Cryptocurrency explained: What is decentralised finance?
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Decentralised finance, or DeFi, is one of the fastest growing areas in cryptocurrency.
While Bitcoin challenged the idea of electronic currency, DeFi looks to reimagine our broader financial infrastructure.
Investment in DeFi services has flourished in 2020. At the start of the year, DeFi’s total locked-in value was $US662.5 million. Today, that value is $US11.19 billion.
DeFi is an umbrella term for decentralised financial services. The sector develops new platforms for banking, trading, and insurance without intermediaries or paperwork. Therefore, service fees are lower than traditional providers. This is attractive for many people.
In that context, ‘decentralised’ refers to the distributed nature of the network. These networks are made up of many connected computers in numerous locations.
This differs from a centralised network such as those used by banks, which run their services through a single, central computer system.
DeFi’s rise to prominence is thanks to the Ethereum blockchain.
Why Ethereum? Firstly, it is programmable: anyone can create decentralised applications (dApps) that run on the Ethereum blockchain network. Consequently, the vast majority of DeFi projects are Ethereum based.
Secondly, its network is active: Ethereum has one of the largest communities of participating programmers, developers, and users.
Thirdly, its network supports smart contracts: a fundamental part of DeFi.
Smart contracts are digital contracts. They are computer protocols that digitally facilitate, verify, or enforce aspects of legal contracts or agreements. Smart contracts execute over blockchain networks without any human intermediary.
Say, for example, you want to take out a loan. Rather than approach a bank, you could use a DeFi lending service.
All the specifics of the loan are coded into a smart contract. Interest rates on the loan are derived algorithmically. They’re based on the supply and demand of a given asset.
As an algorithm controls interest rates, there is no loan negotiation required with other parties. Once these terms are set and agreed upon, they cannot be changed.
Once agreed, the loaned funds will be sent to you. All of this occurs by interreacting with a computer, not an intermediary.
According to the World Bank, 1.7 billion people are unbanked. Many of these people live in developing economies. Mobile industry body GSMA’s annual Mobile Economy report provides further insight. It says mobile penetration rates in developing countries are climbing.
In sub-Saharan Africa, mobile internet users will climb from 26 per cent to 39 per cent between 2019 and 2025. That’s 203 million new mobile internet users over six years. In the Asia Pacific, GSMA estimate 700 million more mobile internet users will move online over the same period.
One potential use of DeFi is to supply financial services to this group. To access them you need a smartphone and an internet connection. The low DeFi services fees further increase access.
DeFi’s market share is still relatively small. It is currently 3 per cent of the total cryptocurrency market. DeFi also faces a big challenge. Currently, its user community is specialised. DeFi technology is built for enthusiasts, by enthusiasts. For DeFi to flourish, the technology needs to be adapted for mainstream use.
Market value only paints one part of the picture. It continues to have a committed community rapidly developing the technology. DeFi’s swift rise shows an encouraging trajectory.
This article was developed in collaboration with BTC Markets, a Stockhead advertiser at the time of publishing.
This story does not constitute financial product advice. You should consider obtaining independent advice before making any financial decisions.