What is DeFi? Decentralised Finance Explained

What is DeFi? Cryptocurrency has given rise to a new concept known as decentralised finance or DeFi. Here is the breakdown.

What is DeFi?

Decentralised finance, or DeFi, refers to financial services that are built on top of blockchain networks and run without the use of middlemen like banks or other financial institutions.

It is a financial system that is an alternative to conventional financial services. Earning interest, borrowing money, lending money, purchasing insurance, trading derivatives, trading assets, and other activities are all possible, but the process is quicker and doesn't involve any formalities or a third party.

More or less, instead of lending from a bank, for example, people can lend via a DeFi platform, among other other services.

It is open to everyone, peer-to-peer (directly between two people, not through a centralised system), global, and pseudonymous.*

NB Where you see the following symbol “*“, please note the standard risk warning at the bottom of the article.

How does DeFi Differ from Traditional Finance?

There are several differences from conventional finance.

-DeFi runs on a decentralised system, meaning it is not governed by a centralised institution or authority.

-Regardless of location, wealth, or status, anyone with an internet connection has open access to financial services and products thanks to DeFi.

-DeFi runs on a trustless system, which means that all participants can rely on transactions to be carried out automatically and without the use of middlemen.*

What are some known features of DeFi?

DeFi offers some unique features to its users.

Accessibility

Unlike centralised exchanges where AML/KYC is a requirement, there is no similar requirement in DeFi. There is no requirement to "open" an account or submit an application. By making a wallet, you can simply gain access.*

Transparency

Because DeFi operates on a decentralised system, it is more transparent than traditional financial systems. This is because the decentralised system, through its design, aims to be tamper-proof and fraud-resistant. This system still has a number of risks that you can read below, a key one being the accuracy, transparency and understanding of the coding required for the smart contracts.*

Pseudonymous

Unlike centralised exchanges where AML/KYC is a requirement, there is no similar requirement in DeFi.The DeFi platform does not require you to provide personal details.*

Flexibility

You have the freedom to move your assets at any time, without needing permission, without having to wait for lengthy transfers to complete, and without having to pay uncompetitive fees.*

Quick

Compared to traditional finance, interest rates and rewards are frequently updated quickly (updated as frequently as every 15 seconds).*

What are the disadvantages of DeFi?

DeFi, however, has some drawbacks as well. The absence of regulation is one of DeFi's biggest problems.

There is little oversight or regulation in place to protect users because the system doesn't use conventional financial institutions.

The performance of crypto can be highly volatile, value can drop as quickly as it can rise. Past performance is not a guide to the future.*

How does DeFi work?

DeFi is an emerging financial technology that challenges the current centralised banking system. It provides free, open-source digital marketplaces that enable users who code to innovate and develop their own decentralised apps (dApps).

The majority of dApps that are currently used to interact with DeFi by users run on the Ethereum blockchain.

To understand how DeFi works, it is important to understand the basics of blockchain and smart contract technology.

Blockchain allows information to be recorded and verified without the need for a central authority. Smart contracts, on the other hand, are self-executing contracts that automatically enforce the terms of an agreement between parties.

DeFi platforms use blockchain and smart contract technology to deliver a range of services, such as payment processing, trade and investment, loans, insurance, and asset management.

Uses of DeFi

People are currently using DeFi in a variety of ways:

-Lending out cryptocurrency and earning interest and rewards

-Getting loans instantly without filling out paperwork

-Trading certain cryptocurrency assets between peers

-Putting some of their cryptocurrency into alternative savings accounts and earning enhanced interest rates than they would typically get from a bank

-Placing long or short bets on specific assets.

Some DeFi platforms provide extremely short-term "flash loans," which are unavailable from conventional financial institutions.*

The key players in the DeFi ecosystem

The DeFi ecosystem is made up of various key players. They allow users to transact, lend, borrow, and invest in cryptocurrencies in a decentralised manner.

Some of the main players in the DeFi ecosystem include Aave and Uniswap.

Aave is a decentralised lending platform that allows users to lend and borrow cryptocurrencies without intermediaries.

Uniswap is a decentralised exchange protocol that allows users to trade cryptocurrencies without intermediaries.

Curve Finance is a blockchain protocol that provides a way to swap stablecoins efficiently, with competitive fees and slippage, making it a valuable player in the DeFi space.

Role of decentralised exchanges

Decentralised exchanges, or DEXs, are essential to DeFi because they enable peer-to-peer, trustless cryptocurrency trading.

Decentralised exchanges (DEXs) allow users to trade directly with one another using smart contracts. These smart contracts execute trades automatically when certain conditions are met.

This is different to centralised exchanges that require users to deposit their funds with the exchange and rely on the exchange to facilitate trades.*

DeFi lending and borrowing

One of the most popular use cases of DeFi is lending and borrowing. DeFi lending and borrowing is a way to lend and borrow cryptocurrencies without the need for traditional financial institutions. These transactions take place on decentralised finance (DeFi) platforms that operate using blockchain technology.

One of the benefits of DeFi lending and borrowing is that it is accessible to anyone with an internet connection, making it more inclusive than traditional financial institutions.

Lenders can earn higher interest rates compared to traditional savings accounts, while borrowers can access capital without the need for collateral or a credit score.

However, there are also risks involved in DeFi lending and borrowing. One of the main risks is smart contract risk, which arises from the possibility of bugs or vulnerabilities in the code that can be exploited by attackers.

The volatility of cryptocurrencies can make it difficult for borrowers to repay their loans, which can lead to default and loss of funds for the lenders.

DeFi lending and borrowing provide several opportunities for both lenders and borrowers, but also come with risks that need to be carefully evaluated. It is important to do thorough research and understand the risks involved before engaging in DeFi lending and borrowing activities.*

Staking and yield farming

Staking is the process of holding and locking up a certain amount of cryptocurrency to support the operations of a blockchain network.

In return for holding and protecting the network, stakers are rewarded with more cryptocurrency. Essentially, staking allows individuals to earn passive income through their investment in a blockchain network.

On the other hand, yield farming is the practice of using different DeFi protocols to earn rewards on cryptocurrency holdings.

Yield farming involves lending or providing liquidity to DeFi protocols in exchange for a share of the protocol's fees or rewards. This process incentivises individuals to participate in DeFi and helps to support the operations of the network.

Both staking and yield farming are popular ways to earn passive income in the cryptocurrency world.

BUT it is important to understand the risks associated with these practices and to do your own research before investing in any cryptocurrency. It is also crucial to choose a reputable platform or protocol to participate in staking or yield farming.*

Protection and regulatory concerns in the DeFi space

As these applications are frequently created using open-source code that is susceptible to hacking and other protection breaches, protection is a major concern in the DeFi space. DeFi protocols also frequently use smart contracts, which can be exploited if the code is flawed or the audit is not done properly.

DeFi protocol users and investors should carefully evaluate the protection measures in place before making an investment or conducting business using these protocols.

Because these protocols frequently operate outside of the conventional financial system and regulatory frameworks, regulatory concerns in the DeFi space have also been brought up.

Governments and financial regulatory organisations are debating how to control this new financial structure, especially with regard to problems like fraud and money laundering.

The Future of DeFi: Trends and Predictions

More people and institutions are realising the advantages of decentralised finance. It might eventually be used in traditional finance. Different DeFi protocols may be interoperable in the future. And, DeFi systems may incorporate artificial intelligence to increase efficiency and protection.

Decentralised finance has enormous potential.

Conclusion: Is DeFi right for you?

Decentralised Finance (DeFi) is an alternative financial ecosystem built on blockchain networks that operate without intermediaries such as banks or other financial institutions. DeFi offers accessibility, transparency, and possible levels of protection, and its system operates on a decentralised and trustless basis.

However, DeFi has some disadvantages, such as the lack of regulation, which increases the risk of fraud and scams, and the potential protection issues. Users must be cautious when investing in DeFi projects and conduct thorough research before making any investment.*

Glossary

Blockchain: A digital ledger that stores transactions in a protected, decentralised, and immutable manner. It is maintained by a network of computers that work together to validate and record new transactions.

Cryptocurrency: A digital or virtual currency that uses cryptography to protect and verify transactions and to control the creation of new units. Cryptocurrencies operate independently of a central bank and can be transferred directly between individuals.

Decentralised: A system or network that operates without a central authority or control. In a decentralised system, decision-making is distributed among its participants rather than being concentrated in a single entity.

Decentralised exchanges: Platforms that allow users to trade cryptocurrencies without the need for a central authority or intermediary. They operate using smart contracts and (when the smart contracts are coded correctly) are considered more protected and transparent than centralised exchanges.

Ethereum: A decentralised blockchain platform that enables the creation and execution of smart contracts and decentralised applications (dApps). It has its own cryptocurrency, called Ether (ETH), which is used to pay for transactions and services on the Ethereum network.

IPFS and Arweave: IPFS (InterPlanetary File System) and Arweave are decentralised storage networks that allow users to store and retrieve data in a protected and distributed manner. They use a peer-to-peer network of computers to store data and ensure that it is accessible and available.

Ledger: A record of transactions or other data that is maintained and updated by a network of computers. In a blockchain context, a ledger refers to a digital ledger that records and verifies transactions.

Staking: The act of holding and locking up a cryptocurrency to support the operations of a blockchain network. Staking allows users to earn rewards in the form of additional cryptocurrency or other benefits.

Yield farming: A process in which cryptocurrency holders provide liquidity to decentralised exchanges or other platforms in exchange for rewards or incentives. Yield farming allows users to earn interest on their holdings or to participate in governance decisions on the platform.