Have you ever heard of DeFi before? If already, have you known clearly about how DeFi works or the role it plays in our financial system? If you never heard of DeFi before or you want to make sure you comprehend this term in the right way, keep reading this article to the end. In today’s post, we will explain in detail what DeFi is and why it has become so popular in the field of finance.
Understanding DeFi
What is DeFi or Decentralized Finance? DeFi is a term given to financial services that have no central authority or someone in charge. It uses decentralized money, like certain cryptocurrencies, that can also be programmed for automated activities, so we can build exchanges, lending services, insurance companies, and other organizations that do not have an owner and are not controlled by anyone.
DeFi takes influence from blockchain, the bitcoin digital currency technology that enables many organizations to keep a copy of a transaction history, so it doesn’t require intermediaries like a bank or lawyer.
What made DeFi so popular?
First, authorities have been behind the curve, making DeFi thrive in this vacuum. For instance, in traditional unsecured lending, there is a regulatory obligation that lenders and borrowers know one another’s identities, and thus the lender evaluates the borrower’s financial capability to pay back the debt. When it comes to DeFi, there are no such obligations. Instead, everything is conducted based on mutual trust and private information is preserved.
A second explanation for the acceleration of DeFi is that mainstream players are engaged. Several big financial firms are starting to accept DeFi and are searching for ways to get involved in this new financial service. Therefore, DeFi is approaching more and more people.
The third motive behind this surge is the negative impacts of COVID-19. Global interest rates were pushed much lower by the epidemic. Some jurisdictions are currently in negative territory, such as the eurozone, and others could theoretically follow, such as the US and the UK. In this economic situation, DeFi offers much higher returns to savers than other high-street institutions. It is an alternative form of financing that perfectly fits into the worldwide economy at present.
The Best DeFi’s applications — and notable protocolsÂ
We have known what DeFi is, now let’s take a look at some of its remarkable applications.
1. Decentralized exchanges (DEXs)
The first application of DeFi is decentralized exchanges, which are a type of cryptocurrency exchange that conducts without the need of a middleman. With DEXs, trade can occur between users, allowing one another to buy and sell cryptocurrencies in a faithless environment through an automated process. Assets traded under decentralized exchanges are never held in an escrow or by third-party people, so these exchanges can reduce the risk of theft from hacking of exchanges.Â
2. Lending Platforms
Advocates of DeFi say that DeFi lending platforms are making a huge change to the ecosystem of lending. In lieu of turning to intermediaries, these systems use smart contracts, enabling borrowers and lenders to engage in an open and free platform. Through lending them, lenders can gain interest on their crypto assets, whereas borrowers can obtain liquidity without selling their assets off.
In traditional banking, before you can take out a loan, you need to put up collateral. This is like the borrowing and lending process in DeFi. Borrowers have to over-collateralize their loans by providing assets more valuable than the loan value. Maker, Compound, and Aave are some of the top DeFi lending platforms.
3 .Prediction Markets
Prediction Markets are usually known as the markets forecasting the results of some important events in the future, and participants will make bets based on their predictions. Unlike most traditional prediction markets, such platforms work with blockchain features that do not require intermediaries. Augur, Gnosis, and Stox are examples of DeFi prediction market platforms. A noticeable event that propelled DeFi prediction markets to surge is the U.S. presidential election during 2020.
4. Yield Farming
Yield Farming is the procedure of generating a reward with cryptocurrency holdings. More simply, it means locking up cryptocurrencies and achieving rewards. It’s currently the biggest growth driver of the DeFi space. Compound and Aave are two main markets for DeFi yield farming. Yield farmers are interested in common coins such as ether, dai, tether, and others.
What are the risks of DeFi?
Before coming to the summary and future of DeFi, we will show you some risks related to DeFi.
One of the main risks is bugs in smart contracts and protocol modifications that would influence the existing contracts. Unfortunately, bugs are still relatively common and this can increase the risk of DeFi.
Furthermore, network fees and congestion may also be an issue, especially if we want to prevent liquidations and try to supply more collateral on time. However, this problem might be addressed by the forthcoming Ethereum 2.0 and the second layer scaling solution.
There are also a number of more subtle features or modifications that may propel users to certain non-obvious actions that can cascade across several protocols. To illustrate, let’s take a recent distribution of COMP tokens in the Compound protocol for example. This led users to get into high-interest, non-profitable borrowing that was actually profitable due to the additional COMP tokens being awarded. Although circumstances like that can be very risky, they make the whole environment more robust and less vulnerable to similar situations on the horizon.
Summary and the future of DeFi
After reading this article, you may probably already know that DeFi is an extremely potential and vibrant space that would have more chances to develop in the future. Despite that, we still have to remember that it is still a very new industry, so it’s full of risks.
Yet we are moving into a new financial system that is more liberalized and decentralized than ever, whether we like it or not. The key issue is how best to direct its growth with controls and balances that mitigate the risks and as much as possible distribute the potential benefits. That will be a challenge for us in the next few years.
