DeFi is the abbreviation for Decentralized Finance.
The term refers to those financial services that are provided through decentralized platforms, i.e. not controlled or managed by any single entity, but by a public and open IT protocol. When the decentralized Bitcoin protocol was put forward in 2008, it was created to make bitcoin an inviolable currency not controlled by anyone, but managed only by a public and open IT protocol, so as to avoid manipulation.
Since then, the Bitcoin protocol has proven to work very well in this regard, especially since it has never been manipulated or hacked, and it hasn’t been a victim of tampering or counterfeiting. Given that decentralization, which has made all this possible, has worked so well for Bitcoin, for some years now attempts have been made to exploit it even in the context of financial services. Bitcoin in itself is only a digital currency, and its protocol does not, for example, natively include smart contracts.
Whereas on the Ethereum network, which is based on a decentralized architecture similar in many ways to that of Bitcoin, smart contracts are natively supported, allowing to write and execute decentralized programs capable of creating financial transactions autonomously. Thanks to these smart contracts, it is possible to create decentralized financial tools based on public and open networks such as Ethereum, which are able to provide financial services with unprecedented features.
Obviously, besides the advantages, DeFi platforms also have some limitations. And this is where CeFi (Centralized Finance) platforms come into play, addressing the remaining part of digital financial services.
DeFi Tools have some Advantages:
- First of all, they cannot be manipulated, i.e. once a smart contract is uploaded on the Ethereum network it cannot be altered, arrested, tampered with or counterfeited. It will simply work forever just the way it was designed to work. This makes it immutable, which means that if someone wants to modify it, or perhaps update it to a new version, it is necessary to create another smart contract and move all the assets to the new one.
- Secondly, they are completely predictable, i.e. their behaviour always follows the instructions contained in their computer code. Obviously, the downside is that there is no room for flexibility: the behaviour of these tools is cold and merciless, absolutely unmanageable since it does not allow for actions that differ even minimally from those foreseen by the code.
- Thirdly, they are publicly verifiable by anyone. Thanks to any public blockchain explorer, and the fact that they are open source, anyone can access the code and check in detail how everything works.
These features make DeFi tools absolutely unique because never before has it been possible to create financial platforms that cannot be manipulated in any way, cannot be restricted, hindered or stopped, and which are completely predictable and publicly verifiable by anyone. However, the drawback is that these features do not allow these platforms to provide every financial service.
For example, in the lending sector, DeFi platforms are already widely used, specifically in the crypto sector, precisely because they are extremely secure and predictable, but they require collateral covering at least the entire amount of money borrowed. This means that they cannot be used to grant loans that are based solely on trust, or the prospect of future income, such as bank overdrafts or unsecured loans guaranteed only by a document such as a paycheck.
DeFi cannot be a complete substitute for CeFi
In short, decentralized finance cannot be a complete substitute for traditional finance, but it does allow for services that traditional finance has never been able to provide.
In particular, the trustless nature of DeFi tools, which does not require users to trust them since their behaviour is absolutely predictable, inviolable and verifiable by anyone publicly, makes them something completely new.
This real revolution was started by Bitcoin, the first trustless currency in history, which is not based on trust in the subject that issues and manages it, simply because this subject does not even exist. There’s a well-known motto for decentralized financial tools: “don’t trust, verify”, which clearly illustrates how it’s not necessary to trust anyone in order to use them, as it’s enough to verify personally that everything is as it should be.
As such, DeFi tools are definitely different from CeFi tools, although they offer similar financial services, such as loans. Moreover, they also provide completely new financial services, such as algorithmic stablecoins. By contrast, Centralized Finance (CeFi) tools always require that there is a single managing entity or at least a limited group of entities that have greater powers than simple users. This is sometimes a disadvantage, but it can also be an advantage, such as knowing who to contact to get explanations or help, while for DeFi tools it is much more difficult to get help from third parties in a safe way.
Exploring the combination of DeFi and CeFi
For example, when losing access to a decentralized wallet there is no way to retrieve it, whereas if access to a centralized wallet is lost, in theory, it should always be possible to get help from the manager of the centralized wallet in order to retrieve access.
All traditional financial tools are centralized, the reason being that there has always been a party that provided and managed them. The ability to eliminate the provider makes their use much safer as there is no need for trust. Moreover, this also means that there is no need to use intermediaries in order to take advantage of financial services.
In centralized finance the most popular intermediaries are the banks, without which many traditional financial services simply cannot be used. However, in decentralized finance there are no intermediaries, which makes it possible, for example, to obtain loans from private individuals without having to resort to a banking or credit institution. In fact, it is the decentralized IT platform that provides the service, and not an institution made up of people who may make mistakes or act unfairly if not even criminally.
DeFi is therefore a novelty, and a great innovation, but one that does not solve all the problems of the financial world and will not wipe out CeFi.
Rather, DeFi and CeFi will contribute in a complementary way to offer users innovative financial services that already allow them to do things which until a decade ago were unimaginable.