DeFi – short for Decentralized Finance, is a fast-evolving utility that offers various financial services similar to your bank. These include lending, borrowing, liquidity farming, and interest-bearing savings plans, albeit with your digital assets and a high level of decentralization. To understand the basics of DeFi more, we have to understand centralized finance first.
Centralized Finance
In Centralized Finance, banks, mutual funds, and wealth management companies among others hold your money as your custodial authority. It is no secret they make more money using your money and fairly so to a reasonable extent. Let’s say you are purchasing a mobile phone using your credit card. The card details are then sent to the merchant’s bank for verification. This is followed by banks relaying the exact information to the credit card network for clearance. The credit card network checks your balance, and eligibility among other factors, and processes the request. Once all details are confirmed, the network sends a confirmation to your bank regarding the transaction.
Both the credit card network and bank receive their share of money for providing services to you. And lastly, you pay the outstanding amount on your credit card on a regular basis to keep using the service. Be it for a simple transaction like this or processing your loan application, the banks have an overreaching control over which application they approve. They could give preferential treatment to someone while unfairly working against others. Yes, we are all humans, and such bias at times comes with nature. Now, this is where Decentralized Finance can be a big difference.
What is Decentralized Finance (DeFi)?
Decentralized finance is a financial movement that involves financial products and services based upon blockchains, all completely decentralized as opposed to traditional financial platforms. This new financial system comprises several unique parts, such as trading platforms, digital assets, dapps (decentralized applications), and smart contracts. All of these parts are built on a blockchain.
And since DeFi works without intermediaries like centralized institutions, it gives users access to financial services and activities that can be built on a distributed network.
The idea behind DeFi is to give people an alternative to traditional financial systems, which can be hard to access and use. By making financial services easier to find and use, DeFi is meant to lead to a more inclusive financial system that works for everyone, no matter where they live or how much money they have. DeFi can open financial services to anyone with an internet connection and a DeFi crypto wallet. This would reduce the need for intermediaries and make it easier for people to manage their money.
As the DeFi space continues to grow and change, it could change how finance works traditionally and give everyone access to a more fair and open financial system.
How Does DeFi Work?
DeFi works by leveraging the capabilities of blockchain technology to create a decentralized financial system that operates independently of traditional financial institutions. DeFi applications are built on top of public blockchain platforms like Ethereum, allowing for secure and transparent peer-to-peer transactions without intermediaries.
One of the critical elements of DeFi is the use of smart contracts. These self-executing agreements are stored on the blockchain and enforce the terms of the transaction, ensuring that both parties are held accountable. Users can interact with DeFi platforms through decentralized applications (dapps) to facilitate specific financial activities such as lending, borrowing, and trading. DeFi also relies on decentralized liquidity pools, allowing users to trade assets without a centralized exchange.
- Infrastructure: Ethereum is an example of a DeFi platform for writing programs without a central server. You can make smart contracts with Ethereum. These contracts can be used to set up rules or conditions under which an agreement can be made. A smart contract can’t be changed after it’s been put into place.
- Currency: For a decentralized financial system to be safe and reliable, it needs a currency that can be used to interact with the different protocols.
Now that we know the DeFi basics and how it works, let’s consider its importance.
Why is DeFi Important?
DeFi is important because:
- It enables financial services to be conducted in a decentralized manner without intermediaries like banks or other financial institutions.
- It allows for greater financial inclusion by providing access to financial services to individuals who may not have had access to them before.
- DeFi also offers transparency and security, as all blockchain transactions are recorded, which makes them immutable and tamper-proof.
- It has the potential to disrupt traditional finance and reduce the reliance on centralized institutions, making the financial system more resilient and less vulnerable to economic shocks.
- DeFi applications are programmable, allowing for the creation of innovative financial products and services that are more efficient, cost-effective, and accessible to a broader audience.
What are the Benefits of DeFi?
DeFi has several benefits, which have become increasingly popular in recent years. Some of the key benefits include:
1. Financial Inclusion
DeFi enables anyone with an internet connection to access financial services without the need for intermediaries like banks or other financial institutions. This opens up financial services to people who may not have access to them.
2. Transparency
Transactions on DeFi platforms are recorded on a public blockchain, which makes them transparent and immutable. This provides greater transparency and security compared to traditional financial systems.
3. Decentralization
DeFi platforms are decentralized, meaning a single entity or organization does not control them. This reduces the risk of DeFi hacks, fraud or manipulation and makes the system more resilient and less vulnerable to economic shocks.
4. Innovation
DeFi platforms are programmable, meaning developers can create innovative financial products and services that are more efficient, cost-effective, and accessible to a broader audience.
5. Lower Costs
DeFi platforms often have lower fees than traditional financial institutions because they do not have similar overhead costs. This makes financial services more affordable and accessible to a broader audience.
6. Faster Transactions
DeFi platforms use blockchain technology, enabling faster transactions than traditional financial systems. This makes financial services more efficient and convenient.
What are the Risks of DeFi?
While DeFi (Decentralized Finance) offers several benefits, there are also risks associated with it. Some of the key risks include:
1. Smart Contract Risk
DeFi applications are built on smart contracts, self-executing code vulnerable to coding errors, bugs, and attacks. If a smart contract is flawed, it can result in a loss of funds for the users.
2. Liquidity Risk
DeFi platforms often rely on liquidity pools, which are funds that users contribute to in exchange for tokens representing their share of the pool. If there is not enough liquidity in the pool, it can be difficult for users to withdraw their funds.
3. Market Risk
DeFi platforms can be subject to market volatility and fluctuations in the value of cryptocurrencies. This can result in a loss of funds for users who have invested in the platform.
4. Regulatory Risk
DeFi platforms are often unregulated, meaning they may not have the same legal protections as traditional financial institutions. This can make them vulnerable to regulatory crackdowns or legal challenges.
5. Centralization Risk
While DeFi platforms aim to be decentralized, some platforms may become centralized over time due to network effects or the concentration of wealth. This can result in a loss of trust and transparency for users.
What are the Types of DeFi?
DeFi (Decentralized Finance) encompasses a variety of decentralized financial applications and platforms that operate on blockchain technology. Some of the critical types of DeFi applications are:
1. Decentralized Exchanges (DEXs)
Decentralized exchanges (DEXs) are platforms that allow users to trade cryptocurrencies without the need for intermediaries like banks or other financial institutions. DEXs are decentralized, meaning that a central authority does not control them, and they often rely on liquidity pools to facilitate trade. DEXs typically offer greater security and transparency than centralized exchanges, as they do not hold users’ funds, and transactions are recorded on blockchains.
2. Stablecoins
Stablecoins are cryptocurrencies designed to maintain a stable value relative to another asset, such as the US dollar or gold. Stablecoins can be used as a means of payment or as a store of value, and they are often used in DeFi applications such as lending platforms and decentralized exchanges. The value of stablecoins is usually pegged to the underlying asset’s value. They are often backed by reserves of the underlying asset or held in a smart contract.
3. Lending Platforms
Lending platforms are DeFi applications that enable users to lend and borrow cryptocurrencies without the need for intermediaries like banks or other financial institutions. Lending platforms typically use smart contracts to automate the lending and borrowing process, and they often rely on collateral to mitigate the risk of default. Lending platforms offer greater access to credit and can provide higher yields than traditional lending platforms.
4. Wrapped Bitcoins (WBTC)
Wrapped bitcoins (WBTC) are cryptocurrencies pegged to the value of Bitcoin and can be used in DeFi applications. WBTC is created by locking up Bitcoin in a smart contract, and users receive an equivalent amount of WBTC that they can use in DeFi applications. WBTC allows bitcoin holders to participate in DeFi applications without selling their bitcoin.
5. Prediction Markets
Prediction markets are DeFi applications that enable users to bet on the outcome of future events, such as elections or sporting events. Prediction markets are decentralized, meaning that a central authority does not control them, and they often rely on the crowd’s wisdom to make accurate predictions. Prediction markets can be used for various purposes, including risk management, forecasting, and decision-making.
DeFi vs CeFi – What’s the Difference?
| Point of Comparison | DeFi | CeFi |
|---|---|---|
| Control | Decentralized, users control their funds and decisions. | Centralized financial institutions have control over funds and decisions. |
| Intermediaries | No intermediaries, transactions are executed through smart contracts. | Intermediaries such as banks, brokerages, or payment processors are involved. |
| Transparency | Transparent, all transactions are recorded on the public blockchain. | Not transparent, transaction details may not be publicly available. |
| Access | Open access, anyone with an internet connection can participate. | With restricted access, users need to meet specific criteria to participate. |
| Security | Relies on cryptography and smart contract security. | Relies on institutional security measures such as encryption and firewalls. |
| Innovation | Highly innovative, allows for the creation of new financial products and services. | Limited innovation, new products, and services are often developed slowly due to regulation and bureaucracy. |
What Currency is Used in DeFi?
Unlike traditional centralized finances, DeFi’s primary currency is a cryptocurrency that is used as collateral, interest-earning deposits, for swapping, trading etc. The industry has grown to a point where a vast majority of crypto users are earning passive income by subscribing to various interest-bearing savings and staking plans similar to your banking solutions. As of this writing, there are around 3000 cryptocurrencies in the market backed by decentralized projects/foundations and are largely self-governed by each of their community members (public).
A vast majority of DeFi solutions are built as layer 2 solutions on top of layer 1 blockchains like Ethereum through smart contracts. As per Investopedia, a smart contract is a self-executing contract with the terms of the agreement between buyer and seller being directly written into lines of code. The code and the agreements contained therein exist across a distributed, decentralized blockchain network.
With an overwhelming institutional interest seen in DeFi in recent years, the industry was already worth $100 billion by mid-2021. Fiat currency, in contrast, play a smaller yet valuable role in the DeFi world by allowing ordinary people/investors to buy and trade cryptos using legal tenders like the USD or Euro. Users also use legal tenders to buy ‘stablecoins’. They are crypto coins transacted on a blockchain and are backed by more stable securities like USD reserves or gold. The largest stablecoin in terms of market cap, Tether or USDT, for instance, is pegged 1-to-1 with US Dollar. This enables users to buy and trade more volatile cryptocurrencies with a stablecoin that behaves like fiat currencies for instant clearances and prevention of huge losses from slippage.
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What is the Future of DeFi?
The future of DeFi is interesting and challenging with few generic issues which the industry seeks to overcome in due course of time. Today Web 3.0 that includes DeFi mostly functions on technologies like open source blockchains. Although they have major advantages over their traditional peers as explained above, they are not perfect. As we speak, blockchain, for example, suffers from a vicious problem of ‘scalability trilemma’. It refers to blockchain’s inability to allow all its three fundamental principles – decentralization, security, and scalability — to coexist at the same time. It further states that one of three principles has to be sacrificed at any given time
Today, established cryptocurrency networks like Bitcoin and Ethereum are slow and expensive when compared to say Visa or Paypal. The more recent crypto networks are much faster but they are finding it difficult to keep a high level of decentralization and/or security. Further, the DeFi and crypto industry in general is not regulated like the stock market or banking. DeFi is aiming to facilitate borderless transactions that are inexpensive and easier compared to the current remittance system but we are not yet there.
Without regulations, DeFi is vulnerable to rug pulls (a term used for projects that crowdfund money for seemingly legitimate business cases but end up running away with the money) and a high degree of financial arbitrations/slippages. This is on top of crypto’s infamous volatility issue. Yes, these are some of the challenges in front of the industry to be overcome before it becomes mainstream. But challenges are completely fine when it comes to breakthrough technologies or innovation, right? How else will we know there is more than enough demand for say, privacy or financial opportunities?
Make no mistake, this industry is just over a decade old and there are several projects and nonprofit foundations along with their community aiming to solve today’s issues, compete with traditional institutions and eventually overtake them. In fact, legacy institutions like banking and money transfer institutions like JP Morgan and Paypal have already launched their entry into the DeFi space. As institutional investors are showing, crypto industry-led decentralization is here to stay to transform archaic architectures of traditional finance, healthcare, real estate, government institutions, print media, and social media among others. The work is on us to deliver and serve billions of under-represented and under-served people ultimately through truly disruptive innovations like DeFi.
Conclusion
We hope this post has made the basics of Defi clear to you. DeFi is an emerging field of decentralized financial applications and platforms that operate on blockchain technology. DeFi offers several benefits, including greater financial inclusion, lower costs, and greater transparency and security. However, DeFi also comes with smart contracts, liquidity, market, regulatory, and centralization risks.
Some critical types of DeFi applications include decentralized exchanges, stablecoins, lending platforms, wrapped bitcoins, and prediction markets. As the DeFi ecosystem continues to grow and mature, it has the potential to revolutionize the financial products and services industry and provide greater access to them for people around the world.
Frequently Asked Questions (FAQs)
1. Is DeFi a Cryptocurrency?
No, DeFi is not a cryptocurrency. Instead, it is a term used to describe a range of decentralized financial applications and platforms that operate on blockchain technology. DeFi applications often use cryptocurrencies as a means of exchange, but they are not cryptocurrencies themselves.
2. How do I Start Learning DeFi?
To start learning DeFi, read articles and whitepapers about the various DeFi applications and platforms out there. You can also participate in online communities and forums to learn from other DeFi enthusiasts and experts. Additionally, you can experiment with DeFi applications using small amounts of cryptocurrency to understand better how they work. There are also various courses and tutorials available online that can teach you about DeFi and how to use specific DeFi applications. It’s essential to do your research and only invest what you can afford to lose, as DeFi is still a relatively new and experimental space.
3. What are the Components of DeFi?
The components of DeFi include:
- Decentralized Applications (dapps): These software applications operate on a decentralized blockchain network and provide financial services like trading, lending, borrowing, and more.
- Smart Contracts: These are self-executing contracts coded on the blockchain and facilitate the automation of various financial transactions and processes.
- Blockchain Technology: DeFi applications operate on a decentralized blockchain network, allowing for secure, transparent, and immutable financial transactions.
- Cryptocurrencies: DeFi applications often use cryptocurrencies as a method of exchange, as they can be easily transferred and traded on the blockchain.
- Financial Instruments: DeFi platforms offer various financial instruments, such as lending and trading platforms, stablecoins, prediction markets, and insurance protocols, to facilitate financial transactions and manage risk.
- What is DeFi, and an example?: DeFi stands for decentralized finance; it refers to various decentralized financial applications and platforms operating on blockchain technology. An example of a DeFi application is Uniswap, a decentralized exchange that allows users to trade cryptocurrencies without intermediaries like banks or other financial institutions. Uniswap uses an automated market maker system that relies on liquidity pools to facilitate trades and provide liquidity. The Uniswap platform is open-source and community-driven and has become one of the most popular DeFi applications in the space.
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Opinions expressed in this publication are those of the author(s). They do not necessarily purport to reflect the opinions or views of Shardeum foundation.
About the Author : Snehasish is a Full stack Developer and a blockchain enthusiast who is eagerly setting his foot in Web 3.0. He further blogs about Web 3.0 on his website
