DeFi is one of the fastest-growing cryptocurrency segments. In short, Defi stands for decentralized finance. It’s a term used to describe the growing number of financial applications that are being built on top of blockchain technology. These applications allow users to borrow, lend, trade and invest without the need for a third party. The primary goal of decentralized finance is to become an alternative to the banking sector and replace the traditional current financial system with open-source protocols. DeFi is following the idea of creating an independent and transparent financial ecosystem that is not affected by regulators and the human factor.
DeFi has seen rapid growth in recent months, with over $78 billion worth of value now locked in protocols such as MakerDAO and Compound Finance. Decentralized finance has become a trend since 2019, and so far, its popularity continues to gain momentum. So what are the benefits of using DeFi? And what are the potential risks? Let’s take a closer look.
Why is DeFi important?
DeFi is crucial because it has the potential to create a more inclusive financial system. The current one is controlled by central authorities, such as banks and governments. This centralized structure has many disadvantages, such as high fees, slow transactions, and lack of transparency.
DeFi protocols are built on Ethereum’s decentralized infrastructure, which means that they are not subject to the same limitations as traditional financial institutions. DeFi protocols can offer lower fees, faster transactions, and more transparency.
In addition, DeFi protocols are available to anyone with an Internet connection. It contrasts with traditional financial institutions, which often have strict eligibility requirements. For example, you may need a minimum credit score to qualify for a bank loan. However, there are no such requirements for DeFi protocols. This makes DeFi accessible to a broader range of people.
How does DeFi differ from traditional finance?
DeFi differs from traditional finance in many ways. As we mentioned earlier, DeFi is built on Ethereum’s decentralized infrastructure. This means that it is not subject to the same limitations as traditional financial institutions.
Another difference is that DeFi protocols are written as open-source software. This means that anyone can check the code to ensure that it is secure and transparent. In contrast, the code of traditional financial institutions is often proprietary and not available for public scrutiny.
Finally, DeFi protocols are often permissionless. This means that anyone can use them without obtaining approval from a central authority. In contrast, traditional financial institutions usually require users to go through a lengthy and complicated process to get approved for products and services.
How are DeFi applications created?
Anyone capable of writing a smart contract can create DeFi applications. However, most DeFi applications are made by teams of developers. These teams typically raise money through a process called an initial coin offering (ICO).
An ICO is a fundraising event in which a team of developers sells tokens to investors. The investor receives tokens in exchange for his investment. The funds raised during an ICO are used to finance the project’s development.
Advantages of DeFi
- Accessibility. It has easy access to financial services, especially for those who, for some reason, are isolated from access to the current economic system.
- Transparency. Decentralized finance is built on the principle of openness. All transactions are recorded on the blockchain and available for anyone to see. This level of transparency is impossible with traditional financial institutions.
- Security. Due to the fact that decentralized finance protocols are built on the blockchain, they are much more secure than traditional systems. Blockchain technology is immutable, which means that once a transaction is recorded on the blockchain, it cannot be changed or tampered with.
- Speed. Blockchain technology allows for much faster transaction times than traditional systems. In most cases, transactions on the blockchain are confirmed within a few seconds.
- Lower fees. Another advantage of decentralized finance is that it has lower costs than traditional financial institutions. There is no need for intermediaries such as banks or other financial institutions.
- No bureaucracy. Unlike the traditional financial sector, there are no controllers or accounts that require complex forms to be filled out.
Risks of DeFi
- Volatility. Cryptocurrencies are notoriously volatile, and this volatility extends to the world of decentralized finance. The prices of DeFi protocols can fluctuate wildly, which can lead to losses for users who are not careful about when they enter and exit positions.
- Hacks. Unfortunately, the world of cryptocurrency is not immune to hacks. In 2016, the DAO hack led to the loss of over $50 million worth of ETH. And in 2018, the Parity Wallet hack resulted in the loss of over $30 million worth of ETH. These hacks highlight the importance of choosing a secure wallet to store your cryptocurrencies in.
- Fraud. In 2021, attackers stole more than $10 billion in investments using decentralized finance technology. Fraudsters issue dummy tokens and lure investors with promises of extremely high returns. The standard scheme is to wait until the trading in the pool “warms up” and the token price jumps up, then withdraw all the liquidity and disappear with the money.
- Complexity. The world of cryptocurrency can be complicated and confusing for newcomers. The same is true for decentralized finance protocols. Many DeFi protocols have complicated user interfaces that can be difficult to understand for those unfamiliar with them. This complexity can lead to users making mistakes that result in losses.
- No regulation. Financial institutions are not responsible for the actions of participants within the system. Therefore, it will not be possible to ask for help or service. If the user loses the password or does something wrong, these are exclusively his problems.
Potential use cases
Loan and credit. With DeFi protocols, you can take out a loan without going through a bank. Instead, you can use a decentralized lending platform to borrow money from other users. These loans are often called “crypto loans” or “decentralized loans.” Crypto loans are typically collateralized. You must put up an asset as collateral to secure the loan. If you can not repay the loan, the lender will take possession of your collateral.
Investment and savings. DeFi protocols can also be used for investment and savings purposes. For example, you can use a protocol called MakerDAO to invest in Dai, a stable coin pegged to the US dollar.
Financial banking. With a decentralized bank, you can deposit your funds and earn interest on them. You can also take out loans and borrow against your deposited funds. DeFi protocols can be used to create a decentralized bank.
Decentralized Markets. DeFi protocols can be used to create decentralized markets. These markets can be used to trade a wide variety of assets, including stocks, bonds, and commodities.
These are just a few of the potential use cases for DeFi protocols. In the future, we expect to see even more innovative applications being built on Ethereum’s decentralized infrastructure.
The future of DeFi
Decentralized finance has the potential to revolutionize the financial system. DeFi protocols could provide a more inclusive and efficient alternative to traditional financial institutions by offering lower fees, faster transactions, and more transparency. In addition, the decentralized nature of DeFi protocols makes them much more resistant to hacks and other security breaches.
However, the world of DeFi is still in its early stages, and it remains to be seen whether or not it will be able to live up to its promise. The volatility of cryptocurrency prices and the complexity of many DeFi protocols are significant hurdles that need to be overcome. Even though this is a relatively new segment of the cryptocurrency market, it is quite well developed. At the same time, the pace of development is constantly gaining momentum, and only time will tell what the future holds for decentralized finance.
