What is DeFi?
Decentralized finance (DeFi) is a current trend in the crypto space, and if you’re still unaware, let’s dig a little deeper into DeFi and learn more about it.
DeFi (short for decentralized finance) is referred to as a variety of financial applications and projects built on blockchain technologies, typically using smart contracts. Smart contracts are considered to be automated enforceable agreements that do not need intermediaries to execute and can be accessed by anyone who has an internet connection.
The applications and peer-to-peer protocols of DeFi require no access rights for easy lending, borrowing, or trading of financial tools. The majority of DeFi applications are built using the Ethereum network, but many alternative public networks are emerging that provide superior speed, scalability, security and lower costs.
Centralized Finance vs Decentralized Finance
Traditional financial services – payments, lending and borrowing were only available via established financial institutes and banks. But it transformed with the introduction of blockchain technology. When the concept of cryptocurrency started expanding, the discussion shifted to a new set of considerations, i.e., decentralized finance (DeFi) and centralized finance (CeFi).
Let’s first have a better understanding of these two concepts:
⎯ Centralized Finance (CeFi)
Centralized Finance was the standard for trading cryptos before DeFi was introduced. In centralized finance (CeFi), all crypto trade orders are handled through a central exchange. In centralized finance, the assets and services offered are managed by people, and users need to come to terms with that. This means you don’t own a private key that provides you access to your wallet.
CeFi is about trusting banks and corporations whose overarching goal is to make money. Third parties of this financial system facilitate money movement between parties, with each one charging fees for using their services. You don’t own your cryptocurrencies when buying /selling via a centralized exchange. Moreover, you are subject to the rules set by the centralized exchange.
For example, when you buy something using your credit card the charge goes from the merchant to an acquiring bank, which forwards the card details to the credit card network. The network in its turn clears the charge and requests a payment from your bank. Then your bank approves the charge and sends the approval to the network, through the acquiring bank, back to the merchant. Each entity in the chain receives payment for its services.
However, CeFi platforms are more flexible and convenient compared to DeFi; you can do fiat to crypto conversions and cross-chain exchange. Moreover, you can get higher interest rates when depositing assets on CeFi platforms. In case of issues or troubles, users have access to customer service provided by individuals or companies managing the funds.
Decentralized finance is a financial service that allows people, merchants, and businesses to conduct financial transactions utilizing a set of smart contracts and algorithms to execute its services. This is accomplished through peer-to-peer financial networks that use security protocols, connectivity, software, and hardware advancements.
Smart contracts are automated agreements that don’t require intermediaries or banks. They run on the Ethereum network and use blockchain technology. A blockchain is a distributed and secured database or ledger which is run by using applications called dApps.
Decentralized finance creates a fair and transparent financial system where anyone, who has an internet connection can lend, trade, and borrow using software that records and verifies financial actions in distributed financial databases. It allows unbanked people to access financial and banking services via blockchain technology.
One of the main advantages of DeFi is that users do not require permission to use DeFi. You can directly access the services using your wallet and without providing personal information or depositing money with DeFi. This financial system is accessible to all parties, without any barrier or discrimination.
While using DeFi services you don’t need to trust that the service will perform as promoted. Users can authenticate that DeFi services perform as intended by auditing their code and using external tools such as Etherscan to identify if a transaction was correctly executed.
DeFi Runs on Blockchain
The main technologies for enabling decentralized finance are blockchain and cryptocurrency. When you make a transaction in your account, it’s recorded in your banking transaction history which is owned and managed by a large financial institution. Blockchain is a decentralized, distributed public ledger where financial transactions are recorded in computer code.
When we say blockchain is distributed, that means parties using a DeFi application have an identical copy of the public ledger, which records each and every transaction in encrypted code. This provides users with anonymity, plus verification of payments and a record of asset ownership that’s (nearly) impossible to alter by fraudulent activity.
And by saying blockchain is decentralized, we mean there is no middleman or gatekeeper managing the system. There are parties that verify and record transactions using the same blockchain through a process of solving complex math problems and adding new blocks of transactions to the chain.
DeFI is powered by decentralized apps called “dapps,” or other programs called “protocols” and handles a wide variety of simple and complex financial transactions. It’s powered by decentralized apps called “dapps,” or other programs called “protocols.” These transactions are made in the two main cryptocurrencies, Bitcoin (BTC) and Ethereum (ETH).
Though Bitcoin is the more popular cryptocurrency, much of the dapp and protocol landscape uses Ethereum-based code.
Dapps and protocols are used in the following ways:
- Financial transactions-payments, trading securities and insurance, lending and borrowing are already happening with DeFi.
- DEXs (Decentralized exchanges) facilitate peer-to-peer financial transactions and let users retain control over their money.
- E-wallets are digital wallets that can operate independently of the largest cryptocurrency exchanges and give investors access to everything from cryptocurrency to blockchain-based games.
- Unlike cryptocurrencies, stable coins attempt to stabilize their values by tying them to non-cryptocurrencies, like the U.S. dollar.
- DeFi makes it possible for speculative investors to lend crypto and potentially reap big rewards.
- NFTs (Non-fungible tokens) commodify the previously uncommodifiable by creating digital assets out of typically non-tradable assets, like videos or the first tweet on Twitter.
- Flash loans are cryptocurrency loans when borrowers have the potential to make money by entering into a contract encoded on the Ethereum blockchain without lawyers. If the transaction can’t be executed, or it’ll be at a loss, the funds automatically go back to the loaner.
The DeFi market’s adoption is measured by what’s called locked value that calculates how much money is currently working in different DeFi protocols. Currently, the total locked value in DeFi protocols is nearly $43 billion.
Most centralized financial instruments and technologies roll out slowly over time, governed by the respective rules and regulations of regional economies, but the same moment a dapp is encoded on the blockchain, it’s globally available.
Uniswap is a decentralized exchange (DEX) created by Hayden Adams, who was a mechanical engineer from New York. The idea of the decentralized exchange sprung from posts written by Ethereum founder Buterin. Uniswap facilitates $1 billion or more in daily crypto trading, and the market value of its governance tokens, UNI, is about $12 billion according to CoinGecko, a crypto-data website.
Law student Stani Kulechov founded Aave in 2017, and it was originally called ETHLend. Aave is a platform that lets users lend and borrow crypto tokens. According to Defi Pulse, users have put about $14 billion worth of collateral for loans on the network.
MakerDAO was started in 2014 and co-founded by Rune Christensen. It is a lending and borrowing platform that uses Dai, a stable coin linked to the US dollar. MakerDao is one of the largest decentralized applications on the Ethereum blockchain and users have put up about $6 billion of collateral on the system.
The main advantages of using decentralized finance are the following:
In traditional finance some people cannot open bank accounts or receive loans. But DeFi platform allows anyone with an Internet connection and without any geographical restrictions to have access.
We may say that all transactions, data, and code on the blockchain are transparent to everyone, and this level of transparency builds trust among users.
In DeFi no central authorities are involved, and users do not have to worry about the security of their funds as they are in full control of them at all times.
However, keep in mind that as with any new technology, there is always some risk associated with its use, although this is not greater than that of traditional finance.
By saying interoperability we mean when two blockchain systems talk to each other and exchange value. Although much needs to be done, multiple DeFi platforms can already interact with each other safely.
The business rules are automated within the smart contracts on DeFi platforms eliminating any level of intermediaries and human intervention.
How Risky is Investing in DeFi?
DeFi investments’ main risk categories are the following:
- Software Risk
- Counterparty Risk
- Token Risk
- Regulatory Risk
- Impermanent Loss
- Gas Fees
- Risk of Outsmarting Yourself
The risks of DeFi cryptocurrency investment cannot and should not be underestimated and they come from a number of different aspects of decentralized protocols.
1. Software Risk
DeFi protocols run on the internet often with millions or billions of dollars flowing through them. Like all software applications, DeFi protocols have two main software risks – coding errors, “bugs,” that may cause the software to malfunction, and security vulnerabilities that allow thieves, “hackers,” to break in and steal funds from the protocol.
Software security vulnerabilities can destroy your DeFi investments. For example, reputable DeFi protocols Yearn Finance and Pickle Finance, have been victimized by hackers exploiting security vulnerabilities in their software to steal investors’ funds. If you invest in a DeFi protocol and hackers steal your investment funds, your money will be gone.
However, there are brand new DeFi protocols that offer extremely high rates of return on investments, sometimes 1,000% or 2,000%. While those numbers are enticing, remember that the higher the investment return, the higher the risk.
Larger protocols are more likely to attract negative attention from hackers than smaller protocols. These protocols face frequent, if not constant, attacks on their security. If protocols have operated for months without suffering a security failure, it may suggest that their software security is reasonably sound.
Before investing in a DeFi protocol, make sure you know how long it has been operating and the size of its total deposits. You can also check if the protocol has been hacked. If yes, find out when it happened, how the protocol’s operators responded to it, and what steps they took to prevent it from happening again. In this way, you can determine whether to trust the protocol with your money.
To be clear, there is no DeFi investment with zero Software Risk.
2. Counterparty Risk
Any loan agreement involves counterparty risk, which is the risk of loaning money to someone who does not repay. Many large DeFi lending protocols, including Aave, Compound, and Maker, require that borrowers must provide collateral worth over 100% of the borrowed amount.
Before depositing your money in a DeFi lending protocol, make sure you understand who will be borrowing your money (Individuals? Financial institutions?) and how its loans are collateralized (What percentage of collateral can a borrower withdraw? What types of collateral can borrowers post? Under what circumstances is the collateral liquidated?).
3. Token Risk
Every DeFi investment involves certain cryptocurrency tokens each of which has its own characteristics and its own risks. Take the time to research each of the tokens involved in the investment (How long have they been trading? Are the organizations that created them reputable?).
4. Regulatory Risk
Though nowadays DeFi protocols operate with almost no government oversight or regulation from any government entity it is impossible to predict how the situation could change, and how any new government regulations of DeFi protocols might affect your DeFi investments.
5. Impermanent Loss
You may earn rewards from the DeFi protocol for depositing your tokens in the liquidity pool, but you may also encounter a situation where you would have made more money by simply holding your tokens instead of depositing them in a liquidity pool.
It is very difficult to predict whether the price of any cryptocurrency will rise or fall in the future. So, you can search the internet for an impermanent loss calculator to determine how your investment would have performed based on historical data.
Newer tokens will have less historical price data available than older tokens. Consider this lack of historical information in assessing the risk of a given investment. Invest in liquidity pools that consist only of dollar-pegged stablecoins to avoid impermanent loss. Since all of these tokens are designed to always maintain a value of $1 per coin, their prices should not fluctuate and there should be no impermanent loss in the pool.
6. Gas Fees
Ethereum transaction fees, called “gas fees,” can be very high to deposit funds in a DeFi protocol. First of all, consider whether gas fees will outstrip your likely investment returns. For example, if you expect to earn 10% interest per year on investment, and your gas fee is equal to 10% of the investment, then it will take you a year just to break even.
7. Outsmarting Yourself
Investing in DeFi protocols is both complicated and brand new. Besides the known risks of engaging with DeFi, there would be also unknown risks of DeFi investing that have not yet come to light. Keep in mind that more complicated DeFi investments that offer higher rewards, may be more fun to try and may also be riskier and more difficult to understand.
In conclusion, the DeFi movement is one of the most promising offerings of decentralized space and has the unique opportunity of revolutionizing the global financial landscape. DeFi platforms are a very good option to offer transparent and secure finances. However, if you do not have previous experience, seek the advice of an expert in this field before getting into the fast-changing world of DeFi.
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