The term “DeFi” stands for Decentralised Finance, but what does it mean? To explain, we must first break it all down and then combine it. Let’s first start with the question “What is finance?”
What is finance?
Finance, in general, refers to a system that facilitates the movements of capital and its allocation, with the aim of growing economies and generating returns for capital holders. This includes activities such as payments, exchange, investment, borrowing, and lending. It also includes all products that can be derived to support these such as insurance, leveraged products, futures trading, etc.
Unless you work in a financial institution, you probably don’t deal with these terms day to day. However, we are using this financial system every day! Whether it is for simply paying with our debit card at the supermarket or more complex like our pension contributions being invested by the pension fund; it’s all part of the financial system.
What is Centralisation?
According to the Oxford dictionary, “centralisation” refers to the process of giving control of a country or an organization to a group of people in one particular place. Currently, the financial systems (as described above) are operated by a series of centralised institutions. The most common example of this is a central bank issuing the currency you use and thus having absolute power over its supply and monetary policy.
Why is centralisation problematic?
Whilst centralisation may seem convenient, it creates huge problems. For example, in 2020, more than 20% of the dollars in circulation were printed by the FED! This effectively means that items priced at $1, are now priced at $1.20! Why? Because an old guy in a room in the US decided to.
To further highlight the problem, think about your funds or assets within your Bank or Broker. Whilst your funds are kept safe, you cannot move them without the bank’s cooperation. Your investments are with your broker and you cannot move them to a different broker or access the market directly.
What is Decentralisation?
In 2009 the concept of the blockchain was introduced to the world with the creation of Bitcoin. Later on, the technology evolved to allow for the existence of programmable blockchains (the most widely used of which is Ethereum). This essentially allows for logic (computer code) to be executed and verified by the blockchain as valid without needing a centralised trusted party to verify that (e.g. if A is true, do B).
This huge paradigm leap allows for complex programs and financial products to be constructed. Since they only need the blockchain to be secure, these financial programs and products do not require a single party to operate them, and thus are incredibly resilient as there is no single point of failure! Another huge benefit is that these systems are permissionless which means that anyone in the world can access them at equal terms!
So what is DeFi?
DeFi refers to the term “decentralised finance”. In the last 2 years, decentralised financial products have been built at an incredible pace and anyone can now use a suite of products and services. For example, anyone can now:
- Send and receive funds globally (payments)
- Exchange tokens for each other (Through decentralised exchanges)
- Lend funds to receive an interest
- Borrow funds
- Trade derivative products such as options, futures, bonds etc
DeFi is building towards an alternative financial system to what already exists using a completely different foundation. Hence, among its early adopters, it’s not seen as “buying crypto” but more like migrating your funds to their blockchain compatible form, similar to how in the 80s/90s people migrated from cash to bank accounts.
Why does DeFi matter?
There are many pragmatic reasons as to why DeFi is the next step in the story of money:
- It’s more efficient to have computers do the work than humans. This brings the cost for the end-user as thousands of people can be replaced by a few lines of code
- It gives millions of people access to a financial system that simply does not exist for them (nearly one-third of the world population still does not have access to a bank account).
However, the true reason why DeFi matters is: no genius mind or company can compete with the innovation that can be brought by allowing anyone across the world to build, contribute and use a system,
No one could predict what people would come up with once they had their hands on the internet…