DeFi, a briefer term for decentralized finance, can be understood as a monetary infrastructure emerging in the cryptocurrency landscape. In a constant competition with old-school banking networks, crypto enthusiasts aim to extend the blockchain-based financial ecosystem to oppose the traditional world of centralized financial relationships (CeFi).
If we are to judge by market capitalization, DeFi has yet to gather its strengths to challenge the colossal multi-trillion dollar merchant institutions. In 2021, however, the total contract value of DeFi market made it far past $50 billion, approaching something of $100 billion by some accounts. This is an immense growth to have occurred in just a couple of years.
Simply put, the decentralized finance definition stipulates an alternative to government-controlled banking systems in matters of issuing and regulating currency. Furthermore, DeFi technology can be made service-oriented, providing many capabilities and business solutions. It is currently implemented in fintech companies to enable decentralized loan and insurance giving, securities trading, as well as providing users with savings accounts.
An example of tools from the future realm of DeFi can be Jet-Bot, a pre-made piece of trading automation software meant for Binance markets. It allows the user to follow in other traders’ steps, namely those most successful on Binance. Jet-Bot’s 3-day trial version provides a portfolio of $100,000 in virtual funds to experiments with trends and find your bearings in the fast-changing reality of crypto values. The social openness of this platform makes it a great medium to compare performances and learn the ways of efficiency.
Take-away points of DeFi benefits:
- removes the need for trusted centralized intermediaries;
- secures trading on the systemic level (no risks of the traditional financial exchange);
- dilutes the concentration of service givers, boosts diversity;
- potentially enhances system resilience by having no single vulnerability point or core.
What is decentralized finance (DeFi) used for?
With DeFi, the chief concept revolves around having access to all the capabilities provided by a crypto token.
Blockchain operations make loaning easy, insurance reliable, with many other functions, such as doing derivatives, crowdfunding, and gambling benefiting from high crypto security.
Many name flash loans as one of the most noteworthy capabilities of DeFi. These demonstrate just how sophisticated this innovation is in handling the new risks that pose so much challenge to traditional fintech.
Flash loans enable DeFi users to borrow free of collateral, as long as they take up the obligation to repay the amount to the pool in the same block. In short, a borrower receives a sum of crypto, as decided by the arbitrage and then returns the loan with a percentage, all going in one block.
This scheme, of course, requires the appropriate transaction handling software. Eyes on the prize here are all about allowing users to profit from arbitrage opportunities that arise between various crypto-assets. Using decentralized exchanges would mean much more cost-effective loans, where every party benefits greatly from price disparities and the absence of side fees.
DeFi definition: Advantages of DeFi
Whatever is your financial aim, substituting a CeFi platform with DeFi several brings several potent benefits, namely:
- Lower fees and increased interest rates. Think direct transactions between two traders. With intermediaries eliminated, operation fees receive a great reduction, and the parties get to establish their own interest rates.
- Accessibility. Think no location restrictions. Receiving loans has ever been tied to brick-and-mortar institutions, but nowadays, any person able to connect to the internet can work their DeFi account(s) without hassle.
- Functional autonomy. Think mitigation of risks through decentralization. DeFi doesn’t require any financial cores subject to corruption, bankruptcy, or economic crises. Individual institutions holding your money per se are prone to suffer from being too much interconnected on the governmental level. DeFi platforms leverage the distributed power of many nodes to avoid collapses.
- Enhanced security and transparency. Think full public traceability without disclosing your real identity. Smart contracts are open to review by anyone, yet at the same time, the immutability of blockchain prevents the records from changing. DeFi platform traders proceed with their operations safely and privately, without any risk for their sensitive information or funds being compromised.
Risks of Decentralized Finance
Many of DeFi’s vantage points also constitute risks.
- Low to zero regulatory protection: While having no third party to your decentralized transactions is conducive to innovation, there is also no one to protect you if something goes awry.
- Illusory investment claims: As of now, the deficiency in regulation leaves some investors groping in the dark. The promises of returns run wild and often unrealistic; however, it’s very early to build expectations of what DeFi savings accounts can actually yield.
- Non-intuitive software: Amateur crypto enthusiasts may feel aghast by the actual advanced knowledge today’s DeFi platforms require. At the start of this learning curve, newcomers could be at an especially high risk dealing with sophisticated and more knowledgeable counter-parties.
- Large volatility: As the prices of Ethereum and Bitcoin oscillate wildly, DeFi projects can find themselves dealing with certain complications. This can be quite similar to what banking systems experience in the times of unexpected inflation — only it happens with a greater, totally uncontrollable dynamics.
- Scams and fraud: Not all DeFi projects are equally trustworthy. Some have been deliberately set up to do a “rug pull” to the unwitting investors, which is basically a grab-and-run scheming practice. With little of the justice system in place, handling such cases fairly becomes quite impossible.
What is the role of stablecoins?
Any DeFi market is unimaginable without stablecoins at its foundation. Estimations have it that Aave, Compound, and MakerDAO, among other DeFi lending protocols, are holding around 23% of the overall supply of USDC. Stablecoins are just great when it comes to hedging against cryptocurrency volatility. In this way, participants of such markets avoid the need to use a centralized exchange to convert their crypto-assets into fiat ones. Judging from the frequency of user requests for MetaMask Swaps, the most common trade operations are set around ETH and the rest ERC-20 tokens being converted to stablecoins.
DeFi applications can enjoy liquidity exactly due to said crucial role of stablecoins. In these markets, it is indispensable that DLT-based tokens backed by fiat serve as one of the main kinds of collateral.
Stablecoin-based DeFi protocols are ones that significantly increase the emerging tight connections between the worlds of DeFi and CeFi. Many DeFi proponents agree that popularization of stablecoins would be a great way to promote mass adoption of these platforms.
Simultaneously, such sources of liquidity constitute one of the most vulnerable points of the DeFi market. Furthermore, stablecoins can be a risk-transmitting device in places where DeFi crosses over to the traditional monetary networks. Given the presence of other dangers of these markets (administrative, functional, cyber-security, as noted above), DeFi might sometimes fail to come across to possible investors as a reliable financial system.
Decentralized finance remains in the gestational stage of its evolution. Its unregulated nature suggests numerous infrastructural mishaps, hacking vulnerabilities, and scam opportunities. Current legislation has been crafted based on the concept of detached financial jurisdictions, with each maintaining its own system of rules and laws. The revolutionary idea behind DeFi’s boundless transactions poses a significant challenge to this regulative approach. Many issues must be handled and technologies implemented before DeFi enters safe public use.
In the long term, however, should crypto succeed in subverting the heavily bureaucratized banking and payments networks, it will likely be thanks to DeFi as one of the cornerstones of the new financial order.