Decentralized finance, known by the acronym DeFi, is a term for the “ecosystem” of next-generation financial applications. What sets the DeFi space apart from traditional financial applications is the use of blockchain technology, which is accessible and transparent to the general public. This is the same technology that supports cryptocurrencies and has become more “hot” than ever in recent years. The most important aspect of the DeFi system is that the various applications on it are decentralized. You may have already heard about decentralization in connection with blockchain technology or cryptocurrencies – but what does it mean?
In the world of cryptocurrencies, things can change quickly, but currently DeFi is performing well as a “family” of crypto assets. So whether you are just getting to know the crypto world or have already ventured a little deeper into it, why not dive into DeFi and discover the various opportunities it offers?
What is DeFi
“In a decentralized financial system, a farmer in a developing country would have the same level of access and rights as a top trader at an American financial firm.”
Decentralized finance, or DeFi, represents a shift that enables users to use financial services such as borrowing, lending, and trading without having to rely on centralized entities. These financial services are delivered through decentralized applications (dApps), most of which are deployed on the Ethereum platform.
DeFi is not a single product or company, but rather a range of financial services that mirrors the traditional financial industry, including banking, insurance, bonds, money markets, and much more. DeFi dApps allow users to combine these services to achieve desired financial goals. Due to its composable nature, it is often referred to as money LEGO.
The DeFi system removes the control that banks and institutions have over money, financial products, and financial services.
Here are some key facts about DeFi:
- it eliminates the fees that banks and other financial companies charge for using their services;
- you can store your money in a secure digital wallet instead of a bank;
- anyone with an internet connection can use it without approval;
- funds can be transferred in seconds or minutes.
So what is DeFi? In short, DeFi is a financial system that uses protocols, digital assets, smart contracts, and decentralized applications (dApps) on Ethereum (currently the largest) to build a financial platform that is open to everyone. But before we continue with what DeFi is, let’s first look at what DeFi is NOT. To define this, we must first understand how the traditional financial system is built.
The difference between centralized and decentralized finance
To understand decentralized finance and how it works, it is very helpful to first understand what the difference is between centralized and decentralized finance.
With centralized finance, your money is held by banks and corporations whose primary goal is to generate profit. The traditional financial system is therefore full of third parties that facilitate the flow of money between parties, with each so-called third party charging fees for the use of its services. Say you buy a carton of milk with a credit card. The charge goes from the merchant to the acquiring bank, which forwards the card details to the credit card network.
The network then clears the charge and requests payment from your bank. Your bank then approves the charge and sends the approval to the network, through the acquiring bank and back to the merchant. Every entity in the chain receives payment for its services, as merchants must pay for your ability to use credit and debit cards.
Likewise, all other financial transactions cost a certain sum of money. For example, the approval of loan applications can take several days, and it may also happen that you might not even be able to use banking services if you are traveling.
Two goals of DeFi are to shorten transaction times and increase access to financial services.
Decentralized finance eliminates intermediaries or third parties by enabling people, merchants, and businesses to conduct financial transactions through emerging technology. This is achieved through peer-to-peer financial networks that use security protocols, connectivity, and advanced software and hardware.
Wherever you have an internet connection, you can lend, trade, and borrow assets through financial applications (dApps). The distributed database of financial applications is accessible from various locations; it collects and aggregates data from all users and uses a consensus mechanism (e.g., PoW, PoS…) to verify it.
DeFi uses this technology to eliminate centralized financial models, enabling anyone to use financial services anywhere, regardless of who they are or where they are.
DeFi applications give users greater control over their money through personal wallets and trading services, for which each individual is solely responsible.
IMPORTANT: Although decentralized finance enables self-custody, it does not guarantee anonymity. Your transactions may not carry your name, but they are visible and accessible to anyone, as they are recorded on the blockchain – the originating and destination address, as well as the transaction value and currency, are all visible. If your identity is linked in any way to an address on the blockchain, it can be traced. This can make you a target for certain entities, such as governments, law enforcement, or other entities acting to protect people’s financial interests.
How DeFi works
Decentralized finance uses a technology called blockchain, which is associated with cryptocurrencies. As we have written in some other articles, blockchain is a distributed and secured database, or in other words, a ledger of transactions. Applications called dApps are used to process and handle transactions.
Simply put, DeFi can be understood as a financial ecosystem that stems from blockchain technology. Some compare the emergence of DeFi to the introduction of the printing press for the exchange of information.
To be more precise, DeFi makes it possible for loans, insurance, international payments, and much more to become accessible to anyone with an internet connection. This means that people can take control of their own economy without having to rely on a bank or other financial intermediaries.
Keep in mind that DeFi is a relatively broad term that encompasses many different applications powered by blockchain. Nevertheless, their common denominator is that they are open to everyone, resistant to censorship, and help democratize finance.
Decentralized applications, commonly known as dApps, are at the core of DeFi itself. Building applications powered by blockchain technology is becoming increasingly common and can be compared to the development of smartphone applications. However, dApps are significantly more powerful and can give users access to innovative new financial services. In addition, unlike conventional applications, no central server is used to retrieve data; instead, data is retrieved from the blockchain network, which is distributed across the entire world.
DeFi is mostly built on the Ethereum blockchain
DeFi applications (dApps) are built on top of blockchain, and for most applications, that blockchain is Ethereum. You’re probably wondering why Ethereum and not Bitcoin? Well, there is some DeFi activity on the Bitcoin blockchain, but Ethereum is the better choice at this point, and we’ll tell you why.
If you have read our article Od A do Ž o kriptovaluti Ethereum, then you know that the essence of Ethereum is smart contracts. To briefly summarize, smart contracts are computer programs that automatically execute actions precisely defined within the program code itself. They are written in the programming language Solidity, which is a “Turing Complete” programming language. This means that more complex dApps can be created on Ethereum than on Bitcoin, which only allows partial programming – it is not “Turing Complete”. Developers can program dApps that can manage digital assets called smart contracts.
In the traditional world, a smart contract is similar to any other contract between two parties overseen by a lawyer, but there are differences between them:
- you can reject the lawyer, and
- a smart contract executes itself.
In other words, a smart contract is a protocol that allows parties to interact directly with each other without a third-party overseer – there is no lawyer involved in smart contracts.
Since Ethereum was the one that leveraged smart contracts and became the first dApp development platform, it became the blockchain of choice for many companies looking to build their financial products. Thus, not only are most DeFi applications built on Ethereum, but it is also the reason why the largest share of innovation is happening on their blockchain.
So let’s look at the main characteristics that distinguish public blockchains from private networks used by traditional financial institutions:
- programmability: developers can program dApps that provide low-cost financial services;
- trustless: transactions can be securely confirmed without central entities;
- permissionless: anyone can create and use DeFi dApps;
- decentralization: records are not stored on a single server or central network;
- transparency: transactions are public so that anyone can review them;
- censorship “resistance”: a central party or authority cannot reverse transactions.
Problems that DeFi can solve
Some problems in the financial world that DeFi can solve are:
- limited access to global financial services: global access to financial services already exists, but has numerous barriers (more on this below). Do you have a computer or mobile phone with internet access? That is all you need to get started with DeFi;
- too many barriers to entry: extensive documentation and a well-funded bank account are required, not to mention a favorable geographic location near a financial service provider – these are all barriers to entry in the traditional financial space that DeFi aims to eliminate;
- lack of privacy and security: centralized institutions can inadvertently compromise the wealth and personal data of their customers. In DeFi, users control their own money and do not need a central authority;
- high fees for international payments: DeFi aims to reduce global remittance fees (which amount to approximately 7%) by more than half (to a manageable 3%). By simply eliminating unnecessary fees charged by intermediaries, cross-border payments can be greatly reduced;
- censorship: DeFi offers immutable transactions and a blockchain that central authorities, such as governments, major banks, or big tech tyrants, cannot suppress. Although your transactions can be publicly reviewed, your identity remains pseudonymous;
- complexity: developers ensure that the user interfaces of their dApps look more attractive and easier to use every day. Simple usability will help the masses move away from traditional, complex, centralized systems.
DeFi financial products
At this point you will probably say: “Enough theory! How can I make money with this? What are the financial products offered by DeFi?” There are many ways you can earn, but as with any speculative venture, there are also many ways to lose. So as you continue, keep your risk tolerance in mind.
DECENTRALIZED MONEY MARKETS
This term can confuse those who are not familiar with conventional money markets. Money markets are markets for borrowing and lending assets, and they mostly allow users to borrow or lend various crypto assets.
Decentralized money markets can be viewed as an alternative to the traditional banking system for lending or taking out loans. In addition, they are mostly self-managed using smart contracts that define the rules for the operation of decentralized money markets.
The big difference between decentralized money markets and conventional money markets, however, is that decentralized money markets are open to anyone. They can meet the needs of those who do not have access to financial infrastructure.
In addition, they allow anyone to earn interest on their crypto assets through, for example, lending or borrowing. This gives ordinary people access to mechanisms that banks have been using to make money for centuries. Let’s look at the latter with an example. Person A wishes to borrow an asset, believing that the value of a certain cryptocurrency will rise and wanting to increase their profit in this way. Person B lends their assets through the aforementioned dApps and associated protocols. When Person A returns the borrowed assets (along with a fee), that fee goes directly to Person B, who lent the assets for this purpose. There was no third party or bank involved that would receive the interest.
DECENTRALIZED EXCHANGES (DEX)
Anyone familiar with cryptocurrencies will likely know that trading them is an essential part of the cryptocurrency world. These are often referred to as “decentralized exchanges.” We are not talking about exchanges on ordinary centralized exchanges (Binance, Kraken…). These are exchanges that operate in a decentralized manner and have no central authority. For those unfamiliar with the term “exchange,” it is essentially a platform that allows users to trade specific assets (buying and selling).
In general, decentralized exchanges focus on trading cryptocurrencies, but the underlying technology can be useful for trading any asset. Additionally, decentralized exchanges can reduce the risk of theft, as users do not need to transfer their assets to the actual exchange. Instead, they can allow users to connect directly to the exchange’s trading network, known as “peer-to-peer” (P2P). Nevertheless, it is important to verify their origin, as there are many fake DEX addresses where, once we connect a wallet and transfer assets, the latter can be lost.
Users trade directly with each other on the exchange using their own assets. This can take various forms. Some exchanges use so-called “proxy tokens,” which represent assets (such as cryptocurrency), shares (representing ownership), or a multi-signature deposit system. Some decentralized exchanges (DEX) are:
- Uniswap;
- Loopring DEX;
- dYdX;
- Kyber Network;
- 1inch;
- Pancake swap.
DECENTRALIZED STABLECOINS
Regular cryptocurrencies are still relatively volatile. Although this will likely settle down over time, some investors want crypto assets with all the benefits of blockchain technology but with less volatility. This is where decentralized stablecoins come in. Simply put, stablecoins are a special category of cryptocurrencies with low volatility.
Stablecoins achieve their low volatility by pegging their value to other assets. Perhaps the most obvious example of this is pegging a stablecoin to the value of a national currency, such as the US dollar. However, this is far from the only solution. Some stablecoins are instead pegged, for example, to a basket of commodities or a collection of multiple currencies.
Some of the most well-known decentralized stablecoins:
- Tether (USDT);
- USDC/USD Coin;
- DAI;
- UST.
DECENTRALIZED INSURANCE
From assessing various levels of risk, setting premiums, paying out claims, hacker attacks – loss of assets – and so on, it is close to a perfect use case for blockchain technology and smart contracts. Many observers already assume that decentralized insurance could be one of the next major areas for DeFi.
Decentralized insurance can be resolved without intermediaries, financial institutions, and other inefficient aspects of the legacy insurance sector. Furthermore, decentralized insurance is an excellent choice for reducing risks associated with smart contracts.
DECENTRALIZED SYNTHETIC ASSETS
Another central aspect of DeFi is decentralized synthetic assets. As you have probably already figured out, “decentralized” means it is built using resilient, distributed blockchain technology. So what are synthetic assets?
They are sometimes also known as derivatives. Traders will know that derivatives or synthetic assets track the value of something. This allows traders to gain exposure to an asset they wish to invest in, even if it is difficult to physically invest in it.
These can be things such as gold, traditional stocks, crypto assets, or even commodities. However, decentralized finance and decentralized synthetic assets are particularly important for those who do not have access to traditional financial systems.
Nevertheless, it should also be noted that synthetic or derivative financial instruments do not represent ownership of the asset itself – it is merely a representation of the value derived from it.
INTEROPERABILITY
One of the most exciting features of decentralized financial applications is the number of ways they can be combined to create entirely new products.
Risks associated with DeFi
One of the best things about DeFi is that it allows people to take control of their own assets. However, as the old man in the Spiderman movie says: “With great power comes great responsibility.”
The possibility of high returns can lead people to take great risks, which can cause significant losses if they don’t act responsibly. One minute you can be flying above skyscrapers thinking you’re the incredible Spiderman of DeFi, and the next minute you can crash into “Rekt City”. And you don’t want to end up there.
This is not financial advice, but remember that the higher the potential return, the greater the risk. However, you can choose an appropriate amount that you are willing to risk.
Who can access the wonderful world of DeFi
Absolutely anyone. All you need to get started is an internet connection and a crypto wallet. But first, it is advisable to gain some knowledge. That’s why we invite you to join a free webinar here, which will present how you can earn with cryptocurrencies!
We are not financial advisors. All information regarding cryptocurrencies is accepted at your own responsibility. Do your own research as well.
