What comes to mind when you hear the phrase “financial future”? Most individuals envision mobile payments, online banking, and other cutting-edge technologies. What about decentralization, though?

Decentralized finance (DeFi), for those unfamiliar with the term, is a subset of blockchain technology that focuses on financial applications powered by distributed ledgers. DeFi represents the next generation of financial services, in which individual users have greater control and transparency over their finances.

DeFi has altered how we think about money over the years, and with some of its key advantages, the future holds many opportunities for this technology.

DeFi

DeFi is the technology behind decentralized payments that powers blockchain-based financial services. The system is based on public, programmable blockchains that enable independent, non-intermediary payments, i.e., payments that do not involve banks or other financial institutions.

The new financial service smart contracts and peer-to-peer agreements are signed automatically by buying, selling, or lending participants. Thus, transactions no longer necessitate the participation of banking platforms, attorneys, or any other third party. DeFi applications (DApps) may serve various functions, such as consensus mechanisms, decentralized decision-making, information recording, etc. With DeFi, organizations could significantly increase operational efficiency, reduce expenses, and provide access to financial services for everyone.

The Impact of DeFi on Financial Institutions

DeFi may have a significant impact on how banks operate in the future and has the potential to alter the macroeconomic structure of financial systems. DeFi refers to an economic system without intermediaries such as banks, insurance companies, or clearinghouses. The intelligence of DeFi smart contract development solely powers it. DeFi applications serve the function of conventional finance (CeFi) transparently and universally.

The concept of a new financial system has existed within the blockchain space since its inception. Since 2020, DeFi has expanded rapidly, and billions of dollars have been invested in its ecosystem. Most of the growth is driven by applications (protocols) built on the Ethereum blockchain.

1. Commercial financial institutions

Commercial banks’ primary business model is to accept customer deposits and make loans. Effective financial systems are based on borrowing and lending because fund holders are incentivized to provide market liquidity. In exchange, they receive a return on assets that would be unproductive otherwise. DeFi protocols allow unidentified parties to lend and borrow resources on a larger scale without intermediaries.

These applications connect lenders and borrowers and automatically determine interest rates based on supply and demand. These protocols are accessible to anyone, regardless of location or quantity. The expansion of lending and borrowing protocols fuels recent interest in DeFi applications. In contrast, conventional finance loans in DeFi are typically secured through overcollateralization. Companies, including Aave, are working to enable unsecured loans comparable to traditional finance.

2. Investment banks and financial instrument issuers

Investment bank business models typically involve advisory services for financial transactions. Investment banks engage in the trading or creation of complex financial products and the management of assets. DeFi protocols provide comparable products. Synthetix, for instance, is a protocol for issuing derivatives that enables the decentralized creation and trading of results on assets such as stocks, currencies, and commodities. Decentralized cryptocurrency asset management is evolving. Yearn Finance, for instance, is an autonomous protocol that searches for the highest returns in the DeFi space while investing for its users.

3. Exchanges

The purpose of exchanges is to facilitate the trading of various assets. These consist of stocks or foreign currencies between at least two market participants. CeFi can record cryptocurrency exchange for fiat currency (such as the US dollar). Regular cryptocurrency owners must use centralized exchanges such as Binance or Coinbase to trade one unit of cryptocurrency for another.

With the emergence of decentralized exchanges (DEX), cryptocurrency holders no longer need to leave the cryptocurrency space to trade tokens. Uniswap is a prime example of a DEX. DEX is composed of smart contracts that hold liquidity reserves and operate based on predetermined pricing mechanisms. Automated liquidity protocols play a crucial role in developing a decentralized ecosystem without CeFi intermediaries.

4. Insurances

The most important function of insurance is to mitigate risks and provide market participants with security. Nexus Mutual is one example of a decentralized insurance model. This provides insurance coverage for smart contract bugs. Everything based on smart contracts in DeFi, particularly the exposure of smart contract source code, increases the risk for DeFi users. Decentralized insurance policies are still in their infancy stages. The potential for larger and more sophisticated insurance models to emerge in the DeFi space is anticipated.

Also read: How To Deploy Smart Contract On Polygon | Ethereum Scaling Solution

Conclusion

Accessibility, security, and dependability issues are primarily to blame for the inability of banking institutions to provide services to over 1 billion people. However, DeFi is highly accessible, secure, and dependable for all parties.

Contrary to conventional financial institutions, DeFi also permits you to retain possession of your financial assets. This is a very contemporary and decentralized method. DeFi technology is the future because it solves conventional financial issues.