This blog post is the first of a series focused on helping newcomers to the world of web3 understand the value of decentralized finance. Read on to discover how DeFi and open source technology can help businesses and individuals create a freer and fairer financial system.
The traditional financial and banking services market, also known as centralized finance (CeFi), is one of the largest global industries in the world with a market size of ±$25B that is expected to reach ±$37B in 2025.
CeFi currently encompasses a broad spectrum of money management businesses, providing businesses and consumers with everyday solutions such as commercial banking, investment services, insurance, and more. However, CeFi suffers from significant challenges, including slow digital transformation, strict regulations, and financial exclusion due to social and economic issues.
Decentralized Finance (DeFi) emerged to revolutionize the way we access and use financial services. It allows for greater financial transparency, security, and accessibility, and has the potential to bring the underbanked and unbanked people of the world access to financial services.
In this article, we'll take a closer look at the basics of DeFi, the use cases, benefits and challenges it faces, and what comes next for this groundbreaking technology.
Decentralized finance has the potential to deliver the same financial services that consumers and businesses are used to today without relying on intermediaries like brokerages, centralized exchanges, or banks.
The result? A freer and fairer global financial system that enables everyone to participate and prosper.
While traditional systems rely on a centralized intermediary to authorize and confirm transactions, decentralized finance systems use the network of validators on the blockchain to allow for peer-to-peer transactions without needing a central authority.
DeFi can be traced to the advent of smart contracts. These smart contracts opened the door for developers to build the first decentralized applications on the blockchain (dApps).
Decentralized Applications (dApps) are applications or computer programs that are built on blockchains and designed to carry out a specific task in an autonomous manner, typically through smart contracts.
A dApp inherits all the features of the blockchain it is built upon. For example, dApps developed on the Rootstock blockchain inherit the network's highly secure and resilient attributes.
It is possible to create dApps for almost any purpose. Initially, most dApps were built for recreational or fun uses, e.g., games, art, and music. However, in 2019, more serious uses for dApps began gaining popularity, such as dApps used for financial services. These financial service dApps are what we now refer to as "DeFi."
Some of the most popular use cases of DeFi and types of decentralized applications include:
There are numerous use cases of DeFi, which we will discuss in detail in later in our DeFi Decoded series.
DeFi will transform the way we access, use, and invest our money. It can democratize access to financial services, making them available to people who are currently underserved or excluded from the traditional financial system.
For example, the World Bank reports that ±1.4B people around the world have no access to banking services.
To provide such services to this unbanked population using a centralized finance approach, governments and the private sector would need to develop new policies and practices to rebuild trust in financial service providers. With DeFi being a decentralized, middleman-free environment that only requires access to the internet and some literacy in Web3, it provides a somewhat reliable and accessible alternative to traditional financial services.
By harnessing the power of decentralized and permissionless technology, DeFi provides numerous benefits to businesses and consumers. Some of these benefits are:
Accessibility: DeFi enables anyone with an internet connection to participate in the global financial system, regardless of location or economic status. With more people becoming internet users every year—in 2022 alone, ±170M people became internet users for the first time—we expect that there will be a parallel growth in the number of people using the internet to access DeFi services.
Transparency: DeFi applications are built on blockchain technology, which is transparent and open by design. Blockchains work using a consensus mechanism so for any changes to be made (such as confirming a transaction), multiple users need to review this transaction, confirm that it is valid, and record it transparently on the chain’s public ledger. This is where DeFi differs from traditional CeFi mechanisms, where a central authority reviews transactions and keeps the data confidential.
Control: Blockchain technology provides users with control over their data by allowing them to store it in a decentralized and distributed network. This means that instead of relying on a single central authority to store and manage their data, users can store it on multiple computers or nodes in the network. Because each node has a copy of the data, it is difficult for any one person or organization to alter or delete the data without the consensus of the other nodes in the network. Additionally, blockchain technology uses cryptographic techniques to ensure that the data is secure and cannot be tampered with. This gives users a high level of control and security over their data. As a result, users are in control of their own financial assets and transactions when using DeFi applications, reducing their dependency on centralized institutions.
Security: Blockchain provides users with security by combining decentralized architecture and cryptographic techniques. As mentioned above, the decentralized architecture of the blockchain means that data is stored across multiple computers or nodes in the network rather than being stored in a central location. For hackers or malicious actors to tamper with or corrupt the data, they would need to gain control of a significant number of nodes in the network.
Additionally, blockchain uses cryptographic techniques such as hashing, digital signatures, and consensus mechanisms to secure the data. Hashing is used to convert data into a unique fixed-size output, making it difficult for anyone to tamper with the data without being detected.
Digital signatures are used to ensure that data can only be added to the blockchain by authorized parties, and they also help to ensure the integrity of the data.
To ensure blockchain consensus, consensus mechanisms such as proof of work (PoW) and proof of stake (PoS) are used.
Automation: Most DeFi applications leverage smart contracts as their primary method of automating transactions and financial processes on the chain. Smart contracts by design are self-executing contracts, with the terms of the agreement written directly into lines of code. When certain predefined conditions are met, these contracts can be automatically executed on the blockchain network.
Leveraging the technology of smart contracts, DeFi dApps can automate numerous financial processes, such as the release of funds or the execution of trades, which can reduce the need for intermediaries while increasing efficiency and speed.
Innovation: The open-source nature of DeFi means that anyone can create financial applications and services. Developers and entrepreneurs can harness blockchain technology and tools like RIF to create new financial instruments and markets that were not previously possible with typical financial instruments. For example, DeFi instruments allow developers to:
The main challenge for DeFi applications is their complexity for non-technical users to understand and navigate. Many DeFi applications' interfaces remain unintuitive compared to traditional financial apps and services, and there is a steep learning curve for new users trying to enter the space.
Other challenges include:
Volatility: The value of crypto assets can be highly volatile. Bitcoin, for example, declined by 25% or more 27 times between 2010 and 2022. By comparison, equities such as S&P 500 in the US and Nifty 50 in India recorded just one. This significant volatility compared to traditional financial assets makes it difficult for users to feel comfortable using DeFi protocols that often require some form of cryptocurrency to interact with.
Scalability: DeFi protocols are currently limited by the number of transactions that can be processed on the blockchain they are built upon. This limits the number of users who can use DeFi products and services simultaneously.
Interoperability: Different DeFi platforms are built on different blockchain networks and protocols. For example, some platforms are built on Ethereum, while others are built on other networks, such as Rootstock or Solana. This creates a barrier for users who want to move funds between platforms. They may need to convert their assets to a different format, pay additional fees, or go through a centralized intermediary.
Complexity: A recent report by Visa demonstrates that the largest user base consists of early adopters or young Gen Z and millennials, who are more likely to be familiar with tech trends and terminology. The complexity of the technology, terminology, and UX can stand in the way of mass adoption and hinder the wider population from benefiting from DeFi use cases. And since it can be difficult for users to know how to use and interact with DeFi platforms and protocols properly, this can lead to devastating mistakes and potential financial losses.
Lack of access: On and off ramps are the first platforms that users visit to onboard into the crypto ecosystem, enabling users to exchange their fiat for cryptocurrencies of choice and vice versa. However, to use an on-ramp, you typically need to complete some kind of Know Your Customer (KYC) checks and use an online banking tool to send your money to the ramping platform. This leaves a large portion of the unbanked communities and those lacking the required documentation without the opportunity to access DeFi in the first place.
DeFi is still a relatively new and constantly evolving field, but it has the potential to make financial services more accessible, transparent, and secure for everyone.
In the short term, we can expect continued innovation in DeFi, with the creation of new and improved products and services. In the long term, we may see DeFi becoming more mainstream, with people using DeFi products and services seamlessly in their day-to-day lives.
For DeFi to reach its full potential and become widely adopted, the industry must find ways to make these platforms and protocols more user-friendly and accessible to non-technical users. However, for this to be achieved, the necessary infrastructure is needed.
The Rootstock blockchain will continue to play a significant role as the DeFi industry expands. It is the only smart contract-enabled network backed by the security and resilience of Bitcoin — the world's most established blockchain network, making it the network the ideal foundation for building decentralized financial products.
To make it even easier to build dApps on Rootstock, the Rootstock Infrastructure Framework (known as RIF) was developed to provide the building blocks to quickly, easily and securely create new decentralized finance applications. The ever-growing product suite and open source protocols and services give fintech pioneers and developers the tools they need to create the next generation of decentralized finance products.
RIF and Rootstock are tackling the challenges with DeFi by:
Creating a standardized set of tools that developers can use to construct easy-to-use everyday DeFi products is where the next leap forward in the evolution of finance will originate. By providing the infrastructure for innovation to flourish, RIF aims to allow DeFi products to mature and become an integral part of the global financial system.
Want your DeFi solution to stand out in the market? Contact the RIF experts to find a solution that fits your business.