Decentralised Finance Explained

Introduction

You’ve probably heard of Bitcoin. Bitcoin is a form of currency that is not under the control of any government or central bank. It can be transferred around the world without the need for a bank or financial institution. Bitcoin is what we would call “decentralised” money.

Now let’s imagine a world where you can make trades, deposit money into a savings account, or buy insurance all without going through an intermediary like a bank. This is the promise of DeFi.

The crypto winter of 2022 has exposed many cracks in the DeFi space; projects have failed, investors have lost money, and systems have been exposed to massive cyberattacks.

Can DeFi rival the mainstream financial institutions that we all know today?

What is DeFi?

DeFi is an umbrella term for a range of financial products developed around the blockchain that have no central authority. By using decentralised money, like cryptocurrencies, developers can build exchanges, lending platforms, and insurance companies that have programmed rules built into them. The DeFi market is estimated to be worth $60 billion.

At its simplest, decentralised finance is an open financial sector that runs on software built on top of a public blockchain.

With traditional finance, money is stored and managed by centralised institutions like banks. These firms make money by lending out your money and charging interest on top of the loans. They also collect various fees and commissions for providing additional financial services. The modern financial system is riddled with third party providers (intermediaries) who take a cut from daily transactions.

Today, the financial system is completely centralised, i.e., controlled by an entity. The risks associated with a centralised financial system can include mismanagement, fraud, and corruption.

4 Advantages of DeFi vs Traditional Finance

• People hold their money in secure digital wallets instead of keeping it in banks.
• DeFi eliminates the fees levied by banks and other financial institutions in exchange for their services.
• DeFi is permission-less; anyone with internet access can use it without securing approval from a central authority.
• Funds can be transferred in a matter of seconds.

How does DeFi work?

Decentralised Infrastructure

In the land of DeFi, new infrastructure is built that takes out these banks and institutions. This means that anyone with a computer can create the necessary software to launch a decentralised financial system on a blockchain, meaning that the barriers to entry are much lower.

The most common blockchain used is the Ethereum blockchain, which lets developers create automated code (smart contracts) that can manage any financial service, non-fungible tokens (NFTs) or decentralised autonomous organisations (DAOs).

In all these cases, a certain number of rules can be established as to how a service will work; these rules are coded into a smart contract, and once they are deployed on the Ethereum network, they are executed automatically once the conditions are fulfilled. Once deployed, the smart contract is set in stone.

Smart contracts are also used to build decentralised apps or DApps. While they are similar to normal apps in terms of function, the main difference with DApps is that they run on a peer-to-peer network (like the blockchain).

Decentralised Money (DAI)

Now that the infrastructure is in place, the next step is currency, which would take the form of a cryptocurrency. The volatile nature of Ethereum and Bitcoin makes these unsuitable choices; instead, a new type of cryptocurrency has been created called “stablecoins”. Stablecoins are cryptocurrencies that are pegged to the value of a real world asset, for example, the US Dollar or the Euro.

DAI is a decentralised cryptocurrency based on the Ethereum network. It is a stablecoin, which means that it is pegged to the U.S. dollar, resulting in lower price volatility compared to other blockchain-based currencies. Although not the biggest stablecoin, DAI, through its autonomous governing body, MakerDAO claims to be a truly decentralised stablecoin.

Decentralised Financial Services — Exchanges (DEX)

A decentralised exchange (DEX) is a peer-to-peer marketplace where transactions occur directly between cryptocurrency traders. Decentralised exchanges operate according to a set of rules (smart contracts) that allow users to buy, sell, and trade cryptocurrencies. They also reside on the Ethereum platform. Connecting to a DEX does not involve any sign-up, identity verification, or withdrawal fees. There is no need to deposit funds into an exchange account before conducting a trade. Popular DEXs are Uniswap and Sushiswap.

Decentralised Financial Services — Lending

One of the most popular applications of DeFi is lending, where decentralised money markets will connect borrowers with lenders. You can basically lend your crypto out and earn interest on it, or you can borrow funds by putting your tokens up as collateral. Rates applied on these decentralised lending platforms are adjusted by an algorithm based on how much demand there is for the loans.

Decentralised Financial Services — Insurance

Insurance is a pooling of risk. When a potential event presents the risk of being financially punishing, individuals seek insurance to cover the risk. Insurance companies enable individuals to pool that risk by having each one pay premiums.

In a decentralised world, a Dapp platform connects people who are willing to pay for insurance with people who are willing to insure them for a premium. This happens autonomously. There are two main branches to consider in the fast-growing field of DeFi insurance. The first is blockchain-based insurance, which is used to replace traditional insurance policies. The second is blockchain-based insurance that mitigates the risks associated with DeFi activity. Two examples of decentralised insurance protocols are Etherisc and InsurAce.

Key Risks Everyone Must Understand

DeFi is still in its infancy, and things can go wrong. Smart contracts have had issues in the past when people didn’t define the terms correctly. Hackers have found creative ways to exploit existing loopholes in order to steal money. Additionally, since consumer protection laws don’t apply to DeFi protocols, they are riskier than goods from regulated institutions. According to a report by Elliptic, overall losses caused by DeFi scams and thefts amounted to $12 billion in 2021.

1. Smart Contract Vulnerabilities: DeFi platforms rely heavily on smart contracts, which are subject to coding errors or vulnerabilities. Exploiting these vulnerabilities can lead to hacks or the loss of funds. It is crucial for developers to conduct thorough audits and security checks to mitigate such risks.
2. Price Volatility and Market Risks: DeFi platforms often involve volatile cryptocurrencies and tokens. Sudden price fluctuations can result in significant financial losses for participants, especially if they are exposed to highly leveraged positions or risky assets. Investors should exercise caution and conduct proper risk assessments.
3. Regulatory Uncertainty: DeFi operates in a relatively unregulated space. However, regulatory frameworks are continuously evolving, and increased scrutiny from authorities can introduce uncertainties and potential compliance challenges for DeFi projects. Participants should stay informed about relevant regulations and their potential impact on DeFi activities.
4. Liquidity Risks: DeFi platforms rely on liquidity pools for various functions, such as trading and lending. Insufficient liquidity or sudden liquidity shortages can impact users’ ability to execute transactions or withdraw funds. Users should assess the liquidity conditions of a DeFi platform before engaging in significant transactions.
5. Governance and Centralization Risks: While DeFi aims to be decentralised, certain platforms may exhibit centralization tendencies due to concentrated voting power or control held by a few entities or individuals. This can lead to governance risks, where decision-making power may not be truly distributed among participants, potentially impacting the platform’s direction and security.

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