What Is Defi? Explainer On What Is Decentralized Finance

EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. Decentralized finance has the potential to transform financial intermediation, supply chains, and existing business models. Financial services firms in particular should act quickly to establish themselves as trusted players as regulators catch up with a boom in activity.

Think about the decentralized autonomous organization as an entity that has no central leadership. In DeFi, think of them as counterparts to centralized financial institutions. Smart contracts are highly programmable and have the potential to be designed to execute automatically based on an infinite number of variables. The programmability enables the creation of new financial instruments and digital assets. This is due mainly to the cryptographic security properties of blockchains. Digital assets can be securely transferred using private keys, which allow the owner of an asset to prove to a network that they are the owner of their funds without having to reveal their private key to the network.

Open Finance VS Decentralized Finance

Figure 1 shows that some Asian and European countries recorded the highest web search for information about EmFi during the period. The countries include Singapore, India, United Kingdom , the USA, Germany and Japan. Interest in web information about EmFi exceeded the 50-point mark in Singapore. This indicates that EmFi was relatively more popular in Singapore during the period. This implies that web search for information about EmFi was greater in Singapore than in any other country in the world during the period. The high interest in Internet information about EmFi in Singapore was due to increase in the demand for embedded financial services in Singapore.

In a centralized system, banks and financial institutions act as that infrastructure, while fiat money, like the US dollar, acts as currency. Decentralized finance must replace these components in order to offer a full range of financial services. These more complex financial use cases were even highlighted by Ethereum creator Vitalik Buterin back in 2013 in the original Ethereum white paper. Because of their unprecedented transparency around transaction data and network activity, DeFi protocols offer unique advantages for data discovery, analysis, and decision-making around financial opportunities and risk management. Right now, most cryptocurrency investors use centralized exchanges like Coinbase or Gemini. DEXs facilitate peer-to-peer financial transactions and let users retain control over their money.

A stablecoin is a cryptocurrency that matches its value with a fiat currency. DAI is a decentralized stablecoin that’s pegged against the US dollar – meaning 1 DAI is equal in value to $1 USD. DAI’s value is backed by cryptocurrency collateral, rather than being backed directly by US dollar reserves. Because of its stability, DAI is the ideal currency for decentralized finance.

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This would allow owners of such assets to rebalance their exposure according to their preferences and risk profiles and adjust portfolio allocations. The spectacular growth of these assets alongside some truly innovative protocols suggests that DeFi may become relevant in a much broader context and has sparked interest among policymakers, researchers, and financial institutions. This article is targeted at individuals from these organizations with an economics or legal background and serves as a survey and an introduction to the topic. In particular, it identifies opportunities and risks and should be seen as a foundation for further research. DeFi still is a niche market with relatively low volumes—however, these numbers are growing rapidly.

In some cases, liquidity providers may only participate after a background check, including KYC verification. However, most importantly, other DeFi protocols can use these marketplaces and exchange or liquidate tokens when needed. Existing studies on EmFi in the literature are practitioner white papers rather than academic papers. For example, Plaid and Accenture explored the huge opportunity for EmFi in the financial sector. They showed that EmFi can improve customer experience and unlock a huge market opportunity.

I think we will see more and more crossovers where DeFi-type architectures are being built within the traditional financial services world once we can get greater confidence about addressing risks and the regulatory questions. Smart contract functionality uses programmable algorithms in a digital contract that automatically activates when its predetermined https://xcritical.com/ conditions are met based on a mutual agreement between two parties. The unique feature of a smart contract—and a common feature of decentralized technology—is removing a supervising intermediary such as a lawyer. We are closely monitoring recent events where risks in the system have crystallized and many crypto investors have suffered losses.

As of September 2020, Dai accounts for almost 75 percent of all loans in the DeFi ecosystem. Early decentralized exchanges such as EtherDelta have been set up as walled gardens with no interaction between the various implementations. The exchanges had no shared liquidity, leading to relatively low transaction volumes and large bid/ask spreads. High network fees, as well as cumbersome and slow processes to move funds between these decentralized exchanges, have rendered supposed arbitrage opportunities useless.

There needs to be some decentralized mechanism to allow the price signal to be recorded in the blockchain. If you can manipulate the price oracle, you can use that in some cases to drain funds from the DeFi application that depend on that price oracle. DeFi is about taking the actual financial service provision and transforming it into software that is operating as what are called “smart contracts” on a blockchain. A decentralized exchange can still have centralized components, whereby some control of the exchange is still in the hands of a central authority. A notable example being IDEX blocking New York State users from placing orders on the platform. Decentralized exchanges are a type of cryptocurrency exchange which allows for direct peer-to-peer cryptocurrency transactions to take place online securely and without the need for an intermediary.

  • In June 2020, Compound Finance started rewarding lenders and borrowers with cryptocurrencies, in addition to typical interest payments to lenders, units of a cryptocurrency called COMP.
  • Moreover, they require that the investor is vigilant and well-informed.
  • There are fund management products on Ethereum that will try to grow your portfolio based on a strategy of your choice.
  • For example, MetaMask allows users to directly interact with Ethereum through a digital wallet.
  • Financial services firms in particular should act quickly to establish themselves as trusted players as regulators catch up with a boom in activity.

Decentralized finance eliminates intermediaries by allowing people, merchants, and businesses to conduct financial transactions through emerging technology. Through peer-to-peer financial networks, DeFi uses security protocols, connectivity, software, and hardware advancements. Decentralized finance stands out as an alternative to traditional finance because it can do away with today’s financial bureaucracy, which is a burden of today’s financial system. The use of digital ledger technologies such as Ripple’s XRapid has made it possible for people to gain full control of their assets and their personal financial data when transacting in the global financial sector. At its simplest, decentralized finance is an open financial sector that runs on software built on top of a public blockchain.


The blockchain can be seen as the foundation for trustless execution and serves as a settlement and dispute resolution layer. It’s essential to engage with a reputable and transparent product like you would with any other. One of the fundamental features of blockchain technology is transparency. Thus, if developers of a DeFi application prefer to remain anonymous Open Finance VS Decentralized Finance — like the botched protocol Harvest Finance developed by an anonymous team — that should raise a red flag about its trustworthiness or whether it may be a scam. Every small quantity of “buy” or “sell” of these assets may hugely impact their value. Billionaire Mark Cuban made it known he is not immune to risk when he traded a DeFi app that crashed in one day.

Governments and financial institutions can have unrestricted access to the user’s personal and financial data, which can in turn be leveraged for political or financial gains. Furthermore, centralized financial systems mostly store their data and funds in centrally located servers and vaults. Despite security measures being in place, this architecture heightens the risks of large scale security and privacy breaches—from loss of funds to public exposure of sensitive information.

Open Finance VS Decentralized Finance

Agreements are enforced by code, transactions are executed in a secure and verifiable way, and legitimate state changes persist on a public blockchain. Both Enzyme Finance and Set Protocol allow anyone to create new investment funds. Enzyme Finance has a focus on building an infrastructure for decentralized funds, using smart contract-based rulesets to ensure that fund managers stick to the funds’ strategies. Trading restriction parameters such as maximum concentration, price tolerance, and the maximum number of positions, as well as user and asset whitelists and blacklists, are enforced by these smart contracts.

Decentralized Financial Services

It acts as a gateway between users and liquidity providers, ensuring best execution and atomic settlement. From a technological perspective, there are various ways in which public blockchain tokens can be created (see Roth, Schär, and Schöpfer, 2019). However, most of these options can be ignored, as the vast majority of tokens are issued on the Ethereum blockchain through a smart contract template referred to as the ERC-20 token standard . These tokens are interoperable and can be used in almost all DeFi applications. As of January 2021, there are over 350,000 ERC-20 token contracts deployed on Ethereum.3 Table 1 shows the number of tokens listed on exchanges and the aggregated token market cap in USD per blockchain. Almost 90 percent of all listed tokens are issued on the Ethereum blockchain.

Institutional interest in DeFi will continue to increase as the number of participants and amount of capital locked in these protocols continues to rise. DeFi is still in the early stages of innovation and institutions will have a prominent role to play in developing the ecosystem. There are financial opportunities, including new services and products, as well as operational efficiencies that can be gained by leveraging the existing DeFi ecosystem and infrastructure. As this new financial ecosystem continues to evolve it will create significant growth opportunities for institutions that are able to adapt and embrace these changes. For example, a smart contract could be programmed to exchange a certain amount of currency for another, between two counterparties. If the smart contract code verifies that the required currency from each counterparty has been provided, it will execute the transaction, thus eliminating the need for third parties to facilitate the transaction.

Open Finance VS Decentralized Finance

However, they stressed that issues such as data privacy issues and cybersecurity issues will remain in the absence of effective and meaningful regulation. DApps are typically accessed through a browser extension or application. For example, MetaMask allows users to directly interact with Ethereum through a digital wallet. Many of these DApps can be linked to create complex financial services. For example, stablecoin holders can lend assets like USD Coin or DAI to a liquidity pool in a borrow/lending protocol like Aave, and allow others to borrow those digital assets by depositing their own collateral.

Blockchain For Decentralized Finance Defi

Web3, the Power of DAOs and Transforming the Internet with Nik Kalyani This week host Alex Kehaya joins Nik Kalyani, co-founder, and CEO of Decentology, who are building the future of decentralized apps on the Hyperverse. A great conversation on the power of DAOs, onboarding developers to Web3, and how we can build together to transform the Internet. We are hopeful that the DeFi ecosystem will mature as usability and accessibility improve. TryCrypto is on a mission to make decentralized technology easy for everyone and we believe creating simple, easy-to-understand content is an important part of making this technology more accessible. For complete trust, someone needs to verify the smart contract code to ensure that there is no room for any backdoor entry for a hacker. By the end of 2018, the U.S. banking system had $17.9 trillion in assets.

Your financial situation is unique and the products and services we review may not be right for your circumstances. We do not offer financial advice, advisory or brokerage services, nor do we recommend or advise individuals or to buy or sell particular stocks or securities. Performance information may have changed since the time of publication.

How Does Defi Work?

That’s certainly an area that the regulators are looking at because there have been plenty of examples in the cryptocurrency world where this has happened. There are legal risks as well, where regulators appropriately have concerns about things like money laundering and fraud that are going on in the larger blockchain and cryptocurrency world and as well as in DeFi specifically. In July 2018, decentralized exchange Bancor was reportedly hacked and suffered a loss of $13.5M in assets before freezing funds. In a Tweet, Charlie Lee, the creator of Litecoin spoke out and claimed an exchange cannot be decentralized if it can lose or freeze customer funds. The Ethereum blockchain popularized smart contracts, which are the basis of DeFi, in 2017.

Legal Risks

While your assets are deposited, they’re at risk as centralized exchanges are attractive targets for hackers. If they are not being used at a given moment, this creates an opportunity for someone to borrow these funds, conduct business with them, and repay them in-full quite literally at the same time they’re borrowed. When you use a decentralized lender you have access to funds deposited from all over the globe, not just the funds in the custody of your chosen bank or institution.

In most cases, cryptoasset trades are conducted through centralized exchanges. Centralized exchanges are relatively efficient, but they have one severe problem. To be able to trade on a centralized exchange, traders must first deposit assets with the exchange. They thereby forfeit direct access to their assets and have to trust the exchange operator.

It’s not surprising that the growth is unprecedented, with the Total Value Locked spiking and touching a recent $86 billion. With the value of data on the rise, open finance could also bring about more opportunities for consumers to choose who they share their data with and to profit from it too. But such a change would be easier on paper than in practice due to the regulatory burden, says CEX.IO’s Lutskevych, creating complications for traditional businesses that even want to do so.

Primarily, this is due to the fact that the sector is intermediary-ridden, each of which adds its share to the overall cost of any financial service. In other words, the cost of any financial product partially or fully includes every intermediary cost involved in its production. While making some merchant payment, for instance, the user often has to bear a substantial payment gateway and/or processing fee which, in effect, adds to the overall cost of the product being purchased. The goal of DeFi is to challenge the use of centralized financial institutions and third parties that are involved in all financial transactions.

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