What Is Decentralized Finance (DeFi)?
Decentralized finance (DeFi) is an arising monetary innovation in view of secure appropriated records like those utilized by digital currencies. The framework eliminates the control banks and establishments have on cash, monetary items, and monetary administrations.
The basics of DeFi
DeFi uses a combination of existing blockchain-related technologies — such as digital assets, wallets, smart contracts and auxiliary services including oracles — to create a financial ecosystem capable of bypassing banks, brokers, exchanges and the other middlemen who traditionally manage and process financial services.
Smart contracts, consisting of lines of code embedded in the Blockchainx, are one of the key active ingredients in the DeFi tech mix. They not only outline contract terms and conditions, but also monitor contracts and can automatically set the financial wheels in motion by executing a contract if, or when, its terms and conditions are met.
For example, smart contracts can monitor loan agreements and release collateral upon full repayment. They can also oversee agricultural drought insurance policies, automatically paying out if agreed amounts of rain fail to fall.
Common services offered by DeFi platforms include payments, loans, trades, investments, insurance and asset management. The list is growing rapidly and provides a tantalizing glimpse of a new era of crypto-based innovations, such as decentralized exchanges, synthetic assets and flash loans.
The benefits of DeFi
Here are some benefits of DeFi:
DeFi is permissionless and inclusive.
- Transactions are in real time. The underlying blockchain is updated the moment a transaction is completed, and interest rates are updated multiple times every minute.
- Transactions are transparent. Every transaction on the Ethereum blockchain, which accounts for more than 90 percent of all DeFi traffic, is broadcast to and verified by other users on the network. This level of transaction data transparency ensures any user can view network activity.
- Users can retain custody of their assets using non-custodial crypto wallets or via smart contract-based escrow.
- Smart contracts are highly programmable and can be designed to automatically execute, based on an infinite number of variables.
- DeFi data is tamper proof, secure and auditable, thanks to the use of blockchain architecture.
- Many DeFi protocols are open source. Ethereum and other projects are built with open-source code, which is available for anyone to view, audit and build on. Developers can easily connect multiple DeFi applications built on open-source technology to create new financial products and services, without having to seek permission.
The risks of DeFi
DeFi offers new and exciting financial freedoms, but these come with risks. These risks include:
- DeFi technology is immature and has yet to be fully stress-tested at scale over an extended period. Funds may be lost or put at risk. The DeFi platform Compound, for example, suffered a serious glitch recently during which customers were accidentally sent millions of dollars of crypto.
- A lack of consumer protection. DeFi has thrived in the absence of rules and regulations. But this means users often have little or no protection when things go wrong. No state-run reimbursement schemes cover DeFi and there are no laws enforcing capital reserves for DeFi service providers.
- Hackers are a threat. While hacking is also a risk in traditional finance, DeFi’s extended technological architecture, with multiple points of potential failure, increases the so-called attack surface available to sophisticated hackers. For example, “white hat” hackers exploited a smart contract vulnerability in August 2021, stealing $610 million from the DeFi platform Poly Network. Luckily all funds were returned.
- Collateral requirements are high. Nearly all DeFi lending transactions require collateral of at least 100 percent of the value of the loan, if not more. These requirements vastly restrict eligibility for many types of DeFi loans.
- Private key requirements. With DeFi and cryptocurrency, users must secure the wallets used to store cryptocurrency assets. This is an important requirement for both individual private investors and institutional investors using multi-signature wallets. Private keys, which are long, unique codes known only to the wallet’s owners are used to do this. If a private investor loses their key, for example, they lose access to their funds forever.
