With the introduction of Blockchain technology into our lives, we have often heard of new concepts such as Coin, Metaverse, and NFT, which also include finance or investment opportunities. DeFi is one of these concepts; in fact, it is the most comprehensive and necessary one.
DeFi is a generic name for “decentralized finance“, which is a combination of the English words “decentralized” and “finance”. DeFi covers financial products and services that are accessible to anyone with an internet connection. For this reason, tens of billions of dollars worth of cryptocurrencies have flowed through DeFi applications so far, and this amount is increasing every day. Bitcoin is the most important emerging asset in this space.
Why the need for this decentralized structure where thousands of people can be both users and managers? DeFi was created for the Internet age as an alternative to the banking system, which is opaque, tightly controlled, and held together by decades of infrastructure and processes.
DeFi exists to build a more democratic financial system in the wake of the emergence of cryptocurrencies for freedom. Approximately 1.7 billion people in the world do not have access to the traditional financial system, i.e. banking. DeFi’s first goal was to reach these people whom the current financial system cannot reach.
On the other hand, after the 2008 crisis, many people’s trust in the banking system was shaken. The dominance of one center overall financial instruments, monetary policies, and a system where even banks could make losses at any time were interpreted as both unsettling and discredited. It is precisely for these reasons that governments’ unlimited ability to print money and change valuations has increased people’s interest in systems where no one can intervene based on a certain formula.
With blockchain, where there is no need for centralized authority, the field of finance has become freer. At this point, we can say that DeFi was born out of necessity, like all alternative methods in life.
Thanks to DeFi, banking transactions are carried out not by an authority but through an algorithm created by the system. With millions of devices connected to DeFi networks, it enables transactions to be made through a certain formula. Therefore, there is no central intervention in DeFi systems. It is the users who make the system work.
Of course, financial instruments are not limited to sending and receiving money. With DeFi, different financial functions should also be considered. These include taking loans, giving loans, decentralized stock exchange, insurance, shopping, marketplace, and so on.
All DeFi systems need to have a cause-and-effect relationship. Therefore, smart contracts, decentralized applications and consensus protocols play an important role in DeFi systems. At this point, it may be easier to understand DeFi in layers.
- Blockchain: Contains the transaction history of digital currencies or assets and the status of accounts.
- Assets: ETH and other tokens (currencies).
- Protocols: Includes smart contracts that provide functionality such as a service for decentralized lending of assets.
- Applications: Products used to manage and access protocols.
Advantages and disadvantages of DeFi systems
DeFi claims to offer a better system than traditional financial systems. Therefore, there are areas of use that have advantages over traditional financial systems.
DeFi’s advantages are as follows in general terms:
- It makes money-based banking systems available to everyone.
- It enables borrowing and lending transactions between users.
- It enables the introduction of a new cryptocurrency to the market and the ability to raise funds for projects.
The disadvantages of DeFi can be listed as follows:
- DeFi is a new system, so there are still gaps in some areas.
- Although it aims to be available worldwide, there are very few people using DeFi at the moment.
- So many transactions need to be stored as data somehow. There is not enough infrastructure to store this data.
There is a thriving crypto-economy where you can lend, borrow, go long/short, earn interest and more. Crypto-savvy Argentinians used DeFi to escape inflation. Companies started transferring wages to their employees in real time. Some people even took out and paid millions of dollars worth of loans without needing any personal identification documents.
Here are some of the things you can do with DeFi:
- Send money anywhere in the world
- Fixed currencies accessible
- Can be borrowed with or without collateral
- Token can be traded
- Insurance can be purchased
Borrowing with secrecy: Banks check whether a loan is likely to be repaid before lending. In a decentralized lending system, the parties do not need to identify themselves. The borrower must provide collateral that the lender automatically receives if the loan is not repaid. Some lenders even accept NFTs as collateral. This way, money can be borrowed without a credit check or handing over private information.
Access to global funds: When using a decentralized lender, funds deposited from all over the world can be accessed, not just funds in the custody of the chosen bank or institution. This makes loans more accessible and improves interest rates.
Fast loans: Fast loans allow borrowing without collateral or any personal information. While they are not widely available at the moment, there are hints that they may become more accessible in the future. Usually, the funds used are held in liquidity pools (large pools of funds used for borrowing). If they are not being used at a given moment, this creates an opportunity for someone to borrow these funds, do business with them, and repay them in full, literally the moment they are borrowed.
Lending: In DeFi, the traditional financial institution is replaced by a smart contract. A smart contract is a kind of Ethereum account that can hold money and send/repay it according to certain conditions. Once in use, no one can change this smart contract. It always works as programmed. Contracts are also publicly available for anyone to review and audit. This means that malicious contracts will usually come under community scrutiny fairly quickly.
In the past year, the fraudulent method known as rug pull has been exploited many times.
Starting in 2020 and continuing in 2021, the popularity of the DeFi sector has increased with the financial orientation, and scams in the ecosystem are on the rise. We will briefly touch on ways to avoid losing money in the DeFi space, which is a separate article in itself:
How can you tell if a project is a scam? The first thing that users and investors should pay attention to is whether the protocol has been tested. This is because the smart contracts that make up decentralized finance protocols can be easily cyber-attacked by hackers due to human error. For this reason, it is important to make sure that the protocol to be invested in has been analyzed by independent auditors.
Information about the team: One of the most important things to consider before deciding to invest in a project is who is developing it. The first thing to check is the “About Us” page on the project’s website. Suspicious details and fake LinkedIn profiles with no connections or background should call credibility into question.
Advisors and known investors: The list of project advisors and investors is important. Projects with well-known consultants are often much more credible than others. The same goes for projects with well-known investors. If the project does not disclose the list of its early investors or provide any information about its advisors, it may be another point of suspicion.
Product vetting: When investing in DeFi projects, you should examine the product that the project promises. See if there is a future in terms of whether the product will actually work. The products that the project team has come up with so far can also give an idea.
Smart contract: As mentioned earlier, the smart contract is critical. It is definitely worth checking whether the team has made the project’s smart contract publicly available. This will give you an idea of the potential of the project. Independent experts can also identify potential security vulnerabilities much earlier. On the other hand, the project team may be hesitant to share its smart contract publicly for fear that another project will steal or copy it. In such a case, the prestige of the team behind the project should be taken into account. If the team is reputable and has a proven track record, it may be worth investing in projects that do not share their smart contract publicly.
Has the smart contract been audited: This is one of the most important considerations when investing in DeFi projects. It’s worth repeating. Avoid investing in projects whose smart contract has not been checked by independent auditing companies.
The token distribution and initial market capitalization: If the project team is holding a large portion of the circulating token supply, this should raise suspicion. If the project’s token distribution scheme is not shared publicly, it should be avoided.
If one or more of the above criteria are alarming, one should be very cautious about that project.
DeFi is one of the innovations brought by the changing world. Recognizing and even defining this new concept correctly can prevent possible damage as well as facilitate life and allow for moves that can benefit.