Decentralized finance, or DeFi, is similar to but not identical to Bitcoin (BTC). The term “DeFi” refers to financial systems enabled by decentralized blockchain technology. DeFi is mostly linked to the Ethereum (ETH) blockchain and the cryptocurrencies built on it. DeFi technology generates decentralized currency, removing the need for government-controlled central banks to issue and regulate currency. However, DeFi technology is capable of providing a wide range of other blockchain-based financial services solutions. Fintech companies use DeFi technology to provide savings accounts and loans, as well as securities trading and insurance.
How Does DeFi Work?
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DeFi is a technology that offers an alternative to relying on centralized financial institutions like banks, exchanges, and insurance companies. DeFi systems achieve distributed consensus through the use of “smart contracts” on blockchains like Ethereum. Smart contracts are written by developers to perform specific actions only when certain conditions are met.
When a smart contract is pushed to the blockchain, everyone in the blockchain network has access to and can read the code, but no one can change it. Smart contracts are frequently used to govern decentralized apps, or “dapps,” which are not owned or managed by a single company or individual. While Ethereum was the first platform to develop smart contracts, they are now used by other blockchain platforms as well.
DeFi enables any two parties to transact securely and directly without the need for an intermediary or central authority. As a result, many more people can obtain financial services at lower costs or at higher interest rates than traditional financial institutions.
The following are some of the most popular DeFi applications:
Stablecoins
One of the first applications of DeFi was the creation of stablecoins, or cryptocurrencies with stable values. Stablecoins are considered suitable for making everyday purchases because they are much less volatile than other cryptocurrencies.
- Tether (USDT): USDT is a stablecoin that is pegged to the US dollar. A stablecoin is a cryptocurrency whose value is tied to another fiat currency, such as the US dollar, or to a commodity, such as gold. Tether was the first stablecoin to be created, and it is still the most widely used stablecoin in the ecosystem. It has the largest stablecoins in terms of circulation and market capitalization.
- DAI (DAI): DAI is one example of a stablecoin. The coin is pegged to the US dollar and collateralized by Ether (ETH), the native token of Ethereum, and is issued by MakerDAO, an open-source project on the Ethereum blockchain. DAI is purposefully overcollateralized by Ether, allowing DAI’s value to remain stable even as Ether’s value fluctuates.
- USD Coin (USDC): USDC is another stablecoin, but its collateral is centralized, unlike DAI. USDC stablecoins are backed by a US dollar reserve held in an audited bank account.
Decentralized Exchanges (DEX)
Despite the fact that cryptocurrency is decentralized, several cryptocurrency exchanges, such as MultiBank io, operate as centralized platforms that connect cryptocurrency buyers and sellers.
Most DEXs use smart contracts to perform the functions of centralized exchanges, with the smart contracts providing pricing for each counterparty at or near market prices. Using a DEX allows each party to retain complete control over their respective cryptocurrency holdings rather than depositing them in a wallet held by a centralized exchange that could be hacked.
DEX users who generate liquidity by supplying cryptocurrency can earn money by receiving a portion of transaction fees in certain markets.
Borrowing and Lending
Borrowing and lending services, perhaps the most traditional functions enabled by DeFi, are available to cryptocurrency users. Those who own significant amounts of cryptocurrency but require liquidity in other currencies can borrow money by pledging their cryptocurrency holdings as collateral. Individuals can lend their cryptocurrency deposits to borrowers in order to earn interest, allowing them to profit from the value of their holdings without triggering taxable events. The dapps that enable this decentralized borrowing and lending are designed to automatically adjust interest rates based on the cryptocurrency’s changing supply and demand.
Why Should You Use DeFi?
Regardless of your goals, using a DeFi platform instead of dealing with traditional financial institutions can provide several advantages. People use DeFi for the following reasons:
- Accessibility: While some people are unable to open bank accounts or obtain loans, anyone with an internet connection can use the DeFi platform. Because of this high level of accessibility, DeFi transactions can take place anywhere in the world.
- Low fees and high interest rates: DeFi allows any two parties to transact directly. Transaction fees are greatly reduced when there is no intermediary, and the parties can directly negotiate interest rates. People who lend money through DeFi networks typically receive much higher interest rates than traditional financial institutions.
- Transparency and security: Transparency and security are improved because smart contracts published on a blockchain, as well as all records of completed transactions are available for anyone to review. Blockchains are immutable, which means they cannot be altered.
- While DeFi platform users benefit from the transparency and security provided by blockchain technology, smart contracts are executed in such a way that the platform’s participants’ privacy is protected. Your true identity is not revealed by the publicly available transaction data.
- Autonomy: DeFi platforms are not dependent on any centralized financial institutions. The 2008 financial crisis revealed the significant interconnectedness of most banks and governments, as well as the inherent risks of centralized systems.
Individual financial institutions that hold your money may face difficulties or corruption, or they may become overly leveraged and declare bankruptcy. Much of this risk is mitigated by the decentralized nature of DeFi protocols.
How to Make a DeFi Investment
There are a variety of ways to invest in DeFi. The most basic option, which provides only broad exposure to DeFi, is to purchase Ether or another coin that employs DeFi technology. Purchasing a DeFi-powered coin gives you access to nearly the entire DeFi industry. You can deposit cryptocurrency directly with a DeFi lending platform to earn interest on your holdings. If you are willing to deposit funds for a longer period of time, you can receive higher interest rates. The interest rate paid on your deposit can be fixed or variable and fluctuate with the market.
Due to the high demand for deposits on the various DeFi platforms, a practice known as “yield farming” has emerged. Yield farmers deposit funds on whichever platform offers the highest interest rate or other incentive, and they monitor the current interest rates and incentives offered by other platforms on a regular basis.
If another platform begins to offer a better incentive, yield farmers will maximize their profits by shifting their deposits to the other platform. As incentives shift, yield farmers continue to shift their funds from platform to platform.
Is DeFi Secure?
Because DeFi technology is new, negative outcomes may occur unexpectedly. Programming errors can create profitable opportunities for hackers. Investing in or storing money for a failed DeFi project can result in the complete loss of your funds.
Deposits with traditional centralized financial institutions are insured by the Federal Deposit Insurance Corporation (FDIC), whereas DeFi platforms typically do not offer any way to recover lost funds. If a traditional financial transaction goes wrong, a consumer can file a complaint with the Consumer Financial Protection Bureau (CFPB). But if you become a victim of a fraudulent DeFi transaction, you have no such recourse.
Surprisingly, a new type of DeFi application is becoming available to address these shortcomings. Decentralized insurance is being offered to those who want to protect themselves from losses caused by other smart contracts. It is created by individuals pooling their cryptocurrency as collateral. Individuals who contribute to cryptocurrency pools charge premiums to those who are insured collectively.
