Decentralized Finance: Definition & how it works

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What is DeFi?

DeFi, short for decentralized finance, can be thought of as the financial infrastructure of the cryptocurrency landscape. Over time, cryptocurrency proponents plan to build out the DeFi ecosystem to the extent that it will rival traditional banking operations.

DeFi still has a long way to go to disrupt global banking, which is a multi-trillion dollar industry by market capitalization. However, the DeFi market, as measured by total value locked in contracts, easily topped $ 50 billion and by some accounts surpassed $ 100 billion in 2021. DeFi’s growth has been tremendous over the past few years.

What is attracting so much capital into the DeFi marketplace? Simply put, decentralized finance aims to build out many of the same functions as traditional banking, but with certain advantages. Cryptocurrency, in general, faces much less regulation as opposed to traditional banking, lowering the barriers to entry.

Within the span of a few years, robust lending, borrowing, and trading features have emerged in the DeFi ecosystem. And developers are coming up with ever more sophisticated uses for DeFi. It can power a wide array of financial contracts and then enforce them algorithmically.

Tip: Bitcoin (BTC-USD) and other cryptocurrencies are the units of exchange in the digital world. DeFi, by extension, intends to be the digital bank and wallet where those cryptocurrencies can be stored, traded, and invested.

The Purpose Of Defi

Simply put, DeFi brings banking services to users without having to go through a brick and mortar financial institution. Leading DeFi platforms allow users to borrow and lend money, trade cryptocurrencies and other assets 24/7, send money worldwide, and even engage in more esoteric operations such as buying insurance, art, and royalty contracts.

And, because of cryptocurrency’s lack of a central regulator, these services are available to all users. There is no bank manager deciding who gets to open an account or is approved for a loan. For people that are skeptical of government scrutiny, some DeFi marketplaces offer more privacy than could be found in the traditional banking system.

An overarching aim of the cryptocurrency movement has been to offer a legitimate alternative to fiat currency. With first-generation crypto, however, this was not really possible. It was all well and good to own Bitcoin, for example. However, using it for everyday financial transactions was costly, complicated, and prone to confusion. DeFi is building the architecture to make cryptocurrencies useful for a wide array of everyday applications.

DeFi Apps or Platforms

It’s important to distinguish between DeFi Apps ((DApps)) and the underlying cryptocurrency. There are the actual cryptocurrency coins or tokens themselves, such as Ethereum (ETH-USD), Solana (SOL-USD) and Cardano (ADA-USD).

Developers build their DApps on top of these existing blockchains. Originally, much of DeFi innovation occurred on the Ethereum chain, since it was widely-accepted and understood. Uniswap would be an example of a leading DApp built on Ethereum which allows users to buy or sell a wide variety of lesser-known cryptocurrencies.

However, given high transaction fees to use Ethereum, lately, developers have been exploring alternatives such as Solana, Cardano, and many more rival protocols.

Not all DApps are just brokerages, however. Increasingly, many DeFi applications are being used for lending or borrowing funds or building increasingly specialized contracts such as in areas related to royalties, artwork, and logistics.

DeFi Protocols or Smart Contracts

According to data from Statistathe 10 leading protocols as measured by total value locked (TVL) as of November 15, 2021 are as follows:

This is hardly a comprehensive list. And, in cryptocurrency, things change at the blink of an eye; a project that was outside the top 10 one month can rise to the top in the next.

That being said, these 10 platforms all had at least $ 7 billion of locked-in value in the case of PancakeSwap, and up to $ 21 billion for Curve as of November 2021. These are large enough dollar amounts to attract interest from institutional investors and provide real liquidity for traders looking to participate in these DeFi markets.

Advantages of DeFi

  • Faster Innovation – With less regulatory oversight, DeFi platforms can roll out new types of products and methods of settling transactions with minimal restrictions.
  • Broader Product Types – Within the first several years of DeFi, platforms were already offering lending, borrowing, trading, insurance, royalty contracts, and logistics management, among other uses.
  • Easier to Access – DeFi is particularly taking off with clients who have struggled to gain access to the traditional banking system. DeFi in particular has allowed people in emerging markets to use banking functions that would be otherwise unavailable in their local economy.
  • Lower Fees – For certain transaction types, such as cross-border payments, fees may be much lower on a DeFi transaction than using the traditional banking or payments systems.
  • Transparency – With all transactions being recorded on a blockchain, it is easier for market participants to know a counterparty’s exposure to an asset, and investigate in case something goes wrong.

Disadvantages & Risks of Decentralized Finance

  • Lack of Regulatory Protection – Many of DeFi’s advantages are also risks. The lack of regulators, for example, fosters innovation but also means there is no third party to go to if someone is taken advantage of in a DeFi transaction.
  • Hard-to-Use Software Many DeFi platforms require significant knowledge of advanced computing concepts and are not easy for newcomers to understand. This can put new DeFi users at a significant risk when trying to engage in transactions with more sophisticated counterparties.
  • Unrealistic Investment Claims – Given the lack of regulation, some DeFi projects have offered investors seemingly unachievable investment returns or high-yielding savings accounts. If a DeFi project is offering shockingly high returns on investment, be extra careful before investing money.
  • Outright Scams – Some DeFi projects have been set up to take advantage of customers. In crypto, there is what is called a “rug pull” where developers abandon a project and leave with investors’ money. It is hard for the justice system to handle these cases, given the lack of regulatory oversight.
  • High Volatility – DeFi projects can run into issues because of the rapid price changes of major cryptocurrencies such as Ethereum and Bitcoin. Banking systems relying on fiat currencies, by contrast, do not have to mitigate this issue.

Tip: Regulation is a key difference between banks and DeFi. Many of DeFi’s advantages are possible because it does not have to comply with mountains of regulatory red tape. But, there are trade-offs for the DeFi’s faster and more innovative transaction structures.

Bottom Line

For years, cryptocurrency skeptics argued that there was still little reason to use crypto in everyday life. DeFi is a big part of the effort to change that.

As DeFi takes off, crypto investors are able to start earning interest on their holdings and invest in more complex long-term contracts with their coins and tokens.

There are plenty of risks, as DeFi is a newly-emerging industry with scant regulation. Over the long haul, however, if crypto is to succeed in disrupting traditional banking and payments systems, it will likely be largely due to DeFi’s burgeoning popularity.

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