What Is It Decentralized Finance (DeFi)
A few years ago, smart contracts for ICOs made a splash. For a long time, blockchain has attracted the attention of investors in this way of collecting money. But over time, ICOs faded into the background and a new revolution called decentralized finance began.
We have gathered together all the most important and complete information in our guide to understand whether it is a new crypto bubble or not. Continue reading to understand what DeFi is. We wrote all the most necessary things in simple words and arranging knowledge by category, making it easier to absorb.
What is DeFi
Decentralized finance has become a trend in 2019 and continues to gain popularity in the cryptocurrency world. Decentralized finance refers to an ecosystem of financial apps that are built on popular blockchain networks.
DeFi is a financial instrument as applications and services, various technologies created on the blockchain.The primary task of decentralized finance is to become an alternative to the banking sector and replace the traditional technologies of the current financial system with open-source protocols.
We use these technologies outside of decentralized finance, but they play an important role in the DeFi ecosystem.
There are several components of DeFi:
- DeFi projects are blockchains, distributed ledgers for recording transactions. Currently, DeFi activity is growing across different blockchains, but most DeFi services operate on the Ethereum network because of its popularity among developers and its unique capabilities.
- The second component of DeFi is digital defi coin and assets, or as it is commonly called — tokens. They represent value that can be transferred or sold on the blockchain network.
- The term DeFi refers to the creation of an open, transparent and free financial services ecosystem. Such an ecosystem is available to any user and works without interference from any government authorities. Cryptocurrency holders keep control over their deposits and savings, they interact in the ecosystem using bodies (P2P), and also use decentralized applications (dapps).
- The next component that characterizes decentralized finance is wallets. These are software user interfaces. They are used to managing assets and are stored on the blockchain. Using a wallet with a private key, the user controls his crypto assets.
- Another important component of DeFi is smart contracts. This is blockchain-based programming code. It is a computer algorithm designed to generate, control and provide information about the ownership of something. Smart contract records certain actions and events under pre-defined rules and conditions. Decentralized applications (Dapps) are created based on smart contracts.
- Next comes such a component as stablecoins (digital assets, the value of which is tied to fiat currency or other assets with a stable value).
- DeFi’s governance systems have embedded software mechanisms that drive changes to smart contracts or other blockchain protocols. They often base them on tokens that distribute voting rights among stakeholders.
What are DeFi benefits
If we talk about decentralized financial services, you can immediately summarize all the advantages and these will be: decentralization, transparency, exclusion of the human factor through the use of smart contracts, DeFi tokens allow you to conclude transactions between users with many computers of other participants, easy access to financial services, modular framework, interoperability of applications based on public blockchains and much more.
- Transparency. The DeFi marketplace is based on source code. We can check all data at the address of the smart contract and this information is always available to any user.
- Inclusiveness. We can launch a DeFi product for any project, without the permission of banks and regulatory and governing bodies.
- Ease of access. Using a DeFi product, you can use financial services without intermediaries. Thanks to DeFi, operating costs are significantly reduced and such communities can benefit from the financial services they need.
- Modular framework. The framework allows you to create DeFi applications in advanc, making them less complex and more secure to develop and deploy.
Any technology and financial instrument have not only advantages but also disadvantages.
- The disadvantages of decentralized finance include low system performance. Blockchains are inherently slower, which leads to the creation of additional applications. DeFi application developers are constantly analysing these limitations and optimizing their products.
- The high risk of user error. DeFi applications transfer responsibility from the reseller to the user.
- Randomness. Finding the right application is a daunting task.
How and where is DeFi used?
Cryptocurrency has an extremely volatile price. On the day, the cryptocurrency rate can fluctuate within 10%, and sometimes even exceed this threshold. To lessen this volatility, stablecoins were created. This cryptocurrency is pegged to stable assets. For example, to gold or the US dollar.
Decentralized stablecoins are issued using the over-collateralization method. They operate on decentralized ledgers, run by autonomous organizations, and anyone can check their reserves. DeFi price is lower.
Traditional financial systems require the user to have a bank account in order to use their services. DeFi landing protocols use smart contracts to mitigate the risk of lower transaction costs and counterparty. Decentralized lending and borrowing allow anyone to use their digital assets as collateral to get loans.
Decentralized Exchanges (DEX)
Exchanges can be used to change one cryptocurrency for another. Theyare blockchain-based and they don`t store personal data of users and information about their funds. DEX acts as a platform — a new model for trading and exchanging cryptocurrency assets. They exclude the passage of KYC procedures and dependence on one or more large intermediaries.
Uniswap is a successful example of a DEX exchange that combines trading and lending options.
Peer-to-peer Bet Markets
These are platforms that allow you to place bets on the outcome of certain events (elections, litigation, sports, and other controversial events). Augur is an example of a peer-to-peer bet marketplace platform where anyone can place bets.
DeFi has shown itself in another creative direction — lotteries. The extension of DeFi principles to lotteries allows transferring control of the prize pool to a smart contract on the blockchain.
DeFi enables you to further develop innovative payment methods, making it possible to transfer values directly from the sender to the recipient without the need to trust the crypto assets to the intermediary. DeFi projects aim to change the traditional approach to payments. It changes the configuration of payments from transactions to flows.
Such DeFi projects allow users to trade on centralized exchanges without having to deposit funds on them. Traders gain secure access to the liquidity of centralized exchanges and reduce the threat of hacker attacks.
The Role of Smart Contracts in DeFi
Most of the existing and potential DeFi projects need the creation and use of smart contracts. A smart contract uses computer code. All conditions described in computer code have the unique ability to apply them. A smart contract provides reliable execution and automation of business processes that require manual control in the banking system.
Smart contracts are much easier and faster to use and this is their primary advantage. Despite this, they provide space for new types of risk to emerge. This is because computer code is prone to errors and various vulnerabilities. User’s confidential information blocked in smart contracts is at risk.
What are the risks of DeFi?
Systemic risks in the DeFi sector
These are liquidity and credit risks. The problem with DeFi systems working with cryptocurrencies is volatility. If the price of the underlying assets falls, the assets are liquidated and the system may collapse.
To mitigate these risks, DeFi protocols provide a surplus of assets, lowering the impact on their price.
The risk of hacking smart contracts
The smart contract code is written by a person, so we do not exclude the possibility of making a mistake.
Lack of capital in DeFi loans
Despite its merits, DeFi loans are inferior to loans in the traditional finance sector, since the amounts that can be obtained with the collateral are relatively small.
Popular DeFi projects
Decentralized tools allow users to generate passive income from cryptocurrency assets, and save on commission fees.
They build most of the existing DeFi projects on the Ethereum blockchain. The number of new applications in the decentralized finance industry continues to grow.
The most famous DeFi project is MakerDAO, a decentralized lending protocol. More than half of the blocked airtime falls on this platform.
Using the service, each user can send a certain amount of ETH to a smart contract and issue their token.
Other most famous credit and deposit platforms are InstaDApp, BlockFi, Compound. The latter allows not only taking loans but also investing cryptocurrency at 6% per annum.
Decentralized finance also includes platforms like Fuji, where an inner coin operates, which allow you to instantly convert any currency in the world into cryptocurrency, and use it for the convenience of the platform. Digital asset management also allows you to generate additional income from the growth of the inner coin.
The concept of decentralized finance aims to build platforms for preparing financial services that will not resemble traditional financial technologies and will not depend on political systems. This will create a more open and free financial system.
Decentralization may not be beneficial in all cases. Its most suitable use is in the cryptocurrency world and blockchain. This is critical to building a useful stack of open-source financial products.
If successful, DeFi will take power from large centralized organizations and place it in the hands of the free software community. It is still too early to say how effective this financial system will be. It is also unknown when decentralized finance will go mainstream and be accepted by the public.
But we know for sure that DeFi is one of the fastest-growing segments of cryptocurrency, with a simple idea to make all accepted financial institutions on autonomous smart contracts Ethereum or another blockchain.