DeFi is short for decentralised finance. Along with NFTs, DeFi is one of the hottest crypto sub-industries to get mainstream attention over the last year. It has been mentioned from the likes of Mark Cuban, Elon Musk and other influential A-listers. Let’s take some time today to talk about why.
This article will explain what DeFi is, what it’s used for and why it’s important.
What is Decentralised Finance?
When something is decentralised, it means that it is being controlled by several people or authorities rather than one main entity. Finance is just a broad term that includes any activity regarding money, whether it be transferring, lending or investing – it all falls under the finance umbrella. Therefore, decentralised finance is any activity that involves money operating on a platform that is backed by multiple servers rather than just one.
DeFi protocols are becoming more popular to eliminate flaws and corruption that have been found over the years using CeFi (centralised finance). There are a number of different types of finance which are currently centralised, however, there are opportunities for these systems to make the transition to being decentralised. The section lists of these different types of finances.
What are some Current Types of DeFi Projects?
DeFi is trying to recreate a whole new financial ecosystem in a permissionless and open way. Here are the main parts of the ecosystem it is trying to recreate:
- Transferring Money
- Lending and borrowing
- Margin trading
How Can Money Be Decentralised?
One of the best examples of a decentralised system that is used today is Bitcoin. Bitcoin is a decentralised currency. It was created about 12 years ago by a person, or group of people using the pseudonym, Satoshi Nakamoto, who built the system on a blockchain. A blockchain is a digital ledger that records transactions and distributes them across multiple computers that are connected to it.
Any Bitcoin transactions, big or small, are on this ledger and will be there forever. This makes the system nearly impossible to change or hack because there are so many different servers running it. This also makes blockchain technology considered decentralised. In fact, blockchain technology completely revolutionised decentralisation. Since the Bitcoin blockchain, there have been hundreds of other public and private blockchains created for different purposes.
People often compare the early stages of the internet to the early stages of blockchain technology.
How Does One Build a DeFi System?
The Bitcoin blockchain is only one example of a decentralised infrastructure, however, it is very difficult and uncommon to build other applications on it. The Ethereum blockchain, however, is an open DIY platform that anyone can build decentralised programs or decentralised applications known as dApps on.
Almost all of the DeFi projects out there are built on the Ethereum blockchain. Programmers use the Ethereum blockchain to create automated code or smart contracts on this platform to set up decentralised financial systems.
What are Smart Contracts?
When programmers create smart contracts, they are creating detailed instructions for what they want their product to do. These deFi protocols and autonomous programs are constant and consistent leaving very little room for error.
For example, if the smart contract says, “only pay out a dividend once a profit of $1000 USD is reached” that will happen every time. Although there is no middle man in DeFi, the smart contract is really the master. Once this code is written, it can then run by itself and is impossible to change unless it specifies that it can be changed. If it does get changed it will be shown on the Ethereum blockchain on multiple servers, meaning it is impossible to hide a change if one does occur.
What is a DeFi Lending and Borrowing Platform?
One of the first DeFi projects that was created and is still running today is called Maker DAO. It essentially started the DeFi lending and borrowing movement, a huge part of the financial ecosystem. Another DeFi lending and borrowing project is Compound, which is “an algorithmic, autonomous interest rates protocol built for developers to unlock a universe of open financial applications.” There is also Aave which is “an open source and non-custodial liquidity protocol for earning interest on deposits and borrowing assets.”
What is DeFi Crypto?
Some examples of DeFi crypto are Uniswap, ChainLink and Terra. DeFi crypto or DeFi tokens are intended to recreate traditional financial services such as earn interest or take out a loan. The only difference is instead of using a bank or institution, DeFi crypto allows these actions to happen based on their computer code or smart contract.
What are DeFi Exchanges and their Benefits?
Popular DeFi exchanges also known as DEX’s in 2021 are Uniswap, Kyber, and 0x. The more recognisable exchanges such as Binance, Coinbase and Swyftx are centralised. Centralised exchanges are very popular as they are easy to use and users can buy crypto with fiat currency. Below we’ve listed the pros and cons of decentralised exchanges (DEX’s):
Pros of a decentralised exchange are:
- Faster Trading: peer to peer
- Globally Accepted
Cons for a decentralised exchange:
- Low Liquidity
- Hard to use interface
- No capital for insurance
Is DeFi Safe?
DeFi relies on smart contracts for its functions which makes them safe as users are aware of what they are signing up for. However there are still some risks with this system. Many users do not take the time to read the smart contracts as they are often very long and technical. Secondly, there could be some bugs and protocol changes that affect the existing contracts. Users must also consider if the project is as decentralised as they say they are. Someone could potentially have the admin key to shut it down at some point.
Anything new will always have its flaws and call for some hesitancy. DeFi is still in its early stages yet most of the companies are reputable and have been running for a few years now. They have also improved dramatically since they have been established which is something to consider as well. With even more time these codes and smart contracts will only improve to leave less room for error.
The Future of DeFi
At this stage, it’s likely that the popularity and uses for DeFi will continue to grow. More and more businesses and individuals will adopt DeFi technology in the years to come as it has shown that it can be faster, safer, and smarter than traditional financial instruments and infrastructure.