What is DeFi?
In this guest article from the enter community, we explore a topic close to our hearts - DeFi. What is it, how does it differentiate from traditional finance, and what are the advantages?
In the past, we've always relied on centralized finance; which means that there is a single source of funding that oversees the movement of money, regulated by governments and banks. Decentralized finance, with its three fundamental components cryptography, blockchain technology and smart contracts, is a widely popular alternative to the centralization norm. In this article, we’ll dive deeper into DeFi, explore the difference between centralized/decentralized and look at advantages and risks.
What Is DeFi?
DeFi presents itself as a promising alternative to traditional finance as a successful implementation of blockchain technology (check out this article to understand blockchain technology). DeFi, as the name implies, is a catch-all term for a wide range of financial products and services based on decentralized blockchain technology and decentralized financial applications (DApps) aimed to cut out the intermediary in financial transactions, a goal long pushed for by true traditional financial institutions like banks. This is accomplished by implementing a blockchain-based trust mechanism that enables secure peer-to-peer transactions to take place without the need for a financial institution to charge a commission.
Applications for decentralized finance have created new opportunities for decentralized finance investors to generate passive income. In order to generate passive income from DeFi, investors must commit their DeFi assets as resources to confirm transactions and execute processes using the proof of stake or POS consensus mechanism.
How Does DeFi Work?
“Smart contracts” are programs running on the blockchain that can execute automatically when certain conditions are met. These smart contracts enable developers to build far more sophisticated functionality than simply sending and receiving cryptocurrency. These programs are what we now call DApps. You can think of a DApp as an app that is built on decentralized technology like Ethereum, rather than being built and controlled by a single, centralized entity like Apple.
There are six major DeFi categories, in addition to auxiliary services such as oracles and wallets. The lines between them are not always clear. However, this typology generally reflects participant perceptions of the DeFi market.
Stablecoins seek to maintain a constant value of a token relative to some asset, most commonly the US dollar or other major fiat currencies. It’s easier to trust and invest in a currency that is tied to the US dollar than a weird minor currency.
Exchanges allow users to trade one digital asset for another. It could be from fiat to crypto, like USD to Ethereum, or crypto to crypto, like Bitcoin to Ethereum. There is literally an exchange going on, hence the name.
Credit involves the creation of time-limited interest-bearing instruments, which must be repaid at maturity, and the matching of lenders and borrowers to issue those instruments. This is like setting up a community of lenders and borrowers. You need money, and someone is willing to offer you the money, with an interest.
Derivatives are synthetic financial instruments whose value is based on a function of an underlying asset or group of assets. Common examples are futures and options, which reference the value of an asset at some time in the future. It’s basically an agreement between a buyer and seller for the future price of an asset. Both parties speculate on the asset’s price, at which they agree to buy or sell.
Insurance provides protection against risks by trading the payment of a guaranteed small premium for the possibility of collecting a large payout in the event of a covered scenario. Same rules of insurance also apply here.
6. Asset Management
Asset management seeks to maximize the value of an asset portfolio based on risk preferences, time horizons, diversification, or other conditions. Basically following the wise adage of “not winning big but winning consistently.”
These six categories make up what we have come to know as DeFi.
What Differentiates DeFi From Traditional Finance?
There are several things that stand in direct opposition when we compare DeFi with traditional finance.
- The most important thing is that DeFi allows you to hold your own money, while in traditional finance, your money is always held by a company.
- In DeFi, a transfer of funds happens almost instantly, lasting only a couple of minutes, while in traditional finance, a payment can take several days to be processed, as it is processed manually.
- DeFi markets are always open, while traditional finance markets close when the work day is over.
- In DeFi, transaction activity is pseudonymous, while in traditional finance, your financial activity is tightly connected with your identity.
- DeFi is open to literally everybody, while you must fill out an application in order to use conventional financial services.
- Also worth mentioning is the fact that DeFi is built on transparency, which means that everybody can check the history of a product and its data, how it works, etc. Traditional financial institutions are closed to the public, as you are not allowed to see loan history, management assets, etc.
There are several advantages to using DeFi apps over their CeFi equivalents.
DeFi applications are accessible to anyone, anytime, without the need for complicated sign ups or verifications. They are also censorship resistant. Having equal access is very important, especially after the recent Robinhood Gamestop debacle.
In traditional finance, we have to deal with trusted intermediaries every time we use their services. DeFi services are provided by smart contracts, so anyone can access them without having to deal with the burden or costs of middlemen.
Every interaction with a DeFi service is public information.
DeFi applications are fully interoperable. This means you can combine one or more services to create a new service.
To show how powerful this is, let’s take an example. Say you have Ether in your wallet and there are no services offering good interest rates on Ether. You can create a new DeFi service that does the following: Deposit your Ether into the Dai smart contract and withdraw Dai tokens. Deposit that Dai in a lending pool and earn a decent interest rate. And finally you can also add insurance to protect your funds against certain risks
You can think of each DeFi service as a lego block and new DeFi services are built everyday by using creative ways to combine the existing ones. Doing the same in a CeFi system requires permission and continuous support from each individual service. This gives a huge advantage to DeFi systems in building financial applications that are impractical in our traditional finance.
There are also many risks associated with DeFi. Such as:
Smart contract bugs
There were numerous cases where funds were stolen from DeFi applications using clever hacks that exploited loopholes in the smart contract code. Many DeFi apps go through independent audits to minimize this risk but that doesn’t eliminate the risk, as evident from the millions of dollars stolen from audited services in the past.
It’s possible for the creators of a smart contract to include a backdoor that gives them access to all funds deposited into the contract. The DeFi service in this case is actually centralized. Sometimes a project may include this simply to support easier upgrades or stop the services if they discover an exploit. So, users should always do their own research into the project, team and how they aim to prevent a rug pull before investing in the service.
DeFi applications run on the blockchain they are deployed on. So, a DeFi service may become unusable or very expensive to use if the underlying blockchain cannot sufficiently handle scale. This is evident from the rapid rise of fees to use DeFi services on the Ethereum blockchain. Always watch out for fees every time you interact with a DeFi service. This concern is being addressed through planned upgrades to the Ethereum blockchain and other blockchains that offer similar DeFi services at a much lower cost.
DeFi is seen by many as the future of finance, as it offers the individual more freedom than the traditional financial system could. But while its technology can be impressive, there is still a long way to go before investing in DeFi could be seen as having a small risk level.
Disclaimer: These are the writer’s opinions and should not be considered investment advice. Readers should do their own research.
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