What is DeFi?
DeFi is the short form of ”Decentralized finance” which refers to an ecosystem of financial applications that is built on blockchain system.
The term DeFi may refer to a movement that aims to create an open-source, permissionless, and transparent financial service ecosystem. One that is available to everyone and operates without any central authority. The users would maintain complete control over their assets and interact with this ecosystem through peer-to-peer (P2P), decentralized applications (DApps).
The core benefit of DeFi is enabling easy access to financial services, especially for those who are isolated from the traditional financial system. Another advantage of DeFi is the modular framework it’s built upon, with interoperable DeFi applications on public blockchains. These have the potential to create entirely new financial markets, products, and services.
DeFi eliminates the fees that banks and other financial companies charge for using their services. Individuals hold money in a secure digital wallet, can transfer funds in minutes, and anyone with an internet connection can use DeFi.
How Does DeFi Work?
Decentralized finance uses the blockchain technology as its base to perform the transaction just like cryptocurrencies use. ”A blockchain is a distributed and secured database or ledger”. Applications called dApps are used to perform transactions and run the blockchain.
In the blockchain, transactions are stored in blocks and then verified by other users. If these verifiers approves on a transaction, the block is closed and encrypted; after that another block is created which has information about the previous block within it.
The blocks are “chained” together through the information in each proceeding block, giving it the name blockchain. Information in previous blocks cannot be changed without affecting the following blocks, so there is no way to alter a blockchain. This concept, along with other security protocols, provides the secure nature of a blockchain.
The most popular types of DeFi applications include:
- Decentralized exchanges (DeXs): Online exchanges help users to exchange crypto currencies for other currencies, whether U.S. dollars for bitcoin or ether for DAI. DEXs are a hot type of exchange, which connects users directly so they can trade cryptocurrencies with one another without trusting an intermediary with their money.
- Stablecoins: A cryptocurrency that’s tied to an asset outside of cryptocurrency (the dollar or euro, for example) to stabilize the price.
- Lending platforms: These platforms use smart contracts to replace intermediaries such as banks that manage lending in the middle.
- “Wrapped” bitcoins (WBTC): A way of sending bitcoin to the Ethereum network so the bitcoin can be used directly in Ethereum’s DeFi system. WBTCs allow users to earn interest on the bitcoin they lend out via the decentralized lending platforms described above.
- Prediction markets: Markets for betting on the outcome of future events, such as elections. The goal of DeFi versions of prediction markets is to offer the same functionality but without intermediaries.
In addition to these apps, new DeFi concepts have sprung up around them:
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Yield farming: For knowledgeable traders who are willing to take on risk, there’s yield farming, where users scan through various DeFi tokens in search of opportunities for larger returns.
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Liquidity mining: When DeFi applications entice users to their platform by giving them free tokens. This has been the buzziest form of yield farming yet.
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Composability: DeFi apps are open source, meaning the code behind them is public for anyone to view. As such, these apps can be used to “compose” new apps with the code as building blocks.
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Money legos: Putting the concept “composability” another way, DeFi apps are like Legos, the toy blocks children click together to construct buildings, vehicles and so on. DeFi apps can be similarly snapped together like “money legos” to build new financial products.
What are the risks of DeFi?
While the DeFi world can offer appealing APYs, it is not without risks. Even though they are decentralized, you are essentially consuming financial services, and some of the risks are familiar:
1. Counterparty Risk: If you take part in crypto loans or any other kind of lending, you’re at risk of the counterparty not repaying their debt.
2. Regulatory Risk: The legality of certain services and projects can be difficult to ascertain. If you are invested in a smart contract that is subsequently shut down due to regulatory problems, then your funds can be at risk.
3. Token Risk: The assets you hold have different risk levels affected by their liquidity, trustworthiness, token smart contract security, and associated project and team. As the DeFi pace has many low market-cap tokens, token risk can be particularly high.
4. Software Risk: Code vulnerabilities can undermine the security of smart contracts you’re invested in. Your wallet could also be compromised due to connecting to DeFi DApps and giving them certain permissions.
5. Impermanent Loss: If you’re staking in liquidity pools, divergences away from the price ratio you entered at will cause you to lose some tokens deposited in the pool if you withdraw.
The Future of DeFi
Decentralized finance is constantly evolving. It is unregulated and its ecosystem is riddled with infrastructural mishaps, hacks, and scams.
Current laws were crafted based on the idea of separate financial jurisdictions, each with its own set of laws and rules. DeFi’s borderless transaction ability presents essential questions for this type of regulation.
Who is responsible for investigating a financial crime that occurs across borders, protocols, and DeFi apps? Who would enforce the regulations, and how would they enforce them?
Other concerns include system stability, energy requirements, carbon footprint, system upgrades, system maintenance, and hardware failures.
Is Bitcoin a Decentralized Finance?
Bitcoin is a cryptocurrency. DeFi is being designed to use cryptocurrency in its ecosystem, so Bitcoin isn’t DeFi as much as it is a part of it.
How do I make money with DeFi?
The value locked up in Ethereum DeFi projects has been exploding, with many users reportedly making a lot of money.
Using Ethereum-based lending apps, as mentioned above, users can generate “passive income” by loaning out their money and generating interest from the loans. Yield farming, described above, has the potential for even larger returns, but with larger risk. It allows for users to leverage the lending aspect of DeFi to put their crypto assets to work generating the best possible returns. However, these systems tend to be complex and often lack transparency.
Is investing in DeFi safe?
No, it’s risky. Many believe DeFi is the future of finance and that investing in the disruptive technology early could lead to massive gains.
But it’s difficult for newcomers to separate the good projects from the bad. And, there has been plenty of bad.
As decentralized finance has increased in activity and popularity through 2020, many DeFi applications, such as meme coin YAM, have crashed and burned, sending the market capitalization from $60 million to $0 in 35 minutes. Other DeFi projects, including Hotdog and Pizza, faced the same fate, and many investors lost a lot of money.
In addition, DeFi bugs are unfortunately still very common. Smart contracts are powerful, but they can’t be changed once the rules are baked into the protocol, which often makes bugs permanent and thus increasing risk.