The inception of Bitcoin has led to the development of an entirely new financial ecosystem referred to as Decentralized Finance (DeFi). Unlike traditional finance, users do not need to depend on intermediaries and get limited access to financial services with DeFi. To understand this evolving space and to start getting the maximum benefits out of it, it is essential to understand what is DeFi, how it works, and its applications.
What is DeFi?
Decentralized Finance (DeFi) is an umbrella term for all the financial applications built on top of blockchain networks. It is an open-source, permissionless, transparent financial service ecosystem that doesn't depend on a single central authority. DeFi provides almost all the financial services - earning interest, borrowing, lending, and derivatives trading that we access today in the current financial industry.
One of the most important advantages of DeFi provides access to financial services for people across the world without any limitations, especially for those who are unbanked and cannot access the existing financial ecosystem. Users do not need to depend on traditional financial institutions to perform financial activities like borrowing and lending. They have complete control over their assets and can interact directly with other users through peer-to-peer networks and decentralized applications (dApps).
Why is it important?
The primary goal of decentralized finance is to create an open, decentralized, permissionless, and transparent financial ecosystem. Significant investment and other resources have been placed on DeFi projects to create an advanced and efficient financial space. It holds a huge potential to transform traditional finance into a better and more efficient manner.
With the improvements of the present drawbacks and the unique features of DeFi products, it can gain mainstream adoption in the near future. Hence, it is essential to better understand what is DeFi and how it works to be prepared to interact and embrace DeFi applications to benefit from them.
Advantages and Disadvantages of DeFi
The prominence of DeFi has been increasing substantially for the last couple of years. The decentralized finance ecosystem is definitely a more transparent and open-source system with several other benefits. The elimination of intermediaries will save a lot of time and costs for performing various financial activities. However, it is also important to consider significant problems and risks associated with DeFi to estimate its potential. Let us look at a list of the advantages and disadvantages of DeFi.
- DeFi democratizes the traditional banking and finance system. DeFi users can interact with all kinds of financial services without permission from intermediaries. Users do not have to wait and get approval from financial institutions like banks to withdraw or transfer the funds in the DeFi system.
- Users can take a loan within a few minutes without any geographical limitations at any time of the day with the help of DeFi. All they need is a stable internet connection and an electronic device like a smartphone or PC.
- DeFi is built on highly-secured blockchain technology. It does not demand users to go through KYC verification and cumbersome authentication processes to access financial services.
- DeFi is a transparent financial ecosystem. Distributed ledger technology will record transactions and store all the information along with timestamps. As a result, DeFi is transparent, and users can track the transaction information easily.
- Financial crises can occur due to human error and mismanagement of the system in traditional financial institutions. However, DeFi eliminates human error and mismanagement with the help of smart contracts used in dApps and its decentralized nature.
- DeFi primarily consists of open-source protocols. Developers worldwide can contribute and face the present challenges of DeFi and build secure, efficient, and scalable products and services.
- One of the major drawbacks of DeFi projects is that they are prone to all the limitations of the blockchain network they were built on. For instance, the Ethereum blockchain network has a lot of dApps built on it. When the network goes through certain changes, every project experiences the same.
- Despite innovative solutions like automated market making, many DeFi projects still struggle to provide high liquidity. This is one of the major reasons why centralized platforms are more successful than DeFi platforms.
- The vulnerability of smart contracts used to build DeFi protocols can lead to risks of losing funds. Even the slightest error can cause a huge financial loss.
- The anonymity of decentralized finance may not always be an advantage. This feature may encourage malpractices as fraudsters and scammers can also benefit from it.
- Scalability is another big issue in the DeFi ecosystem. As a result, transactions take a longer time to get executed and charge high transaction fees due to network congestion.
- There is a high possibility for scams such as rug pulls in the DeFi ecosystem. Some DeFi projects are not completely decentralized and are prone to these kinds of scams.
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How does DeFi work
DeFi works on blockchain technology and uses cryptocurrencies and smart contracts to provide financial services without any middlemen. In traditional finance, financial institutions hold immense power because they act as guarantors of transactions as the money flows through them. In DeFi, smart contracts replace financial institutions.
Smart contracts are the self-executing codes that trigger fund transfers or payments when certain predefined conditions are met. Once the program goes live, no one can alter or manipulate the executed transactions. Additionally, these contracts are also public for anyone to inspect and audit. All smart contracts come under community scrutiny, and bad contracts are easily identified. However, more and more advancements are taking place in the DeFi space to double down its strengths and overcome its shortcomings.
Let us discuss some of the notable applications of DeFi.
Decentralized Exchanges (DEXs) operate opposite to how centralized exchanges work. They allow users to trade and exchange cryptocurrencies without any third parties. Users interact with built-in protocols using smart contracts and perform all the financial activities like buying, selling, trading, etc.
Traditional trading platforms use the order book to provide liquidity, whereas DEX protocols involve advanced methods like automated market-making and liquidity pools to provide liquidity. Since they are built using algorithms and smart contracts, DEXs do not have limitations and support trading 24/7. Additionally, users can also be liquidity providers and earn additional income with their present crypto holdings.
Stablecoins also fall under the spectrum of DeFi applications. Stablecoins are cryptocurrencies that are pegged to the value of any stable asset like fiat money, gold, or other assets. The main purpose of creating stablecoins is to leverage the benefits of cryptocurrencies by eliminating their volatility. When we avoid the volatile nature of cryptocurrencies, they can be used for daily life transactions payments.
Dollar stablecoins allow investors to generate yield on their crypto assets and reduce the potential risks of market volatility. For instance, if an investor uses ETH to earn interest, there is a possibility that the drop in ETH price offsets the yield earned, which results in a loss. However, if the same investor uses a stablecoin like USDT or USDC, the value of the asset will be stable, and the generated yield will not be affected by the market volatility, which results in a profit scenario all the time.
Decentralized lending platforms allow users to lend and borrow funds from one person to another. These are peer-to-peer lending platforms that allow lenders to earn interest on their crypto holdings, and borrowers can get loans or access liquidity without selling their assets. These platforms use smart contracts to replace intermediaries like banks and borrowers. Thus, lenders can participate in an open system.
Similar to how users need to provide collateral before taking a loan in the traditional system, users of DeFi lending platforms also need to provide collateral to take a loan. The proponents of DeFi believe that the decentralized lending platforms are democratizing the lending ecosystem. These platforms make a massive difference to the unbanked people who do not have to access traditional financial services.
Make money with DeFi
DeFi offers multiple ways to generate passive income from cryptocurrencies. The simplest way to make money with DeFi is by depositing the present crypto holdings onto a DeFi protocol and earning interest or APY (Annual Percentage Yield) for it. Multiple methods like yield farming, staking, and lending are available today, which allow you to generate passive income from the present crypto holdings. All you need is initial capital, and you can watch it grow over time with DeFi protocols. So, start using DeFi platforms today and generate more income from your present holdings over time.
DeFi investing risks
DeFi is still in its early stages of development. Even though it is an advanced financial system with multiple benefits over traditional finance, it is prone to several risks. Before getting started in DeFi and investing in your crypto holdings, it is crucial to understand its risks. Let us look at five potential risks and understand how they can affect your earnings.
- Software risk - DeFi protocols are software applications built on blockchain technology with the help of smart contracts. Like all software protocols, DeFi platforms are prone to coding errors and defective smart contracts. As a result, they can make the software vulnerable to hacks and thefts. However, the DeFi system is a transparent and open-source system. Anyone can audit and verify the code to reduce this type of risk.
- Counterparty risk - Counterparty risk can be explained as risking money by lending it to someone who does not repay. Any loan agreement system, whether traditional finance or decentralized finance, involves counterparty risk. However, most of the present lending platforms collateralize their loans, which means borrowers must provide collateral worth over 100% of the borrowed amount. You need to research and understand the terms and conditions of a particular DeFi platform before investing your funds in it.
- Token risk - Every decentralized platform involves cryptocurrency coins and tokens. When you deposit funds into a liquidity pool of a DeFi platform, you will get two tokens - the LP token and the native token of the DeFi platform. Tokenomics plays a crucial role in determining the long-term value of a crypto token. You must thoroughly research the tokens involved in a DeFi protocol and understand its ins and outs for the long-term benefit.
- Impermanent loss - Impermanent loss is a risk that liquidity providers take in exchange for the rewards they earn in liquidity pools. For instance, when you deposit crypto into a DeFi protocol, its value might increase or decrease. If the rewards you earn in a certain period are less than the profits you could have made by holding your tokens, you suffer a loss. One way to avoid this loss is by investing dollar-pegged stablecoins into DeFi protocols.
- Regulatory risk - At present, DeFi protocols operate without any oversight or regulation from the government. Hence, these platforms also involve regulatory risks. This situation might change in the future, and we cannot exactly predict what happens to your investments when governments introduce regulations on DeFi systems.
Understand the risks involved in the DeFi ecosystem so that you can make well-informed decisions. If you are a beginner, start with simple DeFi investments like single token pools, stablecoin pairs, etc. Start with small investments and gradually build your DeFi portfolio with advanced investments.
DeFi is a decentralized financial ecosystem that is built on blockchain technology.
You can make money in terms of APY by depositing your crypto holdings into a DeFi platform.