As a business owner, you need to keep abreast with the latest digital finance trends to reach more clients and increase your sales.
In the past few years, several blockchain-based financial applications and protocols have emerged that aim to create a more open, trustworthy, and easily accessible financial system.
This is where decentralized finance comes in. It is an alternative to traditional financial services.
As you know, almost every aspect of lending, borrowing, and trading is controlled by banks and other regulatory bodies like the SEC or the Federal Reserve. These middlemen not only set the rules but also earn a percentage of every transaction as profit.
“Decentralization” essentially means that no central body controls anything. Therefore, decentralized finance disempowers gatekeepers and middlemen while empowering consumers via peer-to-peer exchanges through a public blockchain. Let’s illustrate that with an example.
Suppose you earn 1% interest on the money you’ve put in an online savings account. Your bank, in turn, lends that sum to another of its customers at an interest rate of, say, 2.15% and pockets the profit of 1.15%. Decentralized finance allows you to lend your money directly. While this can offer potentially higher interest rates, remember to factor in network transaction costs (gas fees) and the inherent volatility and smart contract risk to determine your true net return.
This article will help you understand what decentralized banking is all about, how businesses can leverage the ecosystem, and the risks involved.
TL;DR
- Decentralized finance uses the blockchain technology that cryptocurrencies use to remove the need for third parties (banks) in financial transactions.
- Decentralized finance lacks barriers to entry, and anyone with access to the public blockchain and open-source tools can build financial services and tools on the network.
- The DeFi infrastructure for delivering financial products and services uses three key components; blockchain, smart contracts, and cryptocurrencies.
What is decentralized finance (DeFi)?
The idea behind DeFi is to decentralize financial activities and bring financial control to individuals. Essentially, it uses the blockchain technology that cryptocurrencies use to remove the need for third parties (banks) in financial transactions. This reduces transaction times and increases access to financial services.
Cutting out middlemen gives businesses easier access to loans, interest on deposits, and payments. Other financial services accessible through DeFi include insurance, crowdfunding, investments, trades, and asset management.
Differences between decentralized finance and traditional finance
One of the biggest claims of the proponents of this novel form of finance is that it will eventually wipe out the role of middlemen (traditional financial institutions) in financial transactions. To see if this lofty claim is feasible, it helps to understand how traditional finance differs from decentralized finance.
In centralized finance, almost every aspect of banking is managed by a raft of financial middlemen, regulatory agencies, and gatekeepers. You need to deal with each of these players to get access to everything from loans, insurance, payments, and even your own money. These entities facilitate the movement of money, and you must pay for their services.
For example, say you use a debit or credit card to pay a contract worker. The charge will go from the payment processor to an acquiring bank, which will forward the transaction details to the credit card network. The network will clear the charge and request payment from the acquiring bank. The bank approves the charge and sends the approval to the payment processor. Each of them—the bank, the payment processor, and the credit card network—will charge a fee for their services.
DeFi eliminates the middlemen and gatekeepers. With access to DeFi apps and a virtual wallet; you can lend, trade, and borrow from anywhere using DeFi systems and safety protocols without having to involve a bank.
To summarize, decentralized and centralized finance differ on two main points:
- Decentralized finance uses blockchain to guarantee secure financial transactions within the network, while traditional finance relies on laws, regulatory bodies (Federal Reserve and Securities Exchange Commission [SEC]), and financial institutions to act as the trust source—guarantors of secure transactions.
- Decentralized finance lacks barriers to entry, and anyone with access to the public blockchain and open-source tools can build financial services and tools on the network.Traditional finance is different. Only financial institutions that have met stringent capital and regulatory requirements are permitted to facilitate financial transactions.
Decentralized technology helped some businesses find alternative financing during the pandemic when local banks were restrictive. The ability to access global liquidity through crypto markets provided necessary cash flow.
The idea for decentralized finance was born around 2017 after the emergence of the Ethereum blockchain enabled the rise of decentralized applications. The term itself was coined in an August 2018 Telegram cast of ETH developers and entrepreneurs. The DeFi industry has continued to grow rapidly since then.
How decentralized finance works
The DeFi infrastructure for delivering financial products and services uses three key components: blockchain, smart contracts, and cryptocurrencies.
Blockchain
Blockchain is a kind of decentralized ledger that tracks all transactions within a financial ecosystem. The way it works is that every party on a financial platform has an identical copy of the public ledger which records each transaction in encrypted code.
Each transaction is recorded in a new block and verified by other users within the peer-to-peer (P2P) network. If all the users agree on the transaction, the block is closed and encrypted. Another block will have to be created for the next transaction, and the same verification process must be followed.
All these blocks will then be chained together, and the information on one block cannot be altered without affecting the other blocks. This running record of all transactions essentially makes it impossible to alter a blockchain and commit fraud. It’s the essence of the secure nature of blockchain technology.
Smart contracts
If blockchain is the foundation of DeFi, smart contracts are its building blocks. They are executable codes that automatically execute transactions among participants when the contract’s conditions are fulfilled.
For example, a smart contract for lending would automatically execute a liquidation of a borrower’s collateral if the value of that collateral falls below a predefined threshold.
It is these smart contracts that take the place of traditional financial institutions, such as banks or brokerage firms.
Cryptocurrencies
In the world of decentralized finance, cryptocurrency is the de facto currency for transactions and record keeping. DeFi transactions are primarily facilitated using Ethereum (ETH) and other smart-contract platform tokens, as the Ethereum network is specifically designed for deploying the necessary protocols. Bitcoin is rarely used for DeFi applications.
They are designed to automatically execute transactions if certain conditions are met.
DeFi, crypto, and NFTs will continue growing. Only small businesses that can quickly understand and adopt these emerging fintech innovations will thrive in the long term.
With decentralized finance, you can offer your customers peer-to-peer payment options and, on your end, leverage the business services available in the ecosystem.
Access to the DeFi blockchain is enabled through decentralized apps (DApps) created by various groups. Dapps are programmed by developers using open-source software, and they are typically accessed through a browser extension or application.
The smart contracts and DeFi protocols that facilitate transactions within the ecosystem run on these apps. DeFi applications come with a digital wallet, key vault, and secure login to allow you to store and trade tokens securely—tokens are the digital currency in blockchain used to execute transactions or move assets anywhere in the world. You can buy them with euros, dollars, or any other legal tender.
How can businesses leverage DeFi applications?
This new financial ecosystem has many applications that can make the lives of business owners easier, including:
Payments with cryptocurrencies
Financial transactions are one of the core premises of DeFi, and as the adoption of cryptocurrencies continues to grow, more and more ecommerce businesses will start to see them as a fast, secure, and efficient way to accept payments for goods and services.
Cross border payments
Cross-border payments through traditional corporate banks can be prolonged and expensive. Besides the flat fee, many banks charge an unfavorable foreign exchange (FX) spread on the official exchange rate. DeFi platforms can offer a better alternative, where stablecoins and P2P exchange rates can facilitate near-instant, borderless payments at a lower cost.
You will simply convert your funds into tokens and execute rapid same-day payments.
Yield farming
Yield farming offers a way to generate income with your digital assets. You will be providing liquidity to a coin exchange and earn a yield in return.
DApps and coin exchanges need liquid cryptocurrency to provide their services. They will offer you payment in exchange for using your crypto assets to fund their services. This can serve as a tidy source of passive income.
However, you still need to be conscious of the volatile world of cryptocurrency. Although yield farming contracts are ironclad, a fluctuating cryptocurrency could easily lose you a year’s yield or more.
Stablecoins
Stablecoins seek to create the kind of price stability that exists in the world of traditional finance. A stablecoin tries to avoid price swings by being pegged to a fiat currency like the dollar. This means the price of one unit of the stablecoin will always be equal to one unit of the fiat currency it is pegged against.
The leading stablecoin in the USC Coin (USDC). Most DeFi transactions are conducted using USDC, and it offers a stable way for companies to use fintech applications without exposing themselves to volatile price movements.
The advantages of DeFi for businesses
Below are the reasons why you might pick DeFi over traditional finance in the right circumstances:
It provides easier access to loans
Getting bank loans is often a struggle for small businesses, and DeFi markets can help them access capital with fewer barriers. Thanks to smart contracts, anyone with a crypto wallet can obtain both secure and unsecured funding.
It helps businesses circumvent bans and restrictions
Businesses in authoritarian countries may face bans and restrictions on financial activities imposed by oppressive governments. However, these governments can’t track transactions that use digital ledger technologies, making it possible for such businesses to access global financial services.
It offers greater interest rates
You can earn a lot more interest than what your bank is currently paying on your savings bank account by lending your crypto assets into DeFi protocols. Although there are risks, businesses can mitigate them by using stablecoins.
It is permissionless and inclusive
The most attractive part of DeFi is that you no longer need to meet any requirements to qualify for certain financial products. You also manage your funds yourself without having to pay any service fees, and you can move assets whenever you want.
Its transactions are highly visible
Its transactions happen near-instantly, provided the network isn’t congested. Transactions on the Ethereum blockchain are transparent, and the ledger is updated quickly, offering high visibility, though Gas Fees and network congestion can affect final settlement time and cost.
The risks of DeFi for businesses
DeFi offers a lot of promise, but it also presents a few risks to businesses. These include:
Regulatory uncertainty
The network has thrived in the absence of rules and regulations, but this also means participants have nowhere to turn to if a transaction should go awry. This is in sharp contrast to traditional finance, where governments, regulators, and law enforcement agencies are bound to protect your financial interest. In fact, the Federal Deposit Insurance Corp (FDIC) will reimburse you in the event your bank fails.
Security risks
The fact that DeFi platforms are unregulated means mishaps and scams do occur. While a blockchain is basically impossible to tamper with, the software systems that are used to access the blockchain run on the internet and can still be hacked. Hacking can lead to the loss of crypto coins, and funds can be stolen in scams.
Software risks
The technology is new and experimental. And since decentralized applications are code, it has two main risks: errors and bugs. These errors can lead to money losses and destroy your DeFi investments. For example, a bug on the DeFi platform Alchemix led to borrowers reclaiming millions of dollars in collateral without fulfilling the terms of their contracts.
Gas fees
Running DeFi protocols on Ethereum requires what is called a gas fee. The fee is like a payment to make the machine run. The payment becomes particularly relevant when your transaction requires more than one step to complete. When using smart contracts, you must always consider whether the fee would likely outstrip your investment returns.
Private key requirements
Crypto wallets are secured with private keys, and there is no way to recover a lost key because the unique code is only known by the owner of the wallet. So, if you lose your key, you will lose access to your funds forever. For businesses, the critical mitigation strategy is using a multi-signature (multi-sig) Wallet, which requires multiple designated individuals to authorize a transaction, protecting against single points of failure.
What’s next for decentralized finance?
The ecosystem is still in the beginning stages of its evolution, and the infrastructure for its regulation is still under development and debate.
DeFi’s borderless transaction ability makes it difficult to craft laws for separate financial jurisdictions. There is a need to figure out who will create regulations and who will be responsible for investigating financial crimes that occur on the network across borders.
Other concerns include its carbon footprint, scalability, liquidity, and system maintenance. The proponents of the payment vertical will have to first address its many issues before it is ready to replace today’s financial system.
Conclusion
This article has provided you with all you need to know about decentralized finance. You should identify the areas where the payment vertical can be beneficial to your financial activities and evaluate the pros and cons of taking the leap.
Stax does not currently offer acceptance of cryptocurrencies, but we are experts in the fundamental principles that future digital finance demands: security, efficiency, and transparent cost savings. Partner with Stax today to ensure your payment infrastructure is modern, robust, and ready to adapt to any payment evolution.
Quick FAQs about decentralized finance (DeFi)
Q: What is decentralized finance (DeFi)?
Decentralized finance, or DeFi, refers to a financial ecosystem that uses blockchain technology to facilitate peer-to-peer financial transactions without the need for traditional intermediaries like banks. However, institutional DeFi is now the standard for businesses, with many business-grade platforms requiring KYC/AML (know your customer/anti-money laundering) at the smart contract level.
Q: How does DeFi differ from traditional finance?
DeFi eliminates the need for middlemen by using blockchain technology, allowing for direct peer-to-peer transactions. Traditional finance relies on banks and regulatory bodies to facilitate and secure transactions.
Q: What are the benefits of using DeFi for businesses?
DeFi offers businesses greater access to loans and higher rewards or risk premiums on deposits. It also provides real-time transaction transparency and reduces costs by eliminating intermediaries.
Q: What are the key components of DeFi?
The key components of DeFi include blockchain technology, smart contracts, and cryptocurrencies. These elements work together to enable secure, decentralized financial services.
Q: How can businesses leverage DeFi applications?
Businesses can use DeFi for various financial activities, such as accepting cryptocurrency payments, conducting cross-border transactions, and engaging in yield farming to earn passive income from digital assets.
Q: What are the risks associated with DeFi for businesses?
Risks include regulatory uncertainty, security vulnerabilities, software bugs, gas fees, and the potential loss of funds due to lost private keys or scams.
Q: What are smart contracts in the context of DeFi?
Smart contracts are self-executing contracts with the terms of the agreement directly written into code. They automatically execute transactions when certain conditions are met, replacing the need for intermediaries.
Q: Can DeFi replace traditional financial systems?
While DeFi offers many advantages, it is still in its early stages and faces challenges such as regulatory hurdles and technological scalability. It is unlikely to fully replace traditional finance in the near future but can complement it.
Q: What are Stablecoins, and how do they relate to DeFi?
Stablecoins are cryptocurrencies pegged to a stable asset like the US dollar. They provide price stability in DeFi transactions, mitigating the volatility associated with other cryptocurrencies.
Q: How can businesses protect themselves from DeFi risks?
Businesses can mitigate risks by using reputable DeFi platforms, thoroughly understanding smart contracts, maintaining secure private key management, and staying informed about potential regulatory changes.
Q: What are decentralized exchanges (DEXs)?
Most crypto transactions are facilitated by centralized exchanges. They are secure online platforms like Coinbase and Gemini that enable the buying, selling, transferring, and storing of cryptocurrency by investors.
Decentralized exchanges are different. They connect users directly via smart contracts that utilize automated market makers (AMMs) or on-chain order books, allowing users to trade cryptocurrencies with one another without an intermediary.
Q: Is Bitcoin DeFi?
Bitcoin is just a type of cryptocurrency Ethereum is the primary type of cryptocurrency used in DeFi transactions.
Q: What is total value locked (TVL)?
TVL is the sum total of all cryptocurrencies currently working in different DeFi protocols. It sums up all funds staked, loaned, deposited in a pool, or used for other financial actions across the ecosystem.
