Open source finance refers to financial softwares and softwares as a service of which the source code is made publicly available. Combined with the power of blockchain, open source financial software built on public chains are collectively referred to as Decentralized Finance (DeFi) applications.
What Open Source Finance and DeFi Bring Us
Everybody deserves to have the right to access the financial systems. However, a large number of people are excluded from financial services in the world. The main reason is that traditional finance is under the control of companies and governments that are centralized and make decisions on behalf of others. Traditional finance is not welcoming to everyone. It is selective, it is censoring people, it is not even publicly verifiable. People who have access to financial systems have to trust the third parties, and it is a fact that trusted third parties are security and privacy holes. They are much like closed-source software, it is a black-box that nobody except a few knows what is happening inside. The seed for open source currencies and finance has been planted by Bitcoin, and now we have much more sophisticated open source finance software built on top of blockchain, i.e. DeFi’s.
DeFi involves decentralized applications (DApps), financial protocols and digital assets built on open blockchains such as Ethereum. It is a very broad term that includes even Bitcoin, since Bitcoin is also a digital asset itself. The aim of DeFi is to transform traditional financial products into open, publicly verifiable, borderless, censorship resistant, decentralized, and transparent protocols that run without intermediaries. The cornerstone of DeFi applications is being open source. Combined with being on the blockchain, this allows:
- To check if the software does what it says.
- To check if the software that is running on the network is the same software that is open-sourced.
- Better security and stability. As Linus’ Law says, “given enough eyeballs, all bugs are shallow”.
Currently, DeFi applications on the Ethereum network are a hot topic. They use smart contracts - computer programs on Ethereum blockchain - instead of third parties. Everything is automatised by computer programs and the code is the law. Therefore you do not need to trust anyone but the code. If the code works properly, it is not possible to stop a DeFi application and everybody in the world with an internet connection can use it.
In addition to the benefits mentioned above, DeFi also increases accessibility. Unfortunately, 3rd world countries still suffer from the lack or hardness of accessing trusted financial institutions. However, smartphone usage has been reported higher at least in several of those countries, especially in Sub-Saharan Africa. Given that all you need to have a smartphone or a computer with an internet connection to use DeFi, it gives an opportunity to people with disadvantages to use financial services.
Types of DeFi applications
The DeFi ecosystem houses different types of applications, each providing a specific type of financial service. Mainly, DeFi applications can be divided into three categories based on their functionality:
- Borrowing & Lending: Nowadays the most popular type of DeFi application is borrowing and lending platforms. Like the traditional finance applications, users deposit money and earn interest from other users borrowing their assets. However, in DeFi, all assets are digital, and smart contracts handle the connection of the lenders and borrowers, enforce the terms of the loans, and distribute the interest. As of writing, Aave and Compound are the largest borrowing and lending platforms.
- Monetary services: DeFi applications that focus on monetary services handle issuance of stablecoins, mortgages, and insurance. It is very critical to have decentralized stablecoins for people who do not want volatility. An example of decentralized stablecoin would be DAI which is pegged to the US dollar and brought by Maker DAO.
- Decentralized Exchanges and Marketplaces: Perhaps the most important DeFi applications are decentralized exchanges (DEXs). The cryptocurrencies aim to bring open finance to everyone, yet people still use centrally controlled exchanges which require Know-Your-Customer (KYC) and Anti-Money Laundering (AML) rules. It is obvious that centrally controlled exchanges can censor transactions, and it is not open to everyone. They have the opportunity to overtake user’s funds, manipulate the price and volume of the market. On the other hand, smart contract based decentralized exchanges open the exchange services to everyone. Anyone can verify the smart contract code of the exchange, therefore people do not need to trust any third parties. People can preserve their anonymity and privacy while exchanging different currencies. Currently the most commonly used DEXs are Uniswap, Curve.fi, and Kyber Network.
DeFi and open source finance is still at the infancy stage. However, given the fact that you can almost achieve anything that you can do in traditional finance, in a decentralized, open, verifiable, private and more accessible way, it is only natural to think DeFi will slowly replace traditional institutions.
It is important to note that there are many projects out there which claim to be a DeFi software without even publishing the source code. Without being open source, decentralization does not mean anything at all.
Disclaimer: The author(s) does not credit or recommend any of the software mentioned in the article by any means. They are widely respected open-source projects at the time of writing and given as examples.
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