Learn everything you need to know about DeFi. Understand the terminology, how it works, and its benefits and limitations.
Decentralized Finance, or DeFi, involves using blockchain technology to facilitate traditional financial transactions. This article will help you build the knowledge you need to interact with this new form of finance safely and show the benefits and limitations that this new approach to finance brings.
I avoid diving into any specific DeFi protocols but try explaining how DeFi works, where it stands today in contrast to traditional finance, and the potential future implications.
The definition of DeFi and why it exists
First DeFi we need to understand the definition of DeFi and why it came into existence in the first place.
What is DeFi?
Decentralized Finance seeks to facilitate financial transactions using blockchain technology to reduce the number of intermediaries in financial transactions.
While banks and governing bodies control traditional financial markets, DeFi is governed by an algorithmic protocol and peer-to-peer (P2P) transactions. Reducing these middlemen increases transparency, reduces cost, and improves the speed of transactions.
While in theory, this sounds great, in practice, many unanswered questions currently hinder widespread adoption. But more on that later.
A brief lecture on Financial History
Let’s take a moment and wind back the clock to understand (traditional) financial markets first.
Historically, trade was restricted due to a lack of efficient transportation. People would interact locally by exchanging goods. The invention of a currency as a means of exchange facilitated trade, and money rapidly became the primary medium of trade. Goods would be exchanged for money, and then, in turn, could be exchanged for other goods. The money provided a simple way of storing and transporting value.
This led to a slew of currencies being created. Sometimes to such an extent that neighboring towns would mint their own coins. This raised a new question; how could one buy and sell goods in a place that used different currencies?
Enter Banks and Exchanges
Banks would allow people to store, exchange or lend different currencies. For their services, they would charge a fee.
Ever-improving means of transport led to increased trade and the wealth of merchants. Meanwhile, banks became an integral part of the trade, and many were owned by the merchants that already controlled the exchange of goods. Ultimately creating a mighty and influential class of citizens, increasingly reshaping the distribution of power in society.
The creation of centralized institutions governed by the state aimed to limit and control the power of these all-powerful merchant banks. Central banks were tasked with the introduction and control of major currencies, as well as the oversight of capital flows. By exercising their mandate, they would provide stability to currency values, effectively further facilitating the use of money as a means of exchange.
This is very much the financial system we know today, where a few central banks control monetary systems through other banks, which control how we use the money to store, exchange and lend money.
So, if the current financial system is such a well-thought-through machine, why change it?
Today’s world is very different from when this system was first set in place. Goods and services are exchanged at speeds never seen before. Trade routes have virtually no limits, and technology, such as the internet, has changed our business.
As a result, the traditional financial system, with its many controlling entities and middleman, increasingly needs help to be efficient in terms of speed, cost, and scalability.
Should we just forget about traditional finance and use DeFi instead?
As much as crypto enthusiasts would like to hear a yes, the immediate answer is more likely a no. Rather than just replacing traditional finance, DeFi can enhance and improve the existing setup. To see why let’s take a closer look at DeFi.
What is DeFi, and how can it be used?
As stated initially DeFi allows participants to engage in financial transactions on a peer-to-peer basis and with only a blockchain-based algorithm as a middleman.
Instead of traditional currency, DeFi uses cryptocurrencies and tokens as a transaction medium.
Decentralized Finance currently has three main applications.
- Transfer & Exchange of Assets
- Staking & Liquidity Management
Transfer & Exchange of Assets
Participants can transfer assets directly to each other via decentralized Apps (dApps), such as wallets and exchanges. The underlying blockchain protocol ensures the integrity of the transactions and stores all information.
Tokens and currencies can be bought and sold via exchanges; these exchanges can either be centralized (CEx), i.e., run by a controlled entity, or de-centralized (DEx). A DEX acts as a platform to connect buyers and sellers and is governed by a digital protocol with smart contracts. Anyone can interact with a decentralized exchange without any KYC.
The nature of a DEx provides unrestricted access, high processing speeds, and low cost.
On the other hand, the decentralized nature also means there is no possibility to revert transactions, and no controlling body can be approached in case of fraud or error.
Staking & Liquidity Management
Like banks, many DeFi protocols allow participants to earn interest on their holdings. Often the claim is increased if holdings are locked for a more extended period. These pockets of liquidity are called Pools.
For example, someone decides to buy a USD stablecoin. These coins are then handed to a pool for a set amount of time. At the end of the period, the investor will receive back his coins plus interest.
In addition to Pools, there are Farms. They use a unique token called LP that is generated when two tokens are paired. This LP is returned to the protocol and injects liquidity for other participants. Injecting liquidity via LPs is usually rewarded with a percentage on the trades on this currency.
Example: An investor owns USDT and ETH; he can now combine those holdings in a USDT/ETH LP and hand it to a DEx protocol. The protocol will pay out a reward based on transactions of other market participants that trade USDT vs. ETH or vice-versa.
The use of LP tokens incorporates a risk of so-called “impermanent loss,” which we will discuss in a separate article.
The idea behind pools and farms is to incentivize participants to provide liquidity to the protocol by locking the tokens and handing them to the protocol for further use. This ensures that there is enough supply of tokens and currency to maintain an efficient market and price stability.
Like in the traditional finance market, participants can be classified into two groups: those with capital (lenders) and those seeking capital (borrowers). Lenders are willing to hand their assets to a borrower in return for interest.
Banks usually take the role of the intermediaries, linking the two sides. In DeFi, all lending and borrowing are done peer-to-peer and based on a protocol.
Lending and borrowing rates depend on the degree of decentralization of the protocol. Centralized Exchanges usually offer slightly lower interest rates to lenders as they claim a market maker fee, similar to banks. Decentralized Exchanges typically provide better rates but have an increased risk as participants rely entirely on the underlying protocol’s efficiency.
DeFi opens up microtransaction lending due to the less need for more costly intermediaries. From an administrative perspective, a traditional bank has little interest to hand out micro-loans; if they do, the costs are usually high. To a DeFi protocol, it makes little difference how big the amount is as the process is fully automated and on a peer-to-peer basis.
On the negative side, DeFi lending depends entirely on the stability of the underlying protocol and has no regulatory oversight. This can lead to fraud, a lack of liquidity, and collateral issues due to the volatile nature of crypto tokens.
Now that we understand what DeFi is and how it can be used, let’s take a look at the pros and cons to assess the value of DeFi.
Advantages of DeFi
- Fully automated protocols allow for lower transaction costs, higher return rates, and transparency.
- Elimination of human error, unless the underlying contract is poorly written
- Low barriers to entry; anyone with an internet connection can participate
- Permissionless; complete control by the user, no dependency on market makers and other intermediaries
Disadvantages of DeFi
- Reliance on the underlying blockchain. The blockchain protocol’s weaknesses can affect the DeFi project, including scalability issues and ecological impacts.
- Low Liquidity can render a DeFi project useless since participants cannot withdraw their funds from the protocol.
- Interoperability between blockchains means many projects are siloed
- Lack of regulation and insurance means that participants are more exposed to fraud and misuse.
- Vulnerability of Smart Contracts, where a flaw in the code can lead to the collapse of a DeFi contract or expose it to fraud.
- Risk of centralization and bottlenecks caused by exchanges.
- Your responsibility: even if the blockchain and the DeFi protocol were flawless, the decentralized aspect means that each user is 100% responsible for his actions.
In conclusion, do the risks outweigh the benefits?
First, one must appreciate that DeFi is still a very young concept and thus will continue to have breakthroughs and breakdown moments.
The way forward will undoubtedly be challenging sailing, but DeFi has the means to bring an old, slow, and expensive system into the 21st century. Many central banks and financial institutions have already started to either develop or at least acknowledge the impact of DeFi. However, it will take time to overcome some of the issues—especially creating a legal framework and proper regulations to provide additional safety and security for investors. A lack thereof will prevent large institutions and businesses from adopting the technology simply because they can’t afford scrutiny by regulators.
So, maybe not everything will be DeFi in the near future. But lower costs, additional transparency, ease of access, and transaction speed are compelling arguments to open a dialogue around this new technology. As a result, DeFi is more likely to enhance the current financial system than replace it outright.
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