Taking care of finances is one of the most important things for most people. Many try to find new ways to invest their money to obtain the highest possible return, while others obsess over “safe haven” assets to protect themselves from economic crises.
In this constant search for the best financial tools, an actor who is getting a lot of attention appears on stage: decentralized finance or DeFi. Everyone speaks wonders and how the platforms based on this tool are changing the rules of the game, revaluing finances and the economy in general.
However, when talking about money and finances in general, the most important thing is to avoid mixing emotions and learn to see everything from an objective perspective.
For this reason, today we are going to use this article and try to clarify all those possible doubts that many people who want to approach DeFi may have.
Our goal is to give you the knowledge you need, so that you can wisely decide whether or not DeFi is a financial or investment instrument for you. Let’s get started.
What is decentralized finance or DeFi?
Decentralized Finance can be seen as an evolution of the so-called FinTech that were born at the end of the 20th century.
What they offer is a whole series of services based on a decentralized infrastructure that allows direct user interaction with the platform, with no intermediaries.
This isn’t a new concept, but it’s now and thanks to blockchain technology and its ability to generate self-sustained and decentralized ecosystems, that it has become a reality.
Basically, these are financial applications that work on blockchain technology that reuse concepts already used with success in traditional finance, but without the intervention of any intermediary, such as a bank, for example.
Instead of a bank, it is the software running on a computer that, based on clear and preset rules, makes sure that everything works properly. In this way, a person can obtain loans, earn interests, trade assets, Forex trading and more.
So to summarize:
- DeFi is a financial ecosystem in which financial tools and services can be built in a decentralized way.
- DeFi is based on blockchain technology and is made up of digital assets, protocols, smart contracts and dApps (decentralized apps).
- All these instruments can be combined, modified and integrated to create tailor-made solutions for you.
When and where did DeFi start?
Many people in the field consider Bitcoin as the first DeFi platform in history, however, we have to go a little further back in time.
It turns out that Nick Szabo had already envisioned the idea, back in 1995, when he designed smart contracts.
The problem is that technology of that time didn’t allow the development of that idea, so it was necessary to wait until the arrival of Ethereum in 2014, to see it become a reality.
Ethereum and its smart contracts, allowed developers to create all kinds of applications on a blockchain, almost without limits.
What started back then as some curious tests, is now a movement and a financial ecosystem that moves billions of dollars each year.
But it was in the year 2017 when the boom of Bitcoin and other cryptocurrencies occurred, that DeFi really began to take more notoriety with the appearance on the scene of ICOs. Then, during 2018 and 2019, DeFi kept a constant development, but it was during the first months of 2020 when there was an spectacular growth.
The popularity it has today is such that it has made it possible to link traditional finance and cryptocurrencies.
Thanks to this, it’s now possible to enjoy opportunities with liquidity markets, loan systems and decentralized exchanges that offer a large number of possibilities for everyone.
What are the features of DeFi?
Now that you have a clearer idea about what DeFi is and where it comes from, let’s see in more detail what its main features are.
The interaction between the user and the platform is direct. There is no need for a trusted third party, as the blockchain and smart contracts play this role.
Anyone can access the DeFi platforms from any country in the world, without any limitations.
Thanks to the cryptographic techniques applied through the blockhain, this ensures the access and use of the platforms only for authorized persons.
Its basis is open source or free software, which means that platforms can be audited and tested by everyone. Furthermore, all resource mobilizations are done through the blockchain, what also ensures it’s a public record.
What are the pros and cons of DeFi?
As said before, everything has its positive and negative points. Let’s see what happens in the case of DeFi.
- It allows millions of people in the world to access financial services that would otherwise be inaccessible for them.
- The financing of companies and projects at an international level becomes more accessible and dynamic.
- It allows to expand and diversify the economy and finance thanks to the accessibility and potential of cryptocurrencies.
- Even when blockchain technology is very secure, but the level of security and auditing of smart contracts still needs to be improved.
- The protocols for action against the volatility of cryptocurrencies still need to be improved — an example of this is found in MakerDAO and DAI.
Practical applications of the DeFi ecosystem
Now, let’s see what DeFi can do today and what uses can be made of this promising ecosystem.
When a person needs a loan, he/she can give cryptocurrencies as guarantee without any problems, just as with traditional finances. The difference is that DeFi often offers more convenient interest rates and loans are often approved almost instantly thanks to the involved technology.
Decentralized exchanges (DEX), investment pools, staking systems and prediction markets are just a few examples of the possibilities of DeFi in this regard.
DeFi’s features allow it to be a trusted bridge to process payments between different blockchains thanks to its decentralized and autonomous infrastructure.
Banking and insurance services
There are DeFi protocols that allow users to make certain investments with the advantage that after a short period of time, they can recover their investment with a profit margin, thanks to the interest that was generated.
In addition, there are also systems that allow the issuance of stablecoins and financial insurance systems.
The impact of DeFi in the crypto world
Traditional and centralized finance has always been highly dependent on banks, complex and out of reach for a large percentage of the world’s population.
When FinTech appeared there was an attempt to create a financial system based on digital technology to try to overcome the flaws of the traditional financial system, but still, it was not enough.
However, it wasn’t until the arrival of Bitcoin, Ethereum and the DeFi ecosystem that it was possible to really begin to build a decentralized finance, more secure and accessible to basically everyone.
This has been a game changer in the field, but it also has definitely and positively influenced the crypto world as well. In fact, it’s one of the reasons for the current high appreciation of Bitcoin and cryptocurrencies in general.
And it happens that thanks to activities such as HODL or staking, DeFi is allowing users of the crypto world to create new economic and financial opportunities.
On top of that, the sustained increase in the number of cryptocurrency users, in addition to the potential of players like Bitcoin, have helped to improve future estimates in this sector — $1 billion in liquidity in these markets has much to say.
In addition to the above, DeFi can be the gateway for traditional investors to place their money in the ecosystem to dramatically increase liquidity in it — in fact, it is something that is already happening.
Given this, it’s easy to understand the role that DeFi now has in the crypto world, something that is not being overlooked by the experts.
DeFi as an investment tool
Many experts see in the DeFi ecosystem great potential to be used in different sectors and Forex (FX) is not far behind.
Experts see that as countries move towards creating their own stablecoins, DeFi-based FX may become a success story for those who trade in it.
Due to the growing interest of various institutional entities — case of PayPal, for example — in the cryptocurrency space, it is motivating many governments around the world to develop their own native cryptocurrencies, with China being the spearhead at this moment with its Digital Yuan.
However, many other big countries such as the United States, the United Kingdom, Germany, Japan and South Korea, are already analyzing the possible use cases and the impact that such currencies could have on their economy.
Many experts believe that within a couple of years, these native digital currencies will be a firmly established reality, which will naturally cause Forex trading through DeFi platforms to increase dramatically, which could move an already counted market with a potential of more than $10 billion of capitalization.
What are the risks of DeFi?
We previously mentioned some of the cons that DeFi has. As in everything, there is always some risk to take, even if it’s at a minimal level. Let’s look at the DeFi situation in this regard.
It requires some prior learning
At the moment, DeFi is not yet for the masses. The reason for this is that if you enter the ecosystem, you’ll see that there are a whole series of concepts and technical terminology that most people don’t understand.
This is evident in the DeFi contracts and in the content available on the application’s website, where the terminology can confuse anyone.
Certainly, DeFi offers enormous possibilities, but to participate in financial and investment instruments, it is highly recommended to understand well the functioning of that ecosystem and what you can do in it — all in order to avoid a possible loss of your money.
They still need to improve decentralization
Although DeFi-based platforms run on a blockchain like Bitcoin or Ethereum, they can still have a certain level of centralization. Many platforms will keep a certain level of control to deal with situations where immediate intervention is required.
To make it clearer: there are entities that present themselves as decentralized to the public, but behind the protocol, they have what is known as an “Emergency Shutdown”.
This function of the protocol allows to close all the operation of a platform to avoid the loss of investments within the platform. This poses a risk, since this type of functions can be used by third parties inside and outside a platform to cause damage within it.
It’s also a risk because someone who sells a product as 100% decentralized, when in reality it is not, could have obscure intentions.
The recommendation, in this case, is to research as much as possible about the project in which you want to participate, but that you also keep in contact with the community that maintains it.
An honest community won’t hide anything. Such is the case of MakerDAO and DAI, who publicly reported on “Emergency Shutdown” and the reason for its creation.
Smart Contracts and their current level of security
Although the base level of security in blockchain is excellent, there are certain elements that are vulnerable.
We have an example in several DeFi projects that have presented security flaws in relation to their smart contracts; this has meant millions in theft losses — in the case of platforms like dForce, Uniswap, Balancer, Bancor, bZx, Synthetix. The problem is that security in smart contracts depends on two factors.
First, there must be a good programming work by the developers. If there isn’t also a constant code review, this will impair early bugs detection.
On the other hand, a failure in the programming of the layer that connects the smart contracts with the blockchain, can affect the general operation of the platform.
This last factor was the cause of the attack on Parity wallets in 2017.
Scams are always present
As with the ICO boom in 2017 and 2018, where many people lost a lot of money due to the large number of scams that appeared, the same can happen with DeFi.
There are developers who, in order to jump on the boom of the moment, can follow the fast track by cloning already established systems, copying their positive aspects, but also their flaws.
This allows scams to be done more easily.
State of DeFi platforms today
We saw the first example of a DeFi platform in 2016 with the creation of Ethereum DAO. This platform allowed its participants to exchange their money for different projects through proposals, something that was only possible with the vote of the majority of the participants of said proposal.
Although DAO had certain security problems, it served as the basis for the birth of the world’s first DeFi platforms, many of which still exist, some with more success than others.
These are some of the most important DeFi applications today, which have stood out for their seriousness, commitment and active development.
This is a 100% decentralized, open-source and community-driven P2P exchange platform specially developed for Bitcoin. It runs only in client side.
RIF OS is a fairly complete service platform that includes smart contracts, digital identity, storage, instant payments, integrated payments and decentralized communications, among others.
It is a kind of protocol and tool developers can use to create their own crypto exchanges. It’s built on Ethereum and it’s also the building base of other decentralized exchanges.
It’s a protocol that offers an investment pool with options for lending, yield farming and liquidity mining. In 2020 it achieved a lot of notoriety because it has great potential for building a wide variety of financial applications.
MakerDAO and DAI (https://makerdao.com)
DAI and stablecoins are designed to facilitate the creation of financial applications built on Ethereum. MakerDAO is the protocol behind the stablecoin DAI.
It is a decentralized exchange that only works with stablecoins. This fact makes it possible for the platform to offer great prices (low slippage) when it comes to high volume transactions.
AAVE is a DeFi platform dedicated to decentralized loans. It works for Ethereum users and other important tokens of this blockchain. The platform makes it easy to lean, borrow and earn interests on crypto assets.
The DeFi market is still small compared to traditional finance, but since 2020 its growth rate has accelerated notably, with an increasing number of investments.
The best thing about DeFi is that it has shown that with blockchain, a different financial world is possible. It doesn’t matter the country where you live, with DeFi you can invest and acquire financial products that you might not have access to with traditional finance. You only need a few cryptocurrencies.
As more projects and financial dApps appear, it’s more and more possible to achieve a decentralized financial reality where your money really belongs to you and where you have the freedom to do whatever you want with it.
We can’t be sure of the future of DeFi with complete certainty, but one thing is for sure, the financial world is no longer the same and it’ll never be the same again.