DeFi – short for decentralized finance – is a new vision of banking and financial services based on peer-to-peer payments via blockchain technology. Via blockchain, DeFi enables “trustless” banking, bypassing traditional financial intermediaries such as banks or brokers.
What’s in it for investors? DeFi promises to allow investors to “become the bank” by giving them the ability to lend money between peers and earn higher returns than those available in traditional bank accounts. Investors can also send money quickly anywhere in the world and access their funds through digital wallets without paying traditional bank fees.
Here’s how DeFi works, how it can benefit individuals, how it challenges traditional banking, and the risks it presents.
How DeFi Works
The goal of DeFi is to provide many of the financial services that customers and businesses currently enjoy – loans, interest on deposits, payments – but to use decentralized technology to do so. Indeed, DeFi is changing the industry not so much by changing the what but rather the how. Simply put, DeFi is creating a new infrastructure to deliver similar financial products and services.
To do this, it uses blockchain technology and smart contracts, among other tools. Blockchain is a kind of ledger technology that tracks all transactions on a given financial platform. Think of it as a running record of all transactions on that specific blockchain, recorded chronologically. If person A pays money to person B, it will be permanently timestamped in the ledger.
“The building blocks of DeFi are smart contracts, which are executable codes that can store cryptocurrencies and interact with the blockchain according to its rules,” explains Alexander Lutskevych, CEO and founder of CEX.IO, a company that facilitates DeFi and cryptocurrency.
To enable DeFi, smart contracts automatically execute transactions between participants. When the terms of the contract are met, they carry out their set of instructions themselves.
“DeFi enables smart contracts on the blockchain to replace trusted intermediaries – such as banks or brokerage firms – for peer-to-peer transactions,” says David Malka, CEO of YieldFarming.com, which helps investors gain insights. cryptocurrency income. . “These peer-to-peer transactions in DeFi can include everything from payments, investments, loans and more.”
In this world, cryptocurrency becomes the de facto currency for transactions and records.
“DeFi is a natural continuation of the vision outlined in the Bitcoin white paper of creating electronic money, so this is a very exciting time in the industry,” Malka says.
Main advantages of DeFi
For individuals, the benefits of DeFi include potentially greater security, potentially lower costs, greater types of services, and the ability to earn higher income from their crypto holdings. These and other benefits are enabled through decentralized applications created by various groups.
“Decentralized applications, or dApps, enable people to transfer capital anywhere in the world (with fast, low-cost settlement), peer-to-peer borrowing and lending, crypto exchange services, NFTs, and other services like wallet and crypto storage. solutions,” says Lutskevych.
“DApps are pre-programmed by developers, and depending on their purpose, they can execute transactions on a specific blockchain network, make deals between buyer and seller, or move assets from a decentralized exchange to a decentralized lending platform,” he said.
In short, the only limit is the ability to code an application that executes your instructions.
A currently popular perk for cryptocurrency investors is the ability to generate income. Crypto staking, for example, allows owners of a coin to help support that coin’s ecosystem and earn income by helping to validate transactions. This is part of what is called yield farming. This proved interesting as bank interest rates are at their lowest in years.
“Anyone can provide crypto assets in the form of cash or loans through something called yield farming which pays the depositor with interest and fees,” says Malka of YieldFarming.com. “Yield farming is how you put your crypto to work in order to earn passive income.”
To provide their services, many dApps require a liquid cryptocurrency available on the app. So they offer to pay an income, a return, in exchange for investors who place their coins for a certain period of time. In effect, they provide income to those who provide liquidity – similar to interest paid on deposits in traditional banks, but riskier (as discussed below).
Depending on the type of dApp, cryptocurrency owners can mine the yield through various services such as:
Thus, these yield-generating methods provide another source of profit for investors, although you must pay taxes on crypto profits, just as you would for traditional sources of income.
“Even the least risky farms can easily earn interest rates several times higher than bank savings accounts,” Malka says. “This is especially important during bear markets – where the price of cryptocurrencies like Bitcoin or Ethereum tends to fall.”
DeFi Risks for Investors
Although DeFi looks like a brave new world for finance, DeFi presents various drawbacks and risks for potential participants:
- Complexity: Participating in DeFi is not as easy as going to a local bank. “DeFi can be a challenge for beginners to navigate due to the massive amount of DeFi applications and investment opportunities,” Malka says. “Even the onboarding process can be confusing for some people as you need to transfer money from an exchange like Coinbase to a non-custodial wallet like through MetaMask to start accessing the world of DeFi.”
- Outright scams: Many scammers seek to attract new crypto investors lured by returns that could significantly exceed those offered by traditional financial institutions. A high return might just be too good to be true.
- Flight: Beyond outright scams, it is possible for cryptocurrencies to be stolen via exploits, especially given the coding vulnerabilities in some dApps. “In these exploits, funds may be lost, and then it’s up to the core team behind the DeFi project to decide how, if at all, to compensate participants,” says CEX.IO’s Lutskevych.
- Cost: Interacting with smart contracts requires something called a gas fee, like a token to run a machine. Several steps along the way could easily incur costs, and it could prove especially expensive for those with modest funds. “It’s not uncommon for a ’round trip’ to cost well over $200 in gas costs,” says Lutskevych.
- Volatility: While yield farming can help ease your downside in the volatile world of cryptocurrency, you will still have to endure amazing swings to earn what could be modest returns. In one day, the cryptocurrency could easily lose the year-plus return.
- Fluctuating returns: In addition to fluctuating cryptocurrencies, DeFi participants have to deal with fluctuating returns. Yields may drop as the offering supports a given application.
- Disappearing projects: A given dApp may ultimately be left for dead on the vine as the core team developing it pursues other projects. “If they ever decide to stop, the protocol logic will run as is, but no further upgrades will happen,” Lutskevych says.
These are some of the biggest risks in DeFi and ones that investors considering participating should understand before fully committing.
How does DeFi challenge traditional banking?
One of the biggest claims from DeFi proponents is that this new financial technology will disrupt traditional banking. In the extreme case, they say, DeFi would totally disintermediate – eliminate the middleman – in financial transactions, to be replaced by decentralized networks of peers.
But if DeFi is so powerful, why wouldn’t banks just co-opt the technology and offer it?
“We are certainly seeing traditional financial institutions taking more and more advantage of blockchain and distributed ledger technology,” says Malka of YieldFarming.com. “You will see this really accelerate in the coming years as these traditional institutions all recognize the inherent security of being on the blockchain.”
Malka expects banks to create various DeFi products “to stay competitive and relevant.”
“You can easily imagine a scenario where a traditional bank creates yield farming opportunities that its customers can participate in,” he says.
But such a change would be easier on paper than in practice due to the regulatory burden, says CEX.IO’s Lutskevych, creating complications for traditional companies that even want it.
“Integrating blockchain technology would require revising many well-established processes while exposing them to additional risk,” he says. “More so, subject to regulation, these institutions would need approvals for these activities from regulators.”
At the end of the line
Those looking to get into DeFi, beyond the basics of cryptocurrency trading, should proceed with caution and ensure they are working with a reliable counterparty. While the returns offered by DeFi are attractive, don’t let the potential return blind you to other risks. A downdraft in the cryptocurrency markets could quickly wipe out any small gain from yield farming, and outright scams or theft could wipe out your crypto wealth even faster.