The main thing is that they have to be decentralized, meaning that there’s no corporation, central authority, or agency that overlooks these apps’ business functions.

Why are they so awesome? Two words: smart contracts. You can think of smart contracts as preprogrammed contracts that initiate themselves—meaning they don’t involve a lot of human interaction. These self-initiating and self-executing contracts can handle various tasks, including, but not limited to, making payments and customer approval.

Because of the growing influence of decentralized banking, there are more DApps than ever—saving the time and money of customers and businesses around the world.

Defining characteristics

As the sector continues to expand, it’s crucial to know what components all decentralized applications share.

First, DApps are always open source. This means that the coding is available to the public. Because of its openness, anyone can audit and verify its capabilities, functionality, and security. In layman’s terms, since you can see all the coding, you can create DApps and participate without worry because you’ll see if there’s any malicious coding lurking in the background. Additionally, the interaction within the community can give you more confidence—making it more stable and secure compared to private coding.

The open-source coding is a perfect segue into the next key characteristic: transparency. All activity on the blockchain is public. Although everyone sees the activity, accounts are pseudonymous, listing only a numerical address. This adds an additional layer of anonymity—at the same time, not compromising its transparency.

Since anyone in the world can participate, the DeFi sector attracts a global audience. All you need to participate is a smartphone with Internet access and you’re good to go. This fundamental characteristic of decentralized finance gives it the ability to reach the unbanked, providing financial services that are so desperately needed. To add to its already-inclusive environment, the DeFi sector works without any gatekeepers. This allows anyone to participate without the worry of not being approved—effectively making it permissionless

Developers are even encouraged to participate because of DeFi‘s interoperability—a system’s ability to exchange and use information efficiently. As more developers enter the space, the previous work is kept. Because of this feature, newer developers can stack their DApps and expand their exposure in this new kind of economy.

Developers also have ultimate flexibility in the decentralized environment due to its open-sourced nature. You have a lot of options, especially through third-party application integrations. If you aren’t happy with the current options, you can even build your own interface.

Decentralized banking vs. traditional banking

Although traditional banking has been tried and tested over the years, it does have its quirks—most of which DeFi aims to fix. 

In traditional banking, financial access varies depending on where you are. Some areas may have easy access, while people in other places might find it extremely difficult. Its new-aged counterpart, however, fixes this problem. Because this new kind of finance has a global audience, no one is disqualified from participating.

No matter where you are, you have the same access to decentralized services and networks. There are also no gatekeepers with decentralized banking, making it even more accessible to all.

Alongside the varied financial access, the process traditional banking systems use can often be tedious and expensive. Because DeFi isn’t tied to a central authority, processes are more efficient—mainly due to the little-to-no human intervention that smart contracts entail. From the get-go, rules are written in code and contracts are self-executing.

In a traditional bank, names are directly tied to the account. Although DeFi DApps are fully transparent, accounts are pseudonymous and your real-life identity is protected. Because of this transparency, all transaction activity is available for anyone to view—a feature that isn’t available on most traditional systems.

Why it’s important

With all of the game-changing features that DeFi presents, you can start to see where traditional finance systems may have fallen short. Because decentralized applications don’t require the use of any intermediaries or arbitrators, users have complete control over their funds at all times. It will also reduce the costs surrounding the ecosystem and eliminate single points of failure within the system.

Ultimately, it all boils down to participation. When you think of the unbanked population, it’s easy for the mind to go straight into barren wastelands and deserts, but that’s really not the case. In fact, it can be the opposite.

To put things in perspective, this 2019 study by CNBC found that 25% of US households are unbanked. This proves that even average households can have problems when it comes to financial access.

It’s in those places where decentralized banking can have the most positive impact. Low-income individuals can have access to financial services that can help them immensely.

To give you a better idea, let’s look at some of DeFi’s most significant use-cases. 

DeFi’s use-cases

First, let’s take a look at borrowing and lending. When it comes to borrowing and lending, decentralized banking can have an edge because of its open system. It can settle transactions quickly, collateralize digital assets, and eliminate the need for credit checks. Decentralized finance minimizes the amount of trust required without jeopardizing transactions’ security, which effectively makes borrowing and lending faster, cheaper, and more accessible.

DeFi apps, by their very definition, are financial in nature—making banking services an obvious use-case. The ingenuity of smart contracts allows these services to be less expensive and tedious than their traditional counterparts. This applies to aspects such as insurance and payment intermediaries.

Now, let’s take DeFi’s use-case in decentralized exchanges (DEXes). These marketplaces allow you to trade crypto without needing anyone else to hold your money. Trades on these platforms provide the opportunity for direct trades between users with the help of smart contracts.

A look into the future

With all that being said, it’s safe to say that the concept of decentralized banking has the potential to be paradigm-shifting. As our more traditional systems transition towards decentralization, DApps might see an increase in demand in the future. They might even set a new standard for our economy moving forward.

Cryptocurrencies have done us the courtesy of bringing money into the digital space. DeFi is taking it a step further and it’s only the beginning. All we’ve seen at the moment is a glimpse of how financial services are being democratized—oh, but what a glimpse it is! We have the rare opportunity of seeing a whole new industry build itself from the ground up and it’s extremely exciting to see everything magically unfold.

As for what comes next, we’ll have to wait and see, but if it’s anything like what we see with decentralized finance, we’ve got some exciting times ahead of us. If you need us, we’ll be patiently waiting by the edge of our seat.