Decentralized finance—often called “DeFi”—refers to the shift from traditional, centralized financial systems to peer-to-peer finance enabled by decentralized technologies built on the Ethereum blockchain. From lending and borrowing platforms to stablecoins and tokenized BTC, the DeFi ecosystem has launched an expansive network of integrated protocols. In order to fully understand what DeFi is, read on!
Decentralized Finance (DeFi) Meaning
DeFi is a catch-all term for the various financial protocols and platforms that have been built on Ethereum and other blockchains. These protocols and platforms provide a wide range of financial services, including lending, borrowing, trading, and investing.
The goal of DeFi is to provide a decentralized alternative to traditional financial services. By using blockchains and other decentralized technologies, DeFi protocols and platforms can offer financial services that are more accessible, transparent, and secure than traditional financial services.
By deploying immutable smart contracts on Ethereum, DeFi blockchain developers can launch financial protocols and platforms that run exactly as programmed and that are available to anyone with an Internet connection.
The breakthrough of DeFi is that crypto-assets can now be put to use in ways not possible with fiat or “real world” assets. Decentralized exchanges, synthetic assets, and flash loans are completely novel applications that can only exist on blockchains. This paradigm shift in financial exchanges presents a number of advantages with regard to risk, trust, and opportunity.
Centralized vs Decentralized Finance
Centralized finance (CeFi) is a term used to describe conventional financial institutions and products that are controlled by a single, centralized entity. In contrast, decentralized finance, as previously defined, is a term used to describe financial products and services that are built on blockchains using smart contracts.
DeFi is often seen as an alternative to CeFi because it offers a more open, transparent, and resilient way of providing financial services. One of the key advantages of DeFi is that it enables users to directly control their own financial data and assets, without the need for a central authority.
This control extends to both the financial product itself (i.e., the BTC token, a stablecoin like USDT, or a lending platform) and the underlying protocol (i.e., the Maker lending protocol or Compound).
DeFi also offers transparency and interoperability that is more difficult to achieve with centralized finance.
Some benefits that DeFi offers over CeFi, the takeaway:
- DeFi is built on decentralized infrastructure, meaning it is not subject to the same single points of failure as CeFi.
- DeFi protocols are often open-source, allowing for greater transparency and auditability.
- DeFi applications are often composable, meaning users can easily move their assets from one application to another.
- DeFi protocols often offer staking and yield-generating opportunities, allowing users to earn passive income on their assets.
- DeFi applications often offer lower fees than CeFi counterparts.
How Does DeFi Work?
DeFi applications are built on top of Ethereum and other blockchain platforms and use smart contracts to provide a wide range of financial services.
DeFi protocols provide the infrastructure for these applications and include protocols for lending, borrowing, trading, and managing digital assets. DeFi protocols are open source and permissionless, meaning anyone can use them.
The DeFi Apps work by allowing users to connect their crypto wallets to the app in order to access the various features and services that the app offers. The app then uses the user’s wallet information to facilitate transactions and provide data on the current state of the user’s account.
DeFi Financial Products
There are a few different types of DeFi products available on the market today. Some of the most popular include:
These platforms allow users to lend their crypto assets to others in exchange for interest payments.
The most popular lending platform is MakerDAO. It is a decentralized autonomous organization on the Ethereum blockchain that creates and insures the dai stablecoin.
Compound is another open-source protocol for algorithmic, decentralized interest rate lending and borrowing on the Ethereum blockchain.
These platforms allow users to trade cryptocurrencies and other digital assets in a decentralized manner. The most popular trading platform is 0x, which enables the peer-to-peer exchange of Ethereum-based tokens.
These platforms allow users to place bets on the outcome of future events. The most popular is Augur which is a decentralized oracle and prediction market protocol built on the Ethereum blockchain.
These platforms allow users to insure their crypto assets against loss or theft.
Nexus Mutual is a well-known decentralized insurance platform built on the Ethereum blockchain that allows members to pool their risk and share the cost of claims, similar to a traditional insurance company. However, because it is decentralized, Nexus Mutual is not subject to the same regulations as a traditional insurance company.
The Future of DeFi
The future of DeFi looks bright, with new protocols and products being released all the time. There is currently a strong demand for services surrounding DeFi, but there are a few cons to consider before getting started.
Despite its potential to upend the traditional financial system, realistically, it is not that easy. DeFi is still in its early stages so most DeFi services are not yet regulated, and are not necessarily transparent. Also, let’s not think that banks and corporations are going to give up on one of their primary means of earning profit. Financial institutions will surely find their way into the system to make it work.
How do I Make Money with DeFi?
You can start making money with DeFi by providing liquidity to decentralized exchanges (DEXes). When you provide liquidity, you’re essentially creating a market for buyers and sellers to trade assets. In return for your service, you earn a small fee from each trade that goes through the market you’ve created.
Another option is earning interest on your digital assets. There are a number of protocols (of which we previously talked about) that allow you to lend your assets out and earn interest on them. The interest rates can be quite high, especially if you’re lending out assets that are in high demand.
Lastly, you can also earn money by developing or investing in DeFi applications. As the DeFi network grows, there will be more and more opportunities to get involved in building the infrastructure and applications that will power the new financial system.
Is Investing in DeFi Safe?
Like any investment, there are risks associated with using DeFi applications. The biggest risk is that the value locked in a protocol could plummet in response to a financial crisis.
For example, if a stablecoin loses its peg, some or all of the investors’ money could be wiped out. However, there are precautions you can take to reduce the risk of this happening, such as diversifying your investment across multiple protocols. In other words, don’t put all your eggs in one basket.
Another significant risk is the potential for loss of funds due to hacks or bugs in the protocols. In addition, DeFi protocols are often complex and difficult to understand, which can lead to mistakes being made when using them.
As the industry matures, there are more reputable projects and exchanges that offer DeFi products and services. If you do your research and only invest in reputable projects, then investing in DeFi can be very profitable and safe.