DeFi, or Decentralized Finance, is a rapidly emerging alternative to the traditional financial services industry.
What is DeFi?
Decentralized finance is a growing ecosystem of protocols, applications, and digital assets enabling a wide range of permissionless financial services.
DeFi aims to remove the need for centralized institutions and other third parties from financial services by creating peer-to-peer exchanges.
These decentralized finance protocols use code called ‘smart contracts’ to automate market making processes.
In most DeFi applications, these smart contracts are based on Ethereum, a powerful decentralized computing network.
DeFi vs. Traditional Finance
The DeFi ecosystem offers many of the same services that banks offer – earning interest, borrowing / lending, asset and derivatives trading, insurance, and more.
However, DeFi aims to decrease the involvement of centralized financial institutions and third parties to access these types of financial services. Additionally, DeFi aims to eliminate the barriers to access, reduce fees, and improve transaction speeds.
Governments require traditional financial institutions to collect personal information about their customers. A few of the most well-known regulations are Know Your Customer (KYC) and Anti-Money Laundering (AML).
Decentralized finance platforms aren’t restricted by these requirements. In fact, you don’t even need to create an account to access most DeFi applications – the only requirement is a cryptocurrency wallet.
What are the Benefits of DeFi?
There are a number of benefits to decentralized finance over centralized finance:
Open to all:
Traditional financial institutions are required to collect personal information such as physical addresses, contact information, and government-issued identification to use their services.
DeFi applications enable anyone to access these services without providing any identification or personal information. This allows wider access to financial services to under-banked individuals, as well as financial sovereignty to those that wish to custody their own funds or remain pseudonymous.
In early 2021, stock trading platform Robinhood halted trading on several popular stocks, including Gamestop ($GME). The halt came after Robinhood reportedly faced pressure from its investment partners.
Many retail investors were outraged, and Robinhood has faced litigation for this action. However, the trading halt still caused some investors major financial losses, as they were unable to freely buy and sell their shares.
In DeFi, scenarios like this aren’t possible; no centralized entity has control over the transactions on the network.
Speed and efficiency:
Since cryptocurrency transactions settle in just minutes rather than days, financial services can be performed much faster using DeFi alternatives.
What are the Risks of DeFi?
Supplying crypto assets to DeFi protocols can be risky. If the price of an asset supplied to a liquidity pool changes dramatically, it can cause a loss of the assets as the pool rebalances.
Lack of regulation:
With DeFi still largely in its early stages, many governments haven’t established specific regulations for the Decentralized Finance space.
Properly calculating tax obligations on DeFi activity can be a tedious and difficult process.
Being your own bank comes with a lot of responsibility.
When transacting with cryptocurrencies, your transactions cannot be reversed. This means that if you make a mistake (for example, send assets to the wrong address), there is absolutely no way to recover the funds.
For this reason, it’s extremely important to double-check every transaction before confirming it.
Unfortunately, bad actors often attempt to take advantage of users who are new to crypto and DeFi. By promising outlandish returns, some investors are lured into sending their assets to scammers or malicious protocols.
Services available in DeFi
A few of the most popular DeFi services include:
Stablecoins are cryptocurrencies with values tied to an external asset (for example, dollars or gold). Typically, stablecoins fluctuate in price much less dramatically than traditional cryptocurrencies like Ethereum.
A few of the most popular stablecoins include USD Coin (USDC), Tether (USDT), DAI, and Binane USD (BUSD).
DeFi platforms like Compound allow users to borrow assets or lend out their own assets to earn interest.
While no personal information is required to take out a loan on DeFi platforms, borrowers generally must put up their own crypto assets to collateralize loans. If the borrower doesn’t repay the lender, the digital assets are liquidated.
Users can also utilize these DeFi platforms to earn interest on their crypto assets by lending assets to borrowers.
Decentralized exchanges (DEXs) are similar to trading platforms like Coinbase or Binance. However, DEXs don’t require users to create an account or provide personal information to access the platform.
Instead, users only need a crypto wallet to buy, sell, and trade digital assets on a decentralized exchange.