DeFi: A game-changer in finance
DeFi: short for ‘decentralised finance’. It’s basically using cryptocurrency and/or blockchain for (existing) financial applications.
What is DeFi?
In the big picture, DeFi removes the middleman from financial transactions.
To understand why that matters, we have to return to the idea of blockchain technology. The essence of blockchain is that entities can hold a copy of a history of transactions. This means a central, single source isn’t in control as gatekeepers. Hence, it reduces the speed and sophistication of transactions while keeping users in control of their money.
By using blockchain to support smart contracts, you can write programs that interact with money. That leads to a host of financial services and products such as loans, savings, exchange or trading.
This is possible because of smart contracts (Ethereum is particularly well-known for this). Smart contracts (or decentralised applications, DApps) automatically execute transactions depending on certain conditions. They act as the ‘middleman’ in this case. Smart contracts can be complex and are irreversible.
For example, you make a bet with someone that the temperature next Saturday will drop to 0°C according to an official weather website. You could input the rule into a smart contract and automatically transact money depending on the outcome.
Moreover, Ethereum’s upcoming 2.0 upgrade could increase the scalability of these apps.
Does DeFi benefit us?
Ultimately, DeFi aims to create a financial system that is open to everyone and gives users better control over their finances. It has exploded over the past year with lots of profits reported. Here’s how you can gain from it too:
- Earn competitive interest rates
Do you believe in investing and making money grow? Then you certainly can’t ignore the high interest rates that DeFi contracts have to offer. Lending platforms allow users to gain passive income by lending money and generating interest from loans. - Open to everyone
When you want to get a loan from a bank, there are a few hoops to jump through — background, identity and bank account checks. With DeFi, all users have direct access to services and products. They can compare them and choose the best suitable one. They won’t even need a bank account. - Automated transactions
The smart contracts ensure that orders are executed automatically. This makes it a smooth experience for users.
So, what’s the catch?
One shouldn’t expect such huge returns without potential high risks. Still, people believe that DeFi is the future of finance with the potential for massive gains. Here are a few things to consider about DeFi before getting into it.
- Users are not fully protected
In February 2020, two hackers stole almost 1 million USD from a margin trading application in a flash loan attack. That showed just how vulnerable the DeFi ecosystem could be. As it was with ICO in 2017, DeFi is also currently in a hype phase with lack of investor protection. Irregularities are likely to happen at some point. - DeFi bugs
Smart contracts are great but also irreversible. They can’t be changed once you’ve input rules into the protocol. This means bugs are permanent and could increase risk. - Lack of maturity of the ecosystem and technical environment
DeFi smart contracts and protocols are relatively new and not fully ready for an ‘industrial strength’ usage. That makes it hard to assess products. Moreover, large differences exist in interest rates for somewhat similar services in different protocols.
What are some popular DeFi applications?
There are several popular DeFi applications out there. Many of these offer different gains and levels of risks. It is therefore important to consider what you would like to achieve and the actions you’re willing to take.
Borrowing and lending platforms
As the name suggests, you can deposit money and earn interest when other users borrow your assets. Assets are digital in this case, and smart contracts connect lenders to borrowers. Smart contracts ensure the terms of the loan are observed and distribute the calculated interest accordingly. All this is done without the middleman. Hence, users stand to earn high returns and better understand risks due to blockchain’s transparency. The exchanges are collateralised, meaning users need to have a certain amount of ether (ETH) before taking a loan. A popular platform is Compound, which adjusts interest rates using an algorithm that pushes interest rates higher if there’s more demand.
Decentralised exchanges (DEXs)
This is an online exchange where users can exchange currencies (like USD for bitcoin) via smart contracts and without third parties involved. The smart contracts enforce trading rules, execute trades and securely handle funds. This process doesn’t require sign-ups, identity checks or withdrawal fees.
Stablecoins
A cryptocurrency is tied to an asset outside such as fiat currency like USD or Euros in order to stabilise the price. For example, DAI is a stablecoin pegged to USD and backed by ETH as collateral.
Prediction markets
Users can bet on certain outcomes of future events such as scores and election results, all without intermediaries.
‘Wrapped’ bitcoins (WBTC)
People can send bitcoin to the Ethereum network to be used directly in Ethereum’s DeFi system. They can earn interest on bitcoin that they loan out on lending platforms.
DeFi as smart money Legos
With Legos, you build something new by piecing together smaller bricks. The idea is true to smart contracts — after starting a project, product or service on Ethereum, you can add other ‘money Legos’ to it. Hence, by piecing together various DeFi protocols, you can create powerful financial tools unique to you.
Innovating the financial industry
DeFi has been a huge topic in the crypto community. Yet, it has not received much attention from the financial industry. However, we have seen how the crypto industry has driven innovation in the traditional financial industry. This includes the development of cryptocurrencies towards being an asset class and token classifications triggered by ICOs in 2017 and 2018.
All this suggests that DeFi could trigger even more innovations. This could include making cryptocurrencies an even stronger asset class. Another possibility is the adaptation of DeFi into the traditional financial industry in a modified, regulatory way.
Here to stay
If you believe in a future with digital money, you certainly have to explore what DeFi is all about. For starters, you can check out DeFi Pulse for a list of DeFi protocols and interest rates. Keep in mind that more and more DeFi applications will continue to come up, so keep a lookout.
Cashing in on trading strategies
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You will also have the option to publish and share your trading strategies. The DeFi features will allow:
- users to create smart contracts to trade assets according to a given strategy.
- other Ethereum blockchain users to invest in a strategy, borrow assets and gain from the profits of the strategy’s author.
- Ethereum blockchain users to provide assets at a set interest rate.
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