The Complete Idiot’s Guide to Understanding Defi
We all were once idiots.
Unarguably one of the fastest-growing sectors of the blockchain and crypto space. Decentralized Finance might well be on track to displacing the traditional financial system.
An open finance movement that is making financial services more accessible while keeping banking processes transparent.
Defi did burst into the limelight during the summer of 2020 taking the crypto world by storm.
The Defi summer was explosive such that by May 2021 the total value locked across defi protocols had increased ×88 reaching $88billion at its peak. A figure that only just reached the $1billion mark in May 2020.
As of the time of writing this; Defi’s market cap has risen to mouth-watering $157 billion; almost 7% of the global crypto market capitalization.
Table of content
The flaws of traditional finance; what Defi brings to the table
What is Defi?
Defi refers to the ecosystem of financial services being built on distributed networks (blockchains) with no central intermediaries.
A movement encouraging alternatives to traditional, centralized forms of financial services — Coinmarketcap — Alexandria blog.
Decentralization and transparency are at the core of Defi.
Think of it as having today’s banking system decentralized but this time with more features and even incentives.
For example; Uniswap; a leading Defi protocol airdropped her governance token $uni to early adopters of the protocol at the peak of the Defi summer — September 16 specifically.
It was their way of saying thank you to early adopters who had trusted and interacted with the platform and smart contracts while handing the governance of the protocol to them as a community. For some, the airdrop was worth as much as 5 figures in dollars.
A perfect illustration of the popular saying that “crypto rewards early adopters” with Defi proving time and time again to be at the forefront of the rewarding process.
The Flaws of Traditional Finance; What Defi Brings to the Table
The banking system of today does have its flaws. It reached its climax during the global financial crisis of 2008 which further emphasized the need for a better financial system.
Then came bitcoin in 2009; the first widespread use of blockchain’s decentralized technology.
Ethereum blockchain would come on much later in 2015. Being open-sourced allows anyone who could write codes programme self-executing smart contracts and applications [dapps] on the ethereum network. A feature bitcoin lacked.
Other alternative blockchains like Binance smart chain, Solana and avalanche would also come up in a bid to solve ethereum’s high gas fees problems. However, the Ethereum blockchain remains at the core front of Defi, hosting a large majority of the Defi ecosystem.
With the decentralized nature of these blockchains, smart contracts and the internet; Defi looks to build a better financial ecosystem in three major ways
- Permissionless: anyone with internet access and a smartphone could easily access Defi applications. Removes the pain banks impose with endless verifications and even restrictions such as a maximum account balance.
- Transparency: Defi protocols and transactions being open-sourced and public for anyone to see. Further reducing laundering risks as everyone would inspect and detect such foul play. Also, most Defi protocols are decentralizing ownership giving it back to their community with DAOs — Decentralized Autonomous Organizations. DAOs have governance tokens with community members who hold a certain amount of these mostly airdropped tokens being able to decide the future of these protocols. Removing the risk of monopoly where the few executive board members of banks could make profit-oriented decisions to the demerit of the mass.
- Removal of Middlemen: I find this feature fascinating. In Defi, there is no bank acting as a middleman between you and your money. Take a clue from the millions of Afghanistans whom the traditional banking system failed during the Taliban takeover earlier this year. ATMs were empty and most were left stranded as reality dawned that their hard-earned money was theirs and wasn’t theirs at the same time. Thankfully bitcoin and crypto generally had come to the rescue of many.
Use Cases of Defi
Defi offers use cases ranging from borrowing and lending to stablecoins, exchanges, derivatives and even services such as (fund management, lottery, payments and insurances). For this post, we’ll be looking at the most popular three.
1. Borrowing and Lending: with digital assets (NFTs) as collateral, in just a click, individuals could easily lend money from decentralized protocols without having to go through the never-ending cycle of visits it takes to get bank loans.
More interestingly with liquidity pools, anyone on the Internet could decide to lend to these protocols while getting credited with (liquidity pool) LP tokens.
A concept traditional system had previously reserved for the rich. Market-leading protocols for lending and borrowing are Aave and compound finance.
2. Stable coins: in the high volatility world of cryptocurrency where assets could be down as much as 50% in hours; stable coins such as USDT, BUSD, DAI, USDC offer sanity with a constant value pegged to 1$.
While the popular ones are backed by centralized exchanges such as Binance for the busd. Decentralized back ones such as DAI — backed by Maker DAO have proven to be more secure. Innovations have been paced as even more decentralized stable coins called Algorithmic stable coins have emerged.
3. Exchanges: probably you’re familiar with centralized exchanges(CEXs) such as binance and coinbase.
These exchanges are centralized such that the companies still act as middlemen between you and your funds taking custody of your seed phrase and handing you a custodial wallet. You need just your username and password to login.
In 2019 alone, 12 of these exchanges were hacked with not all being able to reimburse customers. With decentralized exchanges (DEXs) the game changes as you now have custody of your seed phrases with non-custodial wallets such as Metamask and trust wallet.
Fortunately or rather unfortunately you then stand the risk of losing your funds should you lose your keyphrase. Unlike with CEXs where you could request a password reset from your Gmail account.
Uniswap is a very popular example of a decentralized exchange. A Liquidity- pool based DEX that allows anyone to provide liquidity to a pool or pair of assets while earning a part of the gas fees for transactions made on that pool.
A major limitation of DEXs however would be that most crypto transactions still take place on CEXs who have higher liquidity.
Another is the fact that one still has to send funds to CEXs to facilitate withdrawal to local bank accounts.
Present risks associated with Defi
Not your keys; not your crypto
The biggest risk would be the possibility of losing your seed phrases and consequently your assets. A few tips to safeguard your seed phrases would be ensuring to back it up on cloud; think goggle drive. Write on paper in as many places as possible. The key here is to store in as many places as possible; however do not store in places where just anyone could access them. Ultimately you could consider getting a hardware wallet to store your keys.
Being a new and evolving technology other risks such as impermanent loss, rug pulls and smart contracts hacks have evolved. Most of which I’ll be delving into in subsequent articles.
The key however would remain to follow best safety practices for your wallets as the benefits far outweigh the risks involved.
Is Defi 100% decentralized?
Even though Defi protocols are supposed to be immutable (unable to be changed). In many defi protocols, developers still have master keys that could shut down or disable Dapps. This is still a form of centralized control that enables the administrator addresses to intervene in powerful ways.
These backdoor keys were left majorly in case of emergency software bugs and for ease of making upgrades to the smart contracts.
While there is the risk of an attacker gaining access to an administrator’s private keys as these keys could change a lot of things on the protocol. The backdoor keys have their security benefits, it however means that you then have to trust the administrator(s) not to abuse these privileges. Also most protocols have made this privileges such that the administrator accounts are being run by their DAOs who vote on if and when an update should be made.
With rising innovations and test codes being battle-tested we would expect that in he nearest future the developers eventually drop these keys.
Defi — defining the future of finance
With a total value of over $200 billion locked across several defi protocols as of Dec. 2021, Defi’s adoption rate continues to surge. Defi promise of a decentralized world is one enviable and even the common man would want that.
One where you ascertain your money is yours truely. Although the average man also doesn’t want to be his own bank due to risk of losing your funds.
I believe Defi and crypto generally still have a long way to go to in increasing mainstream adoption beyond the mouth watering gains it currently offers.
It’s only a matter of time before Defi catches up with the traditional financial system.
What however remains uncertain is how soon. A decade maybe. Remember the internet today isn’t the same internet that shaped off in the 90s. Man would always innovate.
If you’re looking to join the Defi revolution, it might seem so wide at first. I’ve been there before. The key to winning would be getting well educated, doing your research and sticking with just the right protocol. The earlier the better.
Found this helpful? Do leave a comment on what aspect of Defi you’ll love me to dive into in my next post.
Recommended reading:
How to Defi: Beginner — coingecko
How to Defi: Advanced- coingecko
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