- DeFi is a representation in its true form of web3 in finance.
- Some advantages of DeFi include; transparency, privacy protection, flexibility, and speed.
- Some of DeFi’s key components, amongst others, include; stablecoins, DEXs, lending and borrowing, derivatives, and insurance.
- DeFi is a good example of how web3 is integrating finance into its ecosystem.
The centralized financial system refers to a collection of institutions such as banks, insurance companies, and stock exchanges, all of which allow the exchange of money. Rules to decide which projects get funded, the terms of the funding and who finance them are decided by banks, governments, and other similar institutions. This process is a concern for many as the decision-making process is very centralized, where customers have little or no say.
The concept of centralized finance undermines the idea of financial inclusion and fails the purpose of having a financial system for everyone. For the reasons mentioned above, it is clear that decentralized finance is a better alternative when it comes to autonomy, transparency, and inclusion. This article will cover the reasons that Web3 and decentralized finance will have a positive impact on the financial system we know today.
Decentralized finance or DeFi, is a representation in its true form of web3 in finance, DeFi refers to the processes, technologies and infrastructure that are used to democratize financial transactions. DeFi is a block-chain powered financial ecosystem, in December 2020 the DeFi ecosystem saw a boom whereby the market capitalization of smart contracts grew from $700m to around $15bn. If you wish to learn more about DeFi, Santander has published an in-depth description that’s worth a read.
Before the 2008 financial crisis, the global financial system was fully centralized, whereas, after the 2008 crisis, the decentralized finance movement began to gain momentum in web3. Innovators were dissatisfied with the traditional financial industry and began working to address this dissatisfaction. In October 2008, the Bitcoin whitepaper was published by Satoshi Nakamoto. The publishing of Bitcoin laid the foundation for the creation of the blockchain and cryptocurrency industry which eventually led to the making of DeFi or web3 in finance.
Advantages of DeFi
- Transparent: due to the transaction records being open to everyone, there is a high level of transparency within the decentralized finance industry, which is not possible when it comes to centralized finance.
- Protects identity: exposing real identity in DeFi is not necessary due to the fact that it is simply just not required by the DeFi system.
- Open: any users who own a DeFi-linked wallet are able to access its services. Users are not required to open accounts or engage in lengthy paperwork.
- Flexible: fund transfers can be made without borders, making the movement of assets from one account to another easy.
- Fast: interest rates and rewards are updated often, sometimes within a 15-second time period.
- Creditworthiness nor a bank account is required in order to take out loans.
The financial tools that are available to users are mostly in the form of decentralized applications (dApps). The dApp solutions are powered mainly by smart contracts, giving users more control over their finances. DApps also lower the entry barriers to financial markets. There are some great DeFi projects happening in 2023.
Key components of DeFi
Decentralized finance is the financial layer of the web3 ecosystem and thus is super significant. DeFi is a collection of different components, all of which are responsible for different capabilities. Below we explain some of the most prominent components of DeFi in web3, here is a range of articles where you can find more diverse explanations.
Lending and borrowing
In order to make use of traditional financial services, users are required to have a bank account, a luxury that many do not have. In addition, there are many obstacles when it comes to lending and borrowing to prove you are able to repay the loan. Web3 in finance lifts these barriers by allowing anyone to secure their digital assets to be used for taking out loans. It is also possible to make a return on your assets by taking part in lending pools.
Stablecoins were created in order to address the issue of very volatile cryptocurrency prices. Some stablecoins are centralized, this comes with a drawback, investors are required to trust that the USD (or other currencies that are backing the value of the asset) either exist or are fully collateralized.
Decentralized exchanges (DEXs)
DEXs work differently to traditional crypto exchanges, where users have little control over their traded assets, DEXs facilitate the exchange of crypto assets in the same way and traditional exchanges, however, users are not required to give up custody of their assets.
In DeFi, derivatives can be created without restrictions and in an open and permissionless manner. Derivatives are used in web3 the same way they are used in the centralized financial system, and DeFi derivatives are growing at a rate that is comparable to other crypto assets. You can read more about derivatives within the crypto markets here.
Active and passive fund management also exist in DeFi, the decentralized aspect makes it possible for fund management users to clearly see how their funds are being managed.
Web3 in finance offers users a permissionless way of making payments. Since the emergence of web3 in finance, there have been many new innovative payment methods being created. Making payments in web3 are almost instantaneous and are able to be completed without involving any intermediary.
Insurance is available for DeFi users that will protect their invested assets from a number of different risks. In DeFi it is normal for users to take out parametric insurance. Parametric insurance pays out when the parameters outlined in the original policy are met. Smart contracts are the instrument that is used to facilitate this parametric insurance.
Decentralized Autonomous Organizations (DAOs) were created as a way to democratize the decision-making process within decentralized organizations and to facilitate governance in cryptos. Here you can find some great DAOs to follow in 2023.
Finance in web3 Going forward
DeFi is a good example of how web3 is integrating finance into its ecosystem. DeFi is a good demonstration of how cutting-edge technology is able to bring unmatched efficiency to the financial sector. However, we will still need to be patient and to wait to see DeFi become the standard in finance.
Banks could also benefit from the adoption of web3 by using it to reach new customers beyond their usual channels.
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