Decentralized finance, or “DeFi,” is an emerging digital financial infrastructure that theoretically eliminates the need for a central bank or government agency to approve financial transactions.
Considered by many to be an umbrella term for a new wave of innovation in financial services, DeFi is deeply connected to the blockchain – the distributed, decentralized, immutable public ledger on which bitcoin is based – which allows all computers (or nodes) on a network to hold a copy of the transaction history… with the idea that no single entity has control over or can alter that record of transactions.
Most of the financial services that could be defined as DeFi are found on the Ethereum network, the second largest cryptocurrency marketplace, which also acts as a platform for other blockchain applications to be built on top of it (Ethereum’s cryptocurrency, ether, is used to pay transaction costs). Using decentralized applications, or dApps, two or more parties can exchange, lend, borrow and trade directly using blockchain technology and smart contracts without the involvement and costs of intermediaries.
Differences from Bitcoin
DeFi aims to be a fair, free, and open digital marketplace, at least in theory. In practice, at least for now, this does not always correspond to reality.
But how is DeFi different from bitcoin? While bitcoin is a decentralized digital currency that operates on its own blockchain and is used primarily as a store of value, DeFi is a concept that describes financial services built on public blockchains, such as Bitcoin and Ethereum, that allow users to, for example, earn interest or borrow against their cryptocurrency holdings.
DeFi consists of a variety of applications around financial services such as trading, borrowing, lending and derivatives.
How does DeFi work?
DeFi uses cryptocurrencies and smart contracts to provide financial services to eliminate the need for intermediaries like guarantors. These services include lending (where users can lend their crypto-currencies and earn interest in minutes rather than once a month), receiving a loan instantly, conducting peer-to-peer transactions without a broker, saving crypto-currencies, and getting a better interest rate than from a bank, and buying derivatives like stock options and futures.
To facilitate peer-to-peer business transactions, users use dApps, most of which are on the Ethereum network. Some of the most widely used DeFi services and dApps include coins (Ether, Polkadot, Solana), stablecoins (whose value is tied to a currency such as the U.S. dollar), tokens, digital wallets (Coinbase, MetaMask), DeFi mining (also known as liquidity mining), yield farming, staking, trading, borrowing, lending, and saving using smart contracts.
DeFi is open source, which means that the protocols and applications are theoretically open for users to inspect and innovate. Therefore, users can mix and match protocols to unlock unique combinations of opportunities by developing their own dApps.
What is a smart contract?
It is a computer code that acts as a digital agreement between two parties. A smart contract runs on a blockchain, is stored in a public database, and cannot be changed. Because the blockchain processes smart contracts, they can be sent automatically without the intervention of a third party. The peer-to-peer transaction is only closed when the conditions of the agreement are met.
The obvious advantage of smart contracts is that they can be created so that you can borrow and lend your cryptocurrency without going through an intermediary, thus avoiding much of the risk associated with traditional lending.
If, for example, a borrower can’t meet their obligations under a loan, their lender can simply take back their funds, making collateral unnecessary. In addition, DeFi savings accounts could operate similarly to bank savings accounts, but with higher interest rates or daily, weekly or monthly payments, depending on the platform.
Who created DeFi?
The concept of decentralized finance was not created by one person. Bitcoin is said to have been created by Satoshi Nakamoto, a pseudonym for the person or persons behind the world’s first cryptocurrency and financial blockchain. The identity, or identities, behind Satoshi Nakamoto remain unknown.
Ethereum, the bitcoin-inspired platform, and the one on which a majority of DeFi’s services run, was developed by programmer turned entrepreneur Vitalik Buterin. In 2013, at the age of 19, the Russian-born Canadian wrote a white paper describing an alternative platform to bitcoin that would allow programmers to develop their own applications using an embedded programming language.
That’s how Ethereum was born, and it has grown exponentially over the past nine years. As of mid-January 2022, the market capitalization of the Ethereum cryptocurrency, ether, stood at $385 billion. It is the second-largest crypto currency in terms of market capitalization behind bitcoin, which still reigns as the largest crypto currency with a market capitalization valued at $805 billion, according to CoinMarketCap.
What can you do with DeFi?
As mentioned above, DeFi uses cryptocurrencies and smart contracts to provide financial services without the involvement of banks. With the addition of more dApps, the possibilities of what you can do with DeFi continue to grow.
The most popular uses of DeFi include sending money anywhere in the world (in a short amount of time and at an affordable price); storing money using cryptocurrency wallets (and getting higher returns than at a traditional bank); peer-to-peer borrowing and lending; trading cryptocurrencies anonymously and anytime 24/7; trading tokenized versions of investments such as stocks, funds, other financial assets and non-fungible tokens (NFTs); crowdfunding; and buying insurance with the help of companies like Etherisc.
There is more than one way to leverage DeFi’s growth. One strategy is to generate passive revenue using Ethereum-based lending applications. Essentially, users lend their money and generate interest on the loans. Another strategy used is yield farming, a riskier practice for more advanced traders, in which users scour a myriad of DeFi tokens in hopes of finding opportunities for higher yields, but it is complicated and can lack transparency.
How risky is DeFi?
Like all other new decentralized blockchain networks trading cryptocurrencies, DeFi is very risky, especially since you are using a new technology that aims to disrupt an established institution such as a centralized bank. It’s even riskier for novices lured by the potential gains of yield farming and passive income. Ethereum has security and scam prevention guidelines, as there are also broader potential risks.
Fraud and crime remain a significant problem; according to calculations by blockchain data platform Chainalysis, $14 billion worth of cryptocurrencies were sent to illicit addresses in 2021, nearly double the figure seen in 2020.
About $2.2 billion was stolen outright from DeFi protocols in 2021. The study by Chainalysis even puts the loot collected by perpetrators from victims at $7.8 billion in cryptocurrencies, with about $2.8 billion of that figure coming from a scam dubbed “rug pulls.” At the end of these scams, developers create seemingly legitimate cryptocurrency projects before stealing investors’ money and disappearing.
Many attacks on DeFi exchanges in 2021 can be attributed to errors in the smart contract code governing these protocols, which hackers exploit to steal funds. “The most important point to remember is to avoid new tokens that have not undergone a code audit. Code audits are a process by which a third-party company analyzes the smart contract code behind a new token or other DeFi project and publicly confirms that the contract’s governance rules are ironclad and do not contain any mechanisms that would allow developers to abscond with investor funds,” Chainalysis researchers note.
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