Everything you need to know about decentralized finance (DeFi) — Part 1

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sunflowercorporation

4 min readApr 25, 2022

Allow any Internet user to issue loans, open deposits, and trade on the stock exchange without intermediaries. Here is a text about DeFi, an independent ecosystem made up of blockchain-based financial instruments.

What is decentralized finance (DeFi)?

Decentralized finance (DeFi) is a publicly available and trastless ecosystem of financial applications and services. It is based on public blockchains (primarily Ethereum).

In other words, DeFi makes finance available to anyone and without intermediaries in the form of banks, courts, or brokers.

The DeFi ecosystem covers all details of financial services, including lending, borrowing, and trading within decentralized structures. Any Internet user can interact with the ecosystem and manage assets through peer-to-peer (P2P) and decentralized applications (dApps).

Why do we need the DeFi ecosystem?

We know that bitcoin is a peer-to-peer electronic money system. DeFi is a broader concept. It is a peer-to-peer system of electronic financial instruments. It can provide anyone with all the same traditional financial services, but it’s free of intermediaries and makes an entry barriers lower.

DeFi applications and services are potentially useful for residents of countries with underdeveloped or unstable economies. DeFi services are also in demand in developed countries, especially in the areas of credit, investment, and the development of new revenue models.

What are the key features and benefits of DeFi?

Decentralization and self-government

DeFi has no centralized management. The rules for business operations are written in a smart contract. Once the smart contract is up and running, the DeFi application can operate on its own. A traditional system has people, policies, and legislation. DeFi has minimal or no human intervention.

Due to decentralization, control over the ecosystem is evenly distributed among multiple players. There is no excessive regulation, transactions are transparent, fast in execution, and there is no long chain of intermediaries.

Transparency

The source code of DeFi applications is open to audit, permitting any user to understand the functionality of the contract or find bugs. All transaction activity is public. Transactions are pseudo-anonymous by default.

Cross-border

Almost all DeFi applications are available to any Internet user without intermediaries.

Services that use open-source protocols are more trustworthy. As with blockchain itself, the user can test them, refine them, and use them in other services.

Inclusion

Anyone can create an app and use it. There is no need to wait for permission from a bank or other financial system regulator.

Unlike the traditional financial sector, there are no supervisory authorities. You don’t have to fill out complicated forms to create an account. With wallets, users interact directly with smart contracts.

User Experience Flexibility

The DeFi ecosystem provides a flexible user experience. First and foremost, via competition.

Let’s say the user downloaded an app and doesn’t like its interface. Well, then that client can apply a third-party interface or even create its own. Smart contracts are like an open API. Anyone can create applications.

Interoperability

As we have written, DeFi systems are completely transparent, so it is easier for them to interact with other products or systems.

Users can create new DeFi applications by combining existing DeFi products: stablecoins, decentralized exchanges, prediction markets, etc. This DeFi feature makes it possible to obtain new structures from various combinations.

What are the disadvantages and risks of DeFi?

Systemic risks

These are liquidity risks, credit risks, and volatility risks. If the price of underlying assets blocked in CDP drops rapidly, there is a massive liquidation of assets, and the system can collapse.

To mitigate these risks, DeFi protocols are currently trying to provide credit with excess assets, which has a downward impact on the price of these assets.

Any hype plays both to help and against the market. An overheated market may burst, sooner or later. Some experts point out that the situation is very similar to the ICO bubble of 2017. On the other hand, if we follow the well-known Gartner chart, the bubble will be followed by a fall, followed by a smooth growth and real application of technology.

The risk of hacking

Although working with smart contracts in DeFi eliminates the need to trust a human, there remains a need to trust the smart contract code, which is written by a human.

Centralizing the flow of data

Blockchain protocols obtain data about the outside world through oracles. If the oracle acts “maliciously,” the correct execution of the smart contract is at risk. Centralized data oracles are a vulnerability for DeFi.

DeFi has no specific organization that is responsible for what happens in the ecosystem. All actors have an interest in its prosperity and will therefore make decisions based on their economic benefit.

Nevertheless, decentralized alternatives have already been developed. We’ll be watching.

The lack of capital in DeFi loans

Despite their merits, DeFi loans are inferior to loans in the TradFi sector. The amounts that can be obtained against the corresponding collateral are relatively small.