Decentralized finance, or as popularly known as DeFi is a novel financial system that has managed to capture the imagination of many. It is basically an umbrella term to identify a host of financial applications in the cryptocurrency or blockchain industry that are focused on revolutionizing archaic financial intermediaries.
Let’s dive in.
What is DeFi?
One of the hottest conversations in the space, DeFi refers to financial services that leverage smart contracts which enables a trustless environment. These types of contracts are automated enforceable agreements and don’t need trusting a third party like a bank or lawyer, credit unions, or insurance money, thus eliminating slow and costly intermediaries.
Instead, decentralized finance relies on online blockchain technology.
This technology enables DeFi users to invest, transfer, transact, as well as trade peer to peer using different digital assets. These are done through automated smart contracts.
In short, smart contract blockchains provide a decentralized solution for every financial activity in the world, be it savings, loans, trading, insurance, etc.
Is DeFi safe?
Decentralized finance [DeFi] aims to disrupt the traditional financial infrastructure by transforming it into not just a transparent but also an equitable system. But, DeFi also comes with its own baggage of cons. Investing in this space is very risky. So DYOR!
This space has witnessed massive cases of FOMO and FUD filling in the market which has caused several huge gains. Hence, it is important to identify good projects from the bad. But given the chaos of the market, this poses a massive problem, especially for novice investors.
One of the biggest issues that concern the space is DeFi bugs. Since smart contracts are powerful, they become immutable once they are deployed into a protocol. As a result, this transforms the bugs attached [if any] to become unchangeable baked in the protocol with amplified risks. Hence, it is important for the investors to be careful about the smart contracts they are interacting with.
Despite the fact that the space initial vision is to give people back their financial freedom, snapping back to centralization as well as collateral risks do not fade away.
The DeFi space has witnessed several major exploits and hacks over the last several years. More recently, another kind of scams called, “rug pulls” have increased at an alarming rate in which malicious entities fake places fake token swaps or invalid representations of tokens on the decentralized exchanges or DEXs, and unstake their entire liquidity.
What is DeFi For: Financial transaction without a financial intermediary?
DeFi comprises an ecosystem of applications that are built on top of public blockchains that enable the development of permissionless financial services. Over the past few years, it has unlocked many opportunities across various verticals. Let’s look at some of the specific use cases of the decentralized realm.
Decentralized Exchange [DEX]
Moving towards a trustless economy has bolstered the development of decentralized exchanges or DEXs.
The objective of the genesis of Bitcoin and the wider crypto industry was, in general, anti centralization. However, over the course of time, it was centralized exchanges, such as Binance, Coinbase, and Kraken, that took the center stage and defeated the sole purpose.
Enter DEXs. As the name suggests, these crypto exchanges are decentralized in nature. There are no third-party entities to monitor the security and transfer of assets, unlike its centralized counterparts. These intermediaries are instead replaced by a blockchain or distributed ledger technology [DLT]. Some of the most popular DEXs are Uniswap, PancakeSwap, 1inch Exchange, among others.
Borrowing and Lending
Borrowing and Lending in DeFi protocols enable the users to become lenders or borrowers. A user has complete control over their funds at all times, unlike centralized infrastructures which take custody of users’ deposited assets and loan them out to entities such as market makers, hedge funds, etc. It is the smart contracts again that operate on blockchain systems facilitating the process of borrowing and lending in a decentralized fashion.
DeFi yield farming first gained traction in mid-2020. Yield farming is essentially a mechanism to spawn rewards by locking up cryptocurrencies. Also referred to as liquidity mining, the main objective of yield farming is to maximize a rate of return on capital by utilizing different DeFi protocols.
For instance, an investor, or in this case, a yield farmer needs to search for a profitable strategy to make the highest yield. This can be done by leveraging the less number of DeFi protocols, in general, because it is considered most profitable.
If one strategy stops being feasible, the farmer may transfer their fund between different decentralized finance protocols or even swap tokens to those that can stir up more yield.
Yet another important use-case of DeFi protocols is in the Gaming industry. Built-in economies and creative incentive models have managed to capture this burgeoning space. DeFi is a massive tool in this industry that has the potential to facilitate transaction services in a decentralized manner, and offer reliable payment networks.
Thanks to blockchain technology, it can also enable gamers to verify the genuineness and rarity of their virtual items by bringing transparency into the picture. It can also offer the developer more reasonable earnings from their intellectual products.
Weaving into the DeFi space is the Stablecoin market. A Stablecoin is pegged to a stable asset or basket of assets, like fiat, gold. This cohort of cryptocurrencies has now found implementation across the decentralized finance space for purposes such as remittance payments, and central bank digital currency (CBDC).
They have also become immensely popular thanks to the liquidity providers, traders, as well as various lending and borrowing platforms.
Prediction markets are essentially collections of market participants speculating on the outcome of an event. Blockchain-based prediction markets are exchange-traded markets that are built to trade the outcome of events.
The prices in the market can suggest what the crowd thinks the probability of the event is. It is by using this “wisdom of the crowd” that helps users to vote and trade value on the same.
One of the most popular examples of prediction markets is Augur.
Benefits of Decentralized Finance
DeFi strives to create efficient as well convenient systems by bringing in the pros of blockchain technology to the financial sector. Here are some of the benefits:
Owing to the usage of blockchain and smart contracts, DeFi offers transparency. Meaning that the information about all the undertakings is safely stored on a blockchain and is shared by everyone on the network. Since the data is publicly available, it adds to more transparency.
Elimination of Human Error
Usage of smart contracts in decentralized finance systems effortlessly eliminates human error on a day-to-day basis. This, in turn, does not trigger mismanagement at any level of the entire process. Hence, the underlying technology greatly depends on the kind of smart contracts written.
Blockchain technology makes use of cryptography and consensus algorithms such as Proof-of-Work, Proof-of-Stake, etc. This is what keeps a check from records and data being manipulated on the blockchain network. It is with this immutability nature, changes and alterations in DeFi is practically impossible.
Unlike legacy structures, DeFi enables the execution of several financial operations with just one click, at any time of the day from anywhere in the world. All that the user needs is an internet connection.
DeFi consists of thousands of projects on several different blockchains that are amplifying and evolving simultaneously. The space has grown manifolds in a span of very short duration. The creation of a highly flexible financial system without a central oversight has changed the way financial pillars work.
Decentralized finance [DeFi] is a global experiment that is set to transform the world of finance. Even as the space is still very much in its infancy, the ‘open banking’ movement has been embraced by novice and experts alike. It has seen stellar growth over the past couple of months.
Hence, it can be safely concluded that DeFi has the potential to contribute to groundbreaking success with respect to the financial realm and provide opportunities in terms of financial freedom and the greater good.
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