The New Center of Finance; Decentralized Finance (DeFi)
Meet with Decentralized Finance (DeFi).
We have left behind a whole year that shook the world markets. There was a frequently mentioned topic among cryptocurrency investors, especially; Decentralized Finance, or known as DeFi. This term, which is confusing and a bit misleading, why was it so on the agenda? What made it so special? What does decentralized finance mean? If you have questions like these, don't worry, you are not alone. Let's take a look together at the values, potential, and most importantly, how it came to our present day, that distinguishes decentralized or open-source finance from its centralized alternatives. Let's open the door to financial freedom together.
You know how they say, “you can’t even trust your own father!” The narrative that DeFi is built upon is exactly this. The 2008 crisis and the actions taken by governments in its aftermath exposed the veil of financial corruption. It became clear that the state, as a product of a silent social contract, did not democratically offer financial instruments to its people, and that the concept of value could be easily manipulated by powerful minorities. The interests of society could be easily abandoned for the interests of individuals. Even the mistakes of individuals could be subsidized by the public.
Bitcoin as a Decentralized Money
On October 31, 2008, the Bitcoin paper published by a person or group using the pseudonym Satoshi Nakamoto was an experimental move to decentralize money and the power it brings. Bitcoin, which is a payment tool and currency design whose dynamics are programmed in advance, aimed to make possible the direct, peer-to-peer, and custody-free transfer of money. The records of our transactions were not stored in institutions or individual persons, but in a network system that anyone in the world can participate in without requiring any authority or permission. With this currency, we could exchange anything we wanted, like buying pizza, without having to trust individuals or institutions and entrusting our money to them. We now had a decentralized currency, $BTC, that we could use person-to-person without intermediaries.
Ethereum as a Decentralized Application Infrastructure
While Bitcoin had solved a significant problem, it only supported basic financial transactions such as exchanging currency. However, modern finance utilizes a multitude of financial instruments beyond just exchanges. Building a complex financial instrument on top of Bitcoin, other than exchange, was quite difficult. While alternative blockchain technologies like Namecoin and Coloured Coins were being developed, experiments were also being conducted with blockchain technology. This led Vitalik Buterin, one of the sharpest developers of his time, to ask a question: Can a programmable infrastructure be provided on the blockchain?
Going after this problem, Vitalik published Ethereum's first paper in 2014. He suggested that blockchain was not just for sending and receiving money, but could also be used as a decentralized programming platform. This idea sparked widespread interest and led to Ethereum becoming popular in a short amount of time.
Decentralized Applications
To talk about the decentralization of an application, we need to consider many inputs. However, today, almost all applications developed on the blockchain are defined in this way. However, applications are run by encoding their working principles into smart contracts and loading them onto the blockchain. Users mostly interact with these smart contracts through the interfaces of the applications. Therefore, in order to talk about complete decentralization, we need to look at the application governance model, its interface, the blockchain on which the application is located, and the participation rates of users.
Before delving deeper into decentralization discussions, we need to examine the motivations for the development of these applications. Why do we need to decentralize any application?
Immutability: I mentioned earlier when talking about Bitcoin that the system stores data in a distributed manner and guarantees the immutability of this data (DLT). Because the collection of data in a single center fundamentally carries the risk of modification.
Let's take computer games as an example. Imagine that you have a career that you developed by spending a lot of time. It wouldn't be very pleasant if this career that you developed with great effort was completely deleted, blocked, or its level reduced by a single administrator. Interestingly, Vitalik's motivation was quite similar to this example. The manipulability of centralized structures creates the need for decentralization even in games.
*It should be noted that this rule can be disregarded in some exceptional cases, especially in events that jeopardize user interests and the future of the network. Ethereum DAO hack can be shown as an example.
*Additionally, there are designs that support upgradeable or upgradable contracts today. Although it is argued that this undermines the principle of immutability, these contracts that can be changed with the DAO decision are potential solutions in terms of improving user and developer experience. The AUSD hack and the subsequent process in Acala can be shown as an example.
*DLT stands for "Distributed Ledger Technologies"
Transparency: All records stored in the blockchain are kept completely transparent and open to participants. The data of each transaction can be reviewed and confirmed retroactively, and is stored in hundreds or even thousands of different nodes on some networks.
*This transparency brought about by distributed systems is also one of the most important inputs for DeFi.
Censorship Resistance: It is quite difficult for a distributed system to be controlled or censored by authorities such as governments. The ability to access the records held in multiple nodes via the internet and join the network without requiring permission makes censorship almost impossible.
*Especially with Ethereum's transition to POS and OFAC sanctions, the censorship resistance of POS systems has become a topic of discussion.
Elimination of Intermediaries: In theory, decentralized applications do not require intermediaries between users. For example, AAVE, a kind of decentralized banking application, does not have any bank staff or bank buildings/ATMs. All transactions are controlled and approved by smart contracts according to predetermined rules, and the process is conducted without intermediaries. Reducing or eliminating intermediaries reduces security risks and also lowers fees.
Democratic Accessibility: In theory, having internet access is enough to use a decentralized application. There are no additional procedures, intermediaries, individuals or physical locations required. As a user, your identity, age, race, or language have no significance for decentralized applications. This makes decentralized applications much more accessible than their alternatives.
*This item is also one of the strongest narratives of DeFi.
Interoperability: Applications on the same blockchain can easily access and communicate with each other on the chain. This allows users to use multiple applications together with the same wallet, and develop different strategies on applications. If application codes are open, different developers can also develop protocols that work on each other's products. These types of applications, which are mostly developed to increase user experience and revenue performance, provide access to many hard-to-reach financial strategies and reveal the potential for designing brand new financial instruments.
Many different industries prefer to build their applications in decentralized environments due to the power of these items. These include games, social media applications, identity verification methods, management and voting models, supply chain, and of course financial applications.
Decentralized Financial Applications
The above phrase refers to decentralized applications in general, but it may be most relevant and necessary in the financial sector. A decentralized infrastructure that minimizes the need for trust may be the best solution for the transparency and confidence we need in financial instruments.
We have talked about the importance of immutability using the example of a game. Now, let's take banks as an example. In today's digital world, money has become more abstract than ever. It may seem absurd to describe something that has a material origin as abstract, but even today's banknotes are a tangible representation of an abstract trust assumption. The centralized and entirely trust-based financial sector is not very resistant to digital record manipulations. Think of stock exchanges, credit institutions, and shared manipulated data. Aren't these types of financial areas where we need decentralization the most, where transparency is absent, and personal discrimination and arbitrary regulations are at their peak? Let's take a look at some of the advantages of decentralization.
In decentralized finance applications, you don't need to trust individuals or institutions because transactions are performed directly between individuals (p2p) or between a person and a smart contract (p2c).
Self Custody
Personal wallets or smart contracts are used to store assets, not institutions or banks. This way, there is no custody risk. I know that many people find crypto wallets risky, but I believe that they are exactly what we need. As a society, we forget the fact that we don't even trust banks or the government and keep our gold under our own control, in our own homes. We ensure the safety of our gold ourselves. In fact, this is called "self-custody", where the complete control of assets is in the hands of the owner. Crypto wallets exist exactly for this reason.
The assets you hold in centralized exchanges are not even considered yours. Your assets can be used without your knowledge. For example, after the bankruptcy of FTX, a centralized crypto exchange, we learned that the exchange was lending user assets to the Alameda company as debt. Since the Alameda company also went bankrupt, this debt will never be paid back. Do you think I'm exaggerating? In the lawsuit filed after the Celsius fiasco, it was ruled that users who entrusted their assets to Celsius had given up ownership of their assets. All assets were deemed to be Celsius's property. Not only can users not use their assets, but they also have the right to freeze, suspend, and transfer them. Your centralized exchange account may be suspended one day without warning, and it may take weeks for you to find out why
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I would like to emphasize this point a little more because I find it important. When financial freedom is discussed, it is often confused with being wealthy and rich. However, the freedom in question is related to using assets, not the amount of assets. Today, even banks do not allow you to withdraw more than a certain amount of assets at once. Our say in the control of our own assets is restricted. However, in DeFi, we are the only ones who have a say in our assets. This is the concept of freedom that needs to be addressed.
While we're on the topic of freedoms, let's talk a bit about commonality and interoperability. It's quite difficult to find applications that work cohesively in traditional finance, or you need privileges or have to jump through hoops to access such services. However, in DeFi, there are dozens of applications developed solely in this area. There are two main reasons for this opportunity. One is "self-custody," which means that you still have control over your assets, and the second is that the applications are built on a shared, decentralized infrastructure.
Let's say you put your assets in an application and earn interest. The applications give you tokens in return for your assets. You can also use these tokens as collateral in another application. Or consider that you added liquidity to a decentralized exchange. With new models, tracking and optimizing this liquidity has become difficult. Developers who are aware of this difficulty are developing new protocols to optimize the liquidity on these exchanges for you.
From yield compilers to leveraged markets, debt protocols, and more, many applications can be used together and feed off each other. This situation allows for an increase in user experience and efficiency percentage.
Comparison with Centralized Alternatives
Like many areas, DeFi has its own advantages and disadvantages. I've tried to compare centralized and decentralized entities in bullet points and added it in the form of a graph. Although I have mentioned almost all the points, it is useful to add a few reminders and warnings.
First and foremost, it is important to remember that DeFi is still in its early stages compared to centralized alternatives, and we need to act accordingly. There is a learning curve in DeFi, and as you gain more knowledge, you become more comfortable navigating the space. Especially for new users, gaining experience in topics such as "self-custody" and "contract risk" can take time. During this period, it is important to thoroughly understand the risks associated with DeFi and take necessary security measures to avoid financial and emotional losses. Compared to centralized alternatives, the threshold for user adaptation can be higher in DeFi. However, once that threshold is crossed, the doors to a whole new world on DeFi are opened.
Since I planned this article as an introductory piece, I don't intend to go into detail about protocols and business models. Besides, it's not really possible to cover all of DeFi in one article. DeFi is a growing field that already includes hundreds of protocols. Many of the protocols found in traditional finance also have equivalents in DeFi. I believe that DeFi has completed its infancy phase in the previous cycle and is now entering a growth phase. However, I'd like to remind you that DeFi still carries many experimental protocols and the associated risks. DeFi is currently like the Wild West. It is a world that harbors high potential along with many dangers and is waiting to be discovered.
This article was originally published on the news site uzmancoin.com as Turkish by myself.