Long gone are those days where financial institutions used to assist in almost every step in one’s life whether it be regarding healthcare, corporate or personal relationships, supply-chain of daily products/services used, etc. In a sense, the centralized framework or authoritative architecture is being re-looked/revamped/re-structured holistically. The most appropriate alternative at the moment is the employment of a decentralized framework and applications being run on it. Decentralized Finance also is written as DeFI, in short, is one example of a decentralized ecosystem that draws inspiration from the blockchain. One reason among others for perceiving this to be a fit is the fact that its functionality is based upon open protocols and decentralized applications (DApps). DApps, in short, are applications built and run on an open-source platform, making every step taken more transparent and encouraging responsibility as each user and/or developer has some stake in it. This piece of content pins down a couple of value add-ons for using it, potential practical examples becoming a reality, and a few hurdles coming up for the platform as well.
Like any complex-subtle architecture (malleable products, algorithmic software’s, etc), DeFi is built on a multi-layered structure as well. Just like the internet protocol has been built with multiple layers having unique properties and characteristics, as well as syncing with each other, a similar foundation can be seen in a decentralized platform as well. Initially, DeFI was focused primarily on BFSI (banking, financial services, insurance) inclined firms only. But after observing and scrutinizing its impact on the industry, it expanded by getting utilized in the medical industry also. Seeing such advantages, slowly and gradually, every industry started imbibing it. These are among a few benefits experienced via DeFI in the financial sector, due to which it is spreading in every industry and firm irrespective of their size or nature:
- Decentralized Exchange Protocols – In crux, decentralized exchange protocols assist in shortening the gap which was wide in the traditional financial practices (trusting the exchange operator). Besides the trust factor, users don’t have to deposit their funds, instead, they remain in exclusive control over their assets until the trade gets executed. Few decentralized exchange protocols being utilized in the present day include UniSwap, Bancor, 0x, (Air)Swap.
- Smart contract-based liquidity pools – A liquidity pool can be perceived as one where there exist at-least two crypto-assets in the reserve, allowing anyone to deposit tokens of a particular type while being able to withdraw token(s) of another type. For determining the exchange rate, smart contract-based liquidity pools use numerous permutations and combinations of the constant product model, where the relative price is a function of the smart contract’s token reserve ratio. Moreover, these liquidity pools are not reliant on external price feeds. Two illustrations of such type of pools include UniSwap and Bancor.
- Peer-to-peer (P2P) / Over-the-counter (OTC) protocols – A substitute to the classic exchange / liquidity pool is peer-to-peer protocol(s). Majorly they rely on a 2-step approach. Here the users could query the network for counter-parties who would prefer to trade. As soon as the parties agree on a price, the trade gets implemented on-chain through a smart contract. One can also utilize off-chain indexers for peer discovery. AirSwap is an example of a P2P/OTC protocol.
- Decentralized lending platforms – Loans have been an essential part of the traditional financial processes, and it remains the same even in a decentralized platform. The distinguishing factor here is that there’s no requirement for a borrower or a lender to identify themselves. To avoid the scenario of lender or borrower running away with the funds, two approaches are employed. Firstly, the credit could be provided only under the prerequisite that the loan must be paid back atomically, meaning every fund is flows within the blockchain ecosystem via transactions. Secondly, loans could be secured with a collateral. The collateral is locked with a smart contract and could only be released once the debt is paid.
- Decentralized derivatives – Decentralized derivatives are tokens that define their value via performing of an underlying asset; the outcome of an event; the development of another factor. An oracle is required to pin-point particular variables connectedness leading to dependencies between each other. These dependencies could be reduced by using various independent data sources.
As the blueprint of blockchain and decentralized finance have recently been designed, built, and utilized, there are a couple of challenges which the technology faces. Among many, some include operational security, ‘garbage-in, garbage-out’ problem, ambiguity in regulation, etc. Operational security refers to the appropriate and safe employment of keys (admin keys) which are being utilized in the process. If users don’t store or create keys in a secure manner, a malicious third party might get their hand on them.
In the end, as decentralized applications are built and run on an open-source architecture, fresh and appropriate protocols could help in resolving particular issue/s one at a time.