The New Catch Phrase In The World Of Cryptocurrency Is DeFi? What is Defi? What Are The Benefits & Drawbacks?
Created on June 7, 2021
DeFi is a short form for Decentralized Finance; it’s a blockchain-based financial system that enables decentralized peer-to-peer transactions – no intermediaries, regulators, and third-party interference. DeFi is on a mission to democratize finance by providing robust platforms to decentralize financial services.In a centralized financial system, there are intermediaries such as banks, exchanges, and brokerages. For instance, to get a loan from a bank, the bank makes the rules and takes care of the transactions between the actual lenders (account holders) and the borrowers.
On the other hand, DeFi system removes third-party interference by providing a platform or an application where a borrower can get a crypto loan directly from the lender. Transactions execute automatically based on preset conditions known as smart contracts.Blockchain experts Victor von Wachter and Prof. Dr. Philipp Sander defined DeFi as “an ecosystem comprised of applications built on top of public distributed ledgers, for the facilitation of permissionless financial services.”
How DeFi Works
Decentralized finance works with DeFi applications or services. These applications are also known as dApps. Developers build DeFi services on blockchain protocols (many DeFi projects are built on Ethereum) and make them accessible via the dApps. DeFi platforms operate on preset prerequisites called smart contracts.
Smart contracts are preset conditions written in codes by developers. The conditions must be fulfilled before the transaction can execute automatically. For example, the smart contract that underlies the operation of a ‘lend & borrow’ DeFi service dictates the requirements you must fulfill before you can be allowed to borrow. One of such prerequisites is the provision of crypto collateral.
Here’s what Coinbase says on smart contract and dApp:
“Smart contracts are programs running on the blockchain that can execute automatically when certain conditions are met. These smart contracts enable developers to build far more sophisticated functionality than simply sending and receiving cryptocurrency. These programs are what we now call decentralized apps, or dApps.”
A single organization or its employees don’t regulate the operation of a dApp. It works on a peer-peer basis where individuals can utilize the service independently by basically following the conditions outlined in the smart contract.
DeFi is one of the fastest-growing sectors of the crypto industry. The rate of adoption is measured based on ETH locked in DeFi. The total value of crypto locked in DeFi protocols is about $43 billion. Let’s discuss some of the popular use-cases.
Lending & Borrowing Of Cryptocurrency
There are lending and borrowing dApps out there you can use to lend or borrow cryptocurrency. If you need money, these decentralized services allow you to borrow crypto and pay later according to the smart contract. To borrow, you’re required to deposit crypto to the dApp’s smart contract as collateral. These services match Lenders and borrowers automatically. Some of the popular borrow/lend dApps include Compound, Aave, and dYdX.
Decentralized Cryptocurrency Exchanges (DEXs)
Decentralized exchanges enable investors to do peer-to-peer transactions instead of relying on centralized services such as Coinbase. DEXs aid autonomy and allow users to be in control of their finances. Some popular DEXs include 0x, AirSwap, Bancor, Uniswap, and Radar.
A flash loan enables you to get loans from strangers without collateral, provided you repay the loan in the same transaction that issued the funds. If it’s possible to make profits using the loan, you can execute a trade, pay back the loan and keep the gains within a short time. If the transaction can’t be processed or it will not be profitable, the money automatically goes back to the lender.
Other use-cases range from Yield harvesting, stable coins, non-fungible tokens to e-wallets and prediction markets.
Benefits Of Decentralized Finance
Ease Of Access
DeFi applications are available for access by anyone who can connect to the internet. Everyone has access to the same DeFi services, physical location notwithstanding.
An organization and its workers do not manage the operation of DeFi services. The operational conditions are written in codes, and they execute automatically. Once the requirements are fulfilled, transactions run without the interference of a third party. Human interference comes in only during application upgrades.
The terms of the smart contracts are open to everyone. The codes are open and available on the blockchain for users to audit. Nothing is hidden; anyone that can read codes can study the contract’s provisions and make informed decisions. Transactions are public, and this does not raise privacy concerns since blockchain transactions are anonymous.
Absence Of Regulatory Difficulties
Anyone can create a DeFi service or participate in one. Unlike the traditional financial system, there are no gatekeepers or regulators that request sophisticated documentation before you can participate in decentralized finance services.
Downsides of Decentralized Finance
Smart Contract Problems
One of the challenges associated with DeFi projects is code-related mistakes in smart contracts. A bug not fixed quickly can make the whole system malfunction, thereby leading to more severe issues.
DeFi projects are prone to hacking. It goes without saying that hackers are relentlessly innovating and finding new ways to compromise dApps and steal funds. Hacking is one of the major risks of creating or using a DeFi service. A successful hack of dApps could lead to the loss of a significant amount of money.
Absence Of Consumer Protections
What happens to users’ funds if a DeFi service folds? DeFi not being regulated means there is no one to hold responsible in case a project fails. In the traditional finance system, banks are required to maintain a certain amount of deposit with a central bank (regulator). This is to make sure account holders don’t go empty-handed if the bank crashes. There is no such security with DeFi!
Decentralized finance has some other drawbacks, such as collateralization challenges, private key management problems, liquidity issues, etc.
Decentralized Finance is a new concept that is gaining momentum in terms of adoption. There are obvious drawbacks, but developers and crypto entrepreneurs promise reliable solutions. For instance, insurance companies are sprouting to protect DeFi services.
According to this report, Sarson Funds, a leader in blockchain investing, said they expect DeFi to continue its rapid growth. From all indications, the future of DeFi is bright with attention-grabbing possibilities.