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  • Pascal Hügli

What is Decentralized Finance (DeFi)?



What is DeFi?

DeFi is a new world of finance and stands for “decentralized finance”. DeFi refers to a segment of the digital asset market that is concerned with the democratization of conventional finance by bringing it on-chain. Through peer-to-peer networks, on-chain finance aims to connect all participants directly on the blockchain, enabling financial applications through the use of smart contracts.


How does DeFi work?

DeFi works similarly to traditional finance, albeit with a few important differences. There are three main factors that contribute significantly to DeFi's operations: smart contracts, blockchain technology, and user-supplied liquidity. DeFi apps have been successful because of the interplay and connection of these three things. Blockchain technology guarantees decentralized recording and storage of transactional data. DeFi apps (dApps) are guaranteed to be operational around the clock through the use of smart contracts, and user-supplied liquidity makes sure that trading is possible without depending on third parties for market making.


What are DeFi building blocks?

Decentralized finance (DeFi) building blocks are the foundational components that allow for the creation of decentralized financial applications. Some key DeFi building blocks include:


  1. Smart Contracts: Self-executing contracts that automatically enforce the terms of an agreement between two parties.

  2. Decentralized Exchanges (DEXs): Platforms that allow for the trading of cryptocurrencies and other digital assets in a decentralized manner.

  3. Stablecoins: Cryptocurrencies that are pegged to a stable asset, such as the US dollar, and are designed to maintain a stable value.

  4. Loan and Borrowing Platforms: Smart-contract-based platforms that allow users to lend and borrow digital assets.

  5. Insurance Protocols: Smart-contract-based insurance protocols that provide coverage for risks associated with on-chain financial applications.

  6. Tokenization: The process of converting assets into digital tokens issued on the blockchain that can also be traded on blockchain platforms.

  7. Payment and Settlement Systems: On-chain payment and settlement systems that enable fast and efficient cross-border transactions.


What are some innovations around DeFi?

Some of the innovations around DeFi are:


  1. Flash loans. Flash loans are atomically settled smart-contract-powered transactions.

  2. Liquidity mining. A method of investing that entails lending cryptocurrency to DeFi protocols is known as liquidity mining. Liquidity providers are often compensated with a portion of transaction fees, a portion of native crypto tokens, or, in some cases, both in return for providing cryptocurrency as liquidity and taking on the risk.

  3. Oracles. Real-world information is necessary for many smart contracts in order to comprehend an off-chain event's consequence. Decentralized oracles services provide this type of information, bridging the gap between the on-chain and off-chain worlds.

  4. Money legos. The concept of “money legos,” which refers to various DeFi apps (dApps) as “legos,” is an expression unique to the realm of DeFi. Snapping together these toy blocks is simple and handy because of smart contracts’ inherent composability. DeFi's open-source and composable design makes it possible for various applications in the field to be assembled similarly to how “money legos” are put together to produce new goods and services.

  5. Yield farming. Liquidity mining is progressed one step further by yield farming. Moving money across platforms in quest of the greatest liquidity-mining returns is known as yield farming. DeFi systems are now available that are committed to assisting investors in locating the highest DeFi returns and automating the entire procedure.

  6. Wrapped cryptos. DeFi is where the concept of moving value from one native blockchain to another was first conceived. To date, this is usually done by wrapping one crypto on another blockchain, thereby making it usable on that destination blockchain.


What can you do with DeFi?

Here are a few creative DeFi use cases to get you started:


  1. Some of the earliest platforms in DeFi have been those for lending and borrowing. Liquidity providers can deposit crypto capital to earn interest thanks to lending procedures. The same procedures then provide liquidity to individuals seeking loans. Usually, cryptos must be deposited by borrowers as guarantee/collateral when taking out a loan.

  2. DEXs allow users to exchange cryptocurrencies and other blockchain-based tokens against user-provided liquidity pools rather than through a central order book.

  3. Stablecoins provide DeFi apps' liquidity with some consistency and give investors a practical tool for managing their money.

  4. Smart contract platforms enable the streaming of value in the form of crypto assets. Wages can be earned every second instead of only once at the end of every month.

  5. Games may create internal economies by including cryptocurrency and DeFi mechanisms. Players may buy in-game avatars, exchange accessories, and earn tokens in games like Axie Infinity and Star Atlas. With the incentives and benefits that DeFi offers, the gaming industry will probably employ it extensively in the future.


Why use DeFi?

DeFi provides financial transactions without a middleman, thereby letting you function as your own bank. Similar to how they do with their savings account, investors may utilize a DeFi platform to earn dividends without the help of a financial institution. Also, DeFi allows for faster settlement times, making the use of cryptocurrencies an efficient way to settle payments.


What are the advantages of DeFi?

The most important advantages DeFi brings are the following:


  1. First off, because DeFi applications are constructed on top of blockchains, every transaction is made public. This also makes DeFi protocols transparent in their activities.

  2. Second, most of DeFi apps make their source code available online, making it visible as an open-source license.

  3. Cut out middlemen and fees: Here is an illustration using an example. When investor A establishes a savings account, the money deposited earns 1% interest. These funds are used by the bank to provide a 4% return. In a decentralized financial system, Investor A would receive the bulk of the 4% interest return, while the bank keeps 3% as profit and gives the remaining 1% to the investor.

  4. DeFi applications are capable of collaborating in ways that centralized financial institutions could not. By connecting these “money legos,” new and sophisticated financial products have been created, and this trend is expected to continue.

  5. There is no requirement for you to reveal your identity when utilizing DeFi apps.

  6. DeFi apps may run continuously (and autonomously) since they rely on smart contracts rather than on human input.


Is DeFi safe?

Yes and no. Transparency and security are provided for financial transactions via the use of decentralized ledgers to record information. However, DeFi protocols are only as safe as their smart contracts are. Especially smart contract code failures can lead to hacks and loss of money. Furthermore, users using non-custodial applications need to make sure they understand the risks, one being the fact that a user is solely responsible for his action and there is no helpline to call in case of emergency.


What are the risks of DeFi?

There are several risks DeFi still has. They include:


1. These programs are still created and developed by people, thus errors and hacking can unavoidably occur.

2. The degree of accountability that DeFi imposes on an individual is among the biggest threats. Being your own bank has many advantages, but you also have to accept the associated risks.

3. There are no fail safes in place if something goes wrong due to a lack of regulation and consumer protection.

4. A lot of DeFi services require users to deposit collateral in order to access them. Because of crypto’s volatility, there is liquidation risk and the need to overcollateralize.

5. Many DeFi protocols that call themselves decentralized are not actually decentralized. Because they are only playing “decentralization theater” these platforms still have single points of failure such as admin keys or multi-signature keys controlled by only a few.


What challenges does DeFi currently face?

Although DeFi is innovating and numerous new applications are emerging, there are still challenges, this new on-chain world faces. Some of them are:


  1. DeFi isn’t an even playing field.

Despite its claim of democratizing access, it is quite naive to expect DeFi to instantly level the playing field. After all, financial markets are really prone to economies of scale and scope, as well as huge network externalities. Even if there is free market access, these dynamics cause concentration pressures.

  1. The sector is afflicted by governance concerns.

In contrast to traditional finance, DeFi governance is carried out through decentralized autonomous groups. A DAO, similar to a crypto co-op, distributes decision-making authority among all interested stakeholders, with a community of users voting on ideas using crypto tokens. Such governance votes can be manipulated.

  1. Tax collection is problematic.

Transactions involving digital currencies are taxable, but reporting them is tricky even for the well-intentioned, according to the researchers, because DeFi is primarily constructed on permissionless and pseudonymous blockchains.


How can I use DeFi?

The majority of DeFi protocols are developed on top of networks such as Ethereum or Binance Smart Chain, and the number of rival blockchain networks that allow smart contracts is expanding. It is critical to select a network before using DeFi services.


Most significant protocols now support lots of blockchains, with the main distinctions being ease of use and transaction costs. Networks such as Ethereum, Binance Smart Chain, and Polygon are all available via wallet extensions like as MetaMask, Rabby Wallet, Rainbow, or others, with only a few settings changing to switch networks.


Users may use these wallet extensions to access their cash straight from their browsers, and they are installed in the same manner as any other extension and frequently require users to either import an existing wallet — through a seed phrase or a private key — or create a new one. They are also password-protected for further protection.


What is the future of DeFi?

The future of DeFi is bright. Some think DeFi, or rather on-chain finance, may replace the current financial system in the future and take over as the main way to obtain financial products. It is likely though that only a smaller amount of people will be directly using DeFi protocols. It is much more likely that the broad masses will still be going through trusted third parties to access DeFi protocols. Thus, it will be the institutions and financial players allowing their clients to access DeFi that will directly profit from the advantages DeFi offers. End users will benefit indirectly as institutions can offer better, more efficient, and more tailored maid financial products.


 

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