Why Decentralized Finance Is Important And How It Works

When the global economy began to buckle under pressure from the 2008 financial crisis, it became clear that centralized systems had major shortcomings. Financial institutions can and will fail; they cannot be trusted to regulate themselves effectively. The collapse of Lehman Brothers and other key players dramatically demonstrated this. Today we are seeing an upsurge in decentralized finance solutions that leverage new technologies in novel ways to address these shortcomings and provide greater stability for the economy. These decentralized systems are generally referred to as decentralization finance because they involve decentralized versions of existing financial services. We’ll take a look at how these systems work in practice by exploring six primary examples:

Peer-to-peer lending platforms

One of the earliest and most successful examples of decentralized finance was the rise of peer-to-peer lending platforms. These allow individuals to leverage their cash to make loans to others—typically those who may otherwise have been denied loans due to poor credit history. Decentralized lending platforms like Lending, Prosper, and Funding Circle have been hugely successful, providing more than $100 billion in loans to millions of people and businesses worldwide. These decentralized loan systems provide benefits over more centralized models in several key areas. Decentralized systems can consider a wider range of factors to make more accurate loan decisions than centralized systems that are often limited to a single credit score. As a result, decentralized lenders can better identify and avoid risky borrowers. Borrowers can see all relevant aspects of their loan, and lenders can see how their funds are used.

This means lower rates of fraud, better outcomes for all parties, and a general sense of trustworthiness and legitimacy. Decentralized systems can also provide credit in areas where centralized institutions are unavailable, inflexible, or cost prohibitive. This means a wider range of options for people in underserved communities. - Better pricing: Decentralized systems have lower overhead costs than centralized lending models, resulting in lower interest rates and better returns for investors.

1. Asset-backed tokens

Investors have always used a variety of asset-backed securities to diversify their portfolios and increase their investment potential. These securities typically represent ownership in a portfolio of real-world assets like government bonds, real estate, and gold. Decentralized finance platforms are extending the concept of asset-backed securities to tokenized assets. The underlying asset is digitized and represented as a token on a decentralized blockchain. Decentralized exchanges like Open Finance provide a platform where investors can trade tokens representing shares in various real-world assets, including stocks, commodities, property, and even financial instruments like loans. Decentralized finance platforms can help address some of the shortcomings of centralized systems by providing: Decentralized systems are inherently transparent, with details of every transaction visible to all parties. This can help prevent fraud and ensure that assets are traded as intended.

Asset-backed tokens can be traded quickly and easily across distributed exchanges, meaning token owners don’t have to wait days or weeks to sell their assets. Decentralized exchanges also generally have low trading fees, allowing investors to keep more of their profits.

2. Cooperative Finance

Decentralized finance platforms also allow communities to pool their resources and invest in one another for greater collective impact. This can form investment syndicates, where a wider pool of investors can fund larger projects, or a peer-to-peer lending system. Decentralized finance platforms like Ethic and Loanbase allow communities to fund and support one another, leveraging the mutual trust that comes from working side by side. This allows smaller groups to access larger amounts of capital, which often makes it easier to achieve their goals while benefiting investors and borrowers through lower interest rates. Decentralized finance platforms can also help communities overcome some of the shortcomings of centralized systems by providing: Decentralized finance is designed to allow a community to work together to fund more ambitious projects than a single person or group might find difficult to achieve. 

Decentralized systems allow communities to fund and support each other, which generally leads to lower interest rates for both the lender and the borrower. - Better returns: Collective investment syndicates allow communities of investors to leverage their combined purchasing power and diversified risk to access better investment opportunities than would be available to any single investor.

3. Blockchain-based banking

Some decentralized finance platforms go even further, reimagining the entire banking model, so it is completely decentralized. Banks are typically centralized institutions with a centralized ledger that records all transactions. Decentralized finance platforms like Humany offer entirely blockchain-based banking that does not rely on centralized institutions. This approach allows for greater privacy since the ledger is not being shared with a single third party. It also ensures maximum transparency since all transactions are recorded on a public blockchain. Decentralized finance platforms can help address some of the shortcomings of centralized systems by providing. Banking systems are designed to support the flow of funds between parties, but they don’t always protect your data. Decentralized finance systems keep your information private and don’t share it with other parties. 

Decentralized systems are inherently transparent, with details of every transaction visible to all parties. This can help prevent fraud and ensure that all parties operate as expected. Centralized banking systems often charge high fees for their services, including transaction fees, interest rates, and penalties. Decentralized systems are typically low- or no-fee, making them more affordable for lenders and borrowers.

4. Decentralized exchanges

Decentralized exchanges provide a decentralized version of centralized trading platforms like NASDAQ. Decentralized exchanges can provide greater liquidity, lower trading fees, and a greater range of financial assets than centralized exchanges. Decentralized exchanges are built on blockchain technology, meaning investors and traders are connected directly, reducing the risk of fraud and the need for a middleman. Decentralized exchanges can help address some of the shortcomings of centralized systems by providing greater liquidity. Decentralized exchanges typically have higher trading volume than centralized systems, which allows them to offer a greater range of assets, including illiquid assets that are often left out of centralized exchanges. Decentralized exchanges are operated by open-source networks with no centralized management, which means they don’t charge high trading fees. Decentralized exchanges are designed to support a wide range of assets, including non-traditional assets like cryptocurrencies.

Why decentralization matters

Decentralization is not a silver bullet, but it can help build a financial system that is more stable and more equitable. By increasing transparency and reducing the need for centralized oversight, decentralized systems can help prevent fraud. By lowering the barrier to entry, they can also help more people access financial services and achieve greater financial inclusion. Decentralization also helps address unequal access to financial services and resources, providing new opportunities for people who might otherwise be left behind. It can also help protect against the risk of systems being hacked or controlled by a single party that could otherwise manipulate the system for their own purposes. Decentralization also brings new challenges and requires a larger investment of time and energy from users. When things go wrong, it can be harder to track your money and get the support you need.

Conclusion

The global financial crisis of 2008 demonstrated the shortcomings of centralized systems and the need for new decentralized finance models. Decentralized finance provides a different approach to money management and investment, with greater transparency, lower fees, and more equitable access. Decentralized finance is still in its early stages. It has a long way to go before fully replacing centralized systems. It will take time for decentralized systems to gain credibility, and they will need to overcome many technological challenges to scale effectively. Decentralized finance is a promising new approach, but it will take time to mature and prove itself as a reliable alternative to the current system.