Decentralized finance (DeFi), explained

DeFi aims to revolutionize banking by allowing anyone with internet access to lend and borrow without going through an intermediary. Is this the future of finance?

In just over a decade, the development of cryptocurrencies has spawned a parallel universe of alternative finance. Bitcoin, a payment system in which anyone can send money to a recipient anywhere in the world, was just the start.

Today, the digital money revolution is taking hold in the banking world – and regulators are sounding the alarm.

Imagine there are no banks – instead there are pieces of code running a program that acts like a bank and is open to everyone. They don’t force you to trust them, are censorship-resistant, and best of all, much cheaper than traditional banks.

This is the future that those who create decentralized finance (DeFi) applications aim to create, a future that would revolutionize the entire financial system.

Over the past 18 months, the idea of ​​DeFi has mushroomed in the crypto market, growing 1,200% since the end of 2020.

Although estimates vary, the total value locked in DeFi reached over $189 billion in January 2022.

What is DeFi?

DeFi leverages three main elements: cryptography, blockchain, and smart contracts.

As with cryptocurrencies, DeFi is built on the blockchain – the decentralized, immutable public ledger that allows all computers on a network to maintain a copy of a transaction history. The idea is that no entity has control or can modify the general ledger.

What sets DeFi apart from cryptocurrencies like Bitcoin is that it expands the use of blockchain from direct transfers of value to more complex financial use cases.

While Bitcoin can only be used as a store of value, DeFi – powered by decentralized applications (dApps) – allows parties to trade, lend, borrow and trade directly using the blockchain without intermediaries or costs. .

At the heart of DeFi are smart contracts, which are computer code that acts as a digital agreement between two parties.

Running on the blockchain, smart contracts automatically execute transactions if certain conditions are met and can be used for a variety of financial protocols such as issuing crypto loans and paying interest on assets.

Smart contracts are the fuel that powers DeFi and its popular protocols like Aave, Compound, and hundreds of others. Because they are processed on the blockchain, smart contracts can be sent automatically without a third party being involved.

Most DeFi projects are built on Ethereum, the second largest cryptocurrency platform, as its programming languages ​​are specifically designed to create and deploy flexible smart contracts. They have since expanded to other networks that also use smart contracts, like Solana and Avalanche.

Anyone can use DeFi products by going to an app’s website and logging in with a DeFi-enabled crypto wallet (such as MetaMask on Ethereum or Phantom on Solana).

Since the applications are built on a blockchain, users must then use the tokens of this blockchain to carry out transactions. For example, Ether is needed to pay for transactions on the Ethereum network and SOL is needed on the Solana network.

What’s so unique about it?

There are several key characteristics that make DeFi radically different from the current financial system.

For one, it’s completely open, meaning you can use the apps by creating a digital wallet, rather than requiring a bank account.

Second, you can move funds in almost an instant via the blockchain, reducing wait times for bank transfers to clear.

Third, the fees – at least for now – are much more competitive than traditional banks, although transaction costs vary depending on the blockchain network (Ethereum, for example, tends to have higher fees than other blockchains).

What can you do with DeFi?

There are three basic types of DeFi applications.

Lending and Borrowing

DeFi allows internet users to earn money the same way bankers do – by collecting fees on financial services.

In most cases, this is done by providing liquidity, where investors “stake” digital currencies, only they lend digital currencies to apps rather than people or businesses.

You can lend cryptocurrencies to a protocol in exchange for interest and/or rewards. Similarly, you can borrow digital assets from protocols to complete a transaction.

Most DeFi protocols use over-collateralization, which means you have to put up more than the amount you want to borrow. So if the value of the asset drops, the protocol can take your collateral to avoid losses.

Many advanced DeFi users use an investment strategy called “yield farming,” a risky practice that involves lending or staking cryptocurrency tokens for rewards in the form of interest. It’s like earning interest on a bank account, except you’re technically lending money to the bank.

Trade

While centralized exchanges like Coinbase and Binance take custody of your assets when trading, a decentralized exchange (DEX) removes that middleman so that direct peer-to-peer trading can take place.

Popular DEXs like Uniswap and PancakeSwap allow users to list new tokens to trade as well as swap one token for another. For example, on Uniswap, a user can trade Ether for USD Coin.

DEXs work better the more liquidity they have, so they compete as much for offering attractive offers to liquidity providers as they do for being affordable for traders.

Derivatives

As with regular finance, derivatives are an essential part of any capital market, and DeFi is no exception.

Compared to lending and trading, the DeFi derivatives space is still in its infancy. While derivatives are highly regulated in the real world, DeFi derivatives can be created by almost anyone openly and without permission.

Synthetix is ​​the most popular derivative protocol in DeFi today, enabling the creation of synthetic assets that track the value of a range of tradable things. The protocol currently supports synthetic fiat currencies, cryptocurrencies, and commodities.

The Role of Stablecoins

Because crypto is volatile, it is not very convenient for direct transactions like payments and loans.

For example, if an investor has used Ether in a DeFi protocol to earn interest, it is possible that a price drop in Ethereum will offset any returns earned.

The solution? Stablecoins, which are cryptocurrencies tied to assets like the US dollar, to provide stable value in digital form for blockchain transactions.

Stablecoin tokens like Tether and USD Coin act as a bridge between DeFi and the worlds of centralized finance, allowing investors to generate returns on their crypto assets in the DeFi market while mitigating the adverse effects of market volatility.

What are the risks ?

Participating in the “Wild West” of finance inevitably comes with a corresponding amount of peril.

In many cases, the people facilitating DeFi transactions are anonymous, which has led to fraud becoming rampant. “Rug-draws”, when developers abandon projects after investors have contributed large assets, are a notorious form of fraud in the crypto sphere, with DeFi particularly susceptible.

A poorly created smart contract could have flaws that allow crooks to steal, or other design flaws that affect the value of assets.

Since most DeFi services are uninsured, if a platform goes down or is hacked, millions of people could be at stake. In 2021, DeFi investors lost at least $1.5 billion due to security issues.

Regulatory refusal

Currently, regulation is virtually non-existent, although this may soon change.

In August 2021, U.S. Securities and Exchange Commission (SEC) Chairman Gary Gensler called for tougher regulation, suggesting some platforms may be breaking securities laws.

A few months later, Gensler argued that “without protections, I’m afraid it’s going to end badly.”

Thailand’s SEC has also come out in favor of the regulation, suggesting that some DeFi projects may require a license to operate in the country.

The Bank for International Settlements (BIS) also weighed in, warning that DeFi vulnerabilities “go beyond those in traditional finance” and could even threaten global financial stability.

Source: World TRT

About Emilie Brandow

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