This article is not financial advice. Ensure to do your research before putting money in this volatile asset.
DeFi is short for Decentralized Finance. It represents financial products and services which work without the need of any central intermediary like banks.
Why do we need Decentralized Finance?
Traditional financial system needs middlemen like banks to run. The central intermediaries like banks establish trust when it comes to money matters.
They take care of your money for you. You get a small interest on your deposited amount. Banks then use such deposits to extend loans to someone else at a higher rate.
But this cut which the banks charge for the services they are providing is significant.
You get less than 1% interest on your savings deposit but for availing loans from the banks you have to pay around 10% interest.
With blockchain this need of a trusted central intermediary is solved. DeFi products and services work without the need of any central intermediaries. This comes with a set of advantages which is ultimately passed onto the end customers.
How is DeFi different from TradFi?
Both DeFi and TradFi offer similar types of services.
DeFi runs on smart contracts. After the smarts contract is deployed to the blockchain the DeFi apps can run by themselves without needing much human intervention. Though the community and core contributors remain involved in running them.
The main difference is that DeFi is open and accessible to anyone. There are no barriers to using these applications. You just need a crypto wallet to access the DeFi services.
To avail the traditional financial services such as opening an account, loan requirements, sending money, credit card, trading and Insurance, one has to go through various checks in place. Before giving you access to their services, traditional financial systems need your credit score, history and various other parameters. The central authority checks if you are eligible for the services or not. It is at the discretion of banks whether they want to give the access or not. There is no such requirements in DeFi.
Anyone can build
Anyone from anywhere can create DeFi products which can be used globally.
DeFi is disrupting many of the traditional financial services like lending borrowing, earning interest, insurance, trading. The use cases are endless.
Fast and Flexible
Increased efficiency. As they need less human involvement to keep the processes running, almost all transactions are settled fast. There is no central authority or hierarchy to delay the processes. DeFi works 24×7.
As DeFi apps are built on top of Blockchain, they are transparent. Not only the smart contracts but also the transaction history and the decisions taken are accessible.
How does DeFi work?
You will be accessing the DeFi services usually through softwares known as dapps.
There are 4 components of DeFi
- Smart contracts
Bitcoin decentralized digital money. You can send or receive bitcoin without the need for a central intermediary like a bank.
Then the Ethereum blockchain came up. It works like Bitcoin but it also facilitates creation of applications on its blockchain.
DeFi applications are built on such blockchains.
To use DeFi apps you need the native cryptocurrency of that blockchain. Suppose the DeFi app is built on the Ethereum blockchain, then you need ETH to use the DeFi app.
A crypto wallet is required to use these apps.
Smart contracts are a set of codes stored on the blockchain.
Think of a smart contract as an if-then statement. Once the condition is met, it performs the defined action. These contracts are automatically enforced without the need for any manual interventions.
They are like irreversible agreements and cannot be altered after deployment.
Defi uses smart contracts. (building blocks of DeFi)
The applications that run these smart contracts are known as Decentralised applications or Dapps. Just like mobile apps are built on top of Android or iOS, Dapps are built on the top of the blockchain. The majority of the DeFi applications today are built on top of ethereum. However many other blockchains are also coming up.
DeFi is not only for direct transactions. There are lots of other use cases as well.
Lending – Users can supply their crypto assets (ETH, BAT etc) to earn rewards.
Borrowing – Crypto assets can also act as collateral to borrow loans. Get instant loans Ex- Compound
Decentralized Exchanges – DEX facilitates the trade of cryptocurrencies directly between two individuals without the need of an intermediary. (We have written a detailed article on DEX)
Earning Interest – Savings account alternatives where you put in your crypto and earn interest. usually more than your bank account.
Insurance – Pay a premium for protection of your deposits and smart contract failures. Ex- Opyn
Margin Trading: Borrowing funds to increase position in a trade Ex- dy/dx
Difficult to start with for beginners
Setting up wallets and then accessing DeFi platforms can be overwhelming for beginners.
Bugs in smart contracts
Risks of DeFi getting hacked. Bad actors always look for exploiting vulnerabilities in the smart contracts. Unaudited codes are a major target area of hackers. Even though DeFi services are getting their code audited by security experts, this is an area of concern for them. Over $285m have been lost since 2019. (Source)
- Rug Pools: Bad actors tricking users to exchange good tokens with worthless tokens. They create legitimate looking websites and social media presence for a token with zero utility. When they get enough good tokens they remove liquidity from the exchange which locks the users with these worthless tokens
- Users tricked into sharing their seed phrase in a fake DeFi app. Seed phrase is like your master password. Whoever has the seed phrase controls the wallet.
There is endless things which can be done with DeFi. It is critical to understand DeFi properly before getting into it and do consider the risks as well.