Our current financial system is built on a centralized infrastructure managed by institutions (such as banks). The idea of DeFi, on the other hand, is to create an open financial system that does not require organizations to manage and facilitate the movement and creation of money/assets.
DeFi wants to decentralize and democratize so that anyone can access the financial system with just a digital wallet and an internet connection. Essentially, this eliminates the need to interact with banks, opting instead for peer-to-peer financial transactions that are facilitated through software.
This is a completely new way of looking at how we access financial services such as day-to-day banking, loans, mortgages and trading.
As of 2022, DeFi consists of:
- New financial inventions such as stablecoins.
- Software-defined contracts (“smart contracts”).
- Decentralized Exchanges (“DEX”).
- Decentralized applications (“Dapps”).
While interest in DeFi has skyrocketed over the past few years, the space remains quite risky due to the lack of regulation and technology development risks.
DeFi vs Traditional Finance (TradFi)
What is so wrong with our current financial system that we need DeFi at all?
Let’s take a look at some of the main benefits of DeFi compared to the way things are today. In the traditional financial system:
Source: Tenor.com
- Many people are unable to access the banking system or access financial services due to their income levels.
- Financial transactions are not instantaneous and have inefficient or costly time delays.
- Governments and centralized institutions can close or freeze markets whenever they want.
- Intermediaries such as banks place mark-ups on financial services in order to generate income from their own operations.
- Asset trading hours for things like stocks are limited to certain business hours in different time zones.
- Centralized institutions wield considerable power in how they manage the financial system as a whole, potentially without regard to the perspectives and needs of those who actually use it.
DeFi aims to solve these problems.
Source: Ethereum.org, screenshot by Aubrey Chapnik.
How does DeFi work?
DeFi applications were originally launched on the Ethereum blockchain, but have since expanded to other networks that automate financial transactions such as Solana, Binance Smart Chain, and Avalanche.
Read more: 8 Alternatives to Bitcoin
Everything about DeFi runs on blockchains and cryptocurrencies, where financial transactions are facilitated through software called “smart contracts” rather than through banks (centralized platforms).
Smart contracts are programmed to perform certain functions (such as lending) and once written, no one can change the smart contract once it has been deployed.
For example, a contract designed to pay a weekly benefit could be programmed to send money from one account to another every Friday, subject to certain conditions and as long as there are funds in the account from which the funds are being distributed.
(While DeFi applications can be very complex, this is a simple example.)
Another example of DeFi in action is the MakerDAO credit system and the creation of its DAI stablecoin. (Stablecoins are unique cryptocurrencies designed to match the value of fiat currency; DAI tracks the US dollar.)
Read more: What is a cryptocurrency? All you need to know
With Maker, those who own Ethereum can “deposit” their tokens in smart contracts, which in turn create DAI. Those with DAI can use it to spend on goods or services, or they can save it and earn interest.
For example, the Coinbase Card allows users to spend DAI by converting it to dollars on a Visa card.
Read more: Best Crypto Credit Cards
What are decentralized exchanges (DEX)?
Among the DeFi applications that are getting a lot of attention are decentralized exchanges (or DEXs).
DEX is a peer-to-peer trading platform where transactions take place directly between crypto traders. This is very different from traditional stock trading where you have a brokerage house or investment bank, stock exchange, clearing house, transfer agent and custodial service providers involved in facilitating transactions.
DEX is a great example of what it looks like to conduct financial transactions autonomously from centralized parties or intermediaries. It is simply a set of smart contracts working together to price cryptocurrencies through algorithms and use pools of locked tokens to facilitate transactions.
All DEX transactions are then settled directly on the blockchain so they are visible and accessible to everyone. DEXs are also usually open source, so anyone can see exactly how they work.
To date, the most popular DEXs include Uniswap and Sushiswap. Both run on the Ethereum blockchain and have their own tokens.
The promise of DeFi applications such as DEX extends to all kinds of peer-to-peer lending applications and enables fast and instant transactions.
Are all blockchains decentralized?
Eliminating systems that are controlled and can be changed by one party is at the heart of DeFi. But not all blockchains are the same in terms of how decentralized they are.
Without getting too technical, the way the blockchain is built (“Proof of Work” vs. “Proof of Stake”) and how large investors hold tokens can lead to different levels of decentralization in blockchains.
Since blockchains are built on the idea of a community, less decentralized blockchains are more at risk of being controlled by multiple parties, which is similar to centralized platforms. Thus, the argument that blockchains are not fully decentralized is correct.
To get an idea of how decentralized a blockchain is, you need to understand things like the number of people/groups involved in the decision-making process that governs an individual blockchain, and how the influence of each participant is established.
If you want to learn more about the technical elements of decentralization, this article provides an additional overview: Measuring Decentralization: Is Your Cryptocurrency Decentralized?
Risks of DeFi
Despite how exciting many DeFi applications are, this is still a very risky space.
Over the past few years, there have been several high-profile cases of DeFi software being hacked or stolen and scammed, resulting in the loss of billions of cryptocurrencies. In 2021 alone, $10.5 billion was lost in DeFi, with $12 billion lost in the last two years.
There were two instances in 2022 when DeFi participants melted or succumbed to volatility that tore apart the cryptocurrency markets, wiping out tens of billions.
In May, one of the most popular USD-pegged stablecoin projects, Terra and its native token LUNA, self-liquidated, costing holders more than $60 billion. This crash was the crypto world equivalent of the Bear Sterns crash during the 2008 financial crisis.
In June, Celsius Network, a lucrative cryptocurrency platform, froze withdrawals after using failed DeFi strategies.
These crashes and setbacks, exacerbated by the fact that DeFi remains unregulated, make it very risky to play in this market. This is especially true as many DeFi investors may not understand exactly how the high interest rates that DeFi is known to generate are created.
Read more: 5 things you should know before investing in cryptocurrencies
Final thoughts: what is the future of DeFi?
As the cryptocurrency market matures, DeFi will continue to play a more important role. As someone who is fascinated by this space and has personally invested in Ethereum, I believe it has a bright future and wider adoption. However, this will likely depend on additional rules coming into effect and technical issues being ironed out so that DeFi hacks are not commonplace.
The general adoption of DeFi also requires the creation of a more understandable and accessible infrastructure. Today, participating in DeFi requires a high degree of technical savvy in setting up wallets, buying cryptocurrency, finding the right DeFi programs, and managing everything yourself. It’s not as convenient as just turning on Netflix. As more consumer-facing products with an engaging UX hit the market, more people might want to dive into them.
But until then, DeFi is likely to remain a very high-risk, high-reward space, exploited by crypto enthusiasts with the necessary skills, patience, and funds. If you are interested in participating, be sure to get an education and only risk what you may end up losing.
Featured image: Andrey Yalansky/Shutterstock.com