For a long time, I’ve been wanting to write an article and tell others about decentralized finance. The effect it has on blockchain (the technology behind Bitcoin) is fascinating.
But I haven’t been great at doing so. To be honest, I feel that even though I know more than the average person, I still miss a lot of information. There are others better at explaining this concept than me.
So for now, I’ll leave that to others (see e.g. this graphical introduction to blockchain). What I want to do now though, is to zoom in a bit on one aspect of blockchain: decentralization, and specifically the application of that decentralization in finance.
If that sounds like a bit too much to handle, don’t worry. I’ll try to go slow.
A Starting Point: Understanding Centralization
In essence, decentralization simply means ‘not centralized’. If we look at today’s society, many aspects of it are centralized. Violence is centralized (it is held in the hands of the government / armed forces). The power to lay down rules and legislation is centralized. Finally, the provision of utilities like energy and water is also centralized (only a few companies can do this).
And while we don’t all leave our money at exactly the same bank, we find the concept of centralization in finance. Sure, we have some choice as to which bank we want to use, but choices are pretty limited. Plus the power to create money out of thin air (e.g. when providing a mortgage) is also limited to a few central parties.
There are some clear upsides to centralization. These could be economies of scale (reduced cost), the potential for leadership, and the possibility for one party (such as the government) to intervene for the greater good.
Of course, there are also clear downsides. To come back to finance, if we leave our money with a bank, is it still truly our money? Suppose our government or bank has bad intentions, what then? It could easily change the numbers on our bank accounts, inflate the money supply and make our money essentially worthless (consider the Zimbabwean dollar, among many others), or do another thing that negatively impacts the value of our money.
The Decentralized Approach to Finance
And here’s where decentralized finance comes into play. The idea that using technology (including blockchain), we can create solutions that offer the same functionalities that the financial world currently provides (like borrowing, lending, saving) — but then partly or fully decentralized.
That may still be a bit vague. So let’s consider an example of such a decentralized finance (DeFi) solution: Dharma offers a decentralized savings account. As a user, you can deposit stablecoins (these are cryptocurrencies pegged to the US dollar with the value of $1) and receive an annual interest rate of around 4.6%.
In many ways, this looks exactly like a savings account at a bank. You deposit your funds and receive an interest. Aside from the vast difference in interest rates (at which bank could you get an interest rate of 4.6%?!), the main difference is that this works in a decentralized fashion. Your money will stay yours; you’re not actually providing ownership to your funds to a third party, like you do in case of traditional banking services.
DeFi: Decentralized Finance
And that’s what is so cool about decentralization and DeFi. To have and use services without a central party in control. Again, others have better explanations on how this works (see e.g. this article for more reading), but it’s an amazing concept.
Now I won’t suggest for you to ‘unbank’ yourself and to put all of your money into Dharma (or other decentralized savings accounts). After all, there are many benefits to centralization in finance, like the deposit guarantee scheme here in the Netherlands.
But DeFi is incredibly exciting. And it will be great to see what new DeFi solutions will be built in the future, using blockchain technology. And it really makes you think: who do you trust with your money? The bankers, or open-sourced transparent technology?
I think there’s something to say for both.