Decentralised finance (DeFi) is a blanket term that covers services similar to traditional finance. On the other hand, DeFi is more flexible compared to TradFi and is built on the blockchain, a trustless and permissionless technology. DeFi provides financial services through Decentralised applications (dApps) or protocols using smart contracts encrypted on the blockchain. DeFi covers financial services such as permissionless borrowing, lending and access to yield opportunities.
DeFi provides an alternative to current financial services and is accessible to everyone eliminating hurdles of excess middleman transaction fees and slow transaction rates. With DeFi users also get to enjoy a certain level of anonymity, unlike traditional finance that laden’s its users with cumbersome Know Your Customer (KYC) policies.
Users can access the DeFi ecosystem through Decentralised Applications (dApps). Which allows you to stake, borrow/lend and farm yield, etc. DeFi empowers individuals to become their own bank and opens up a world of possibilities for financial growth and freedom.
How Does DeFi Work?
Just like your traditional bank, DeFi has some core components that underpin its functionality. DeFi relies on blockchain technology, a decentralized and immutable ledger that ensures security and transparency. It serves as the foundation for trustless financial transactions and enables the verification and recording of every transaction.
DeFi operates on a decentralized network, meaning there is no central authority governing the system. Transactions and financial services are conducted directly between peers, eliminating the need for trust and relying solely on the code and rules defined by smart contracts. To ensure that users get easy access to transact on the blockchain, DeFi utilises Decentralised Applications (dApps) that function as banking apps. These dApps use smart contracts that are self-executing agreements written in code, stored and executed on a blockchain. They enable trustless interactions, automating financial transactions and removing the need for intermediaries.
Finally, DeFi uilises interoperability to enable users to interact with different DeFi protocols and platforms. Interoperability enables the creation of a comprehensive DeFi ecosystem where users can access various services across different platforms without restrictions. Currently transferring funds across the border or between different banking sectors can be difficult. Still, with interoperable solutions such as bridges, users can interact with different blockchains (transfer funds from Abitrum to Ethereum without converting the funds).
Use cases of DeFi
Cryptocurrencies and tokens:
Cryptocurrencies serve as the native digital assets within the DeFi ecosystem. They enable peer-to-peer transactions, store of value, and act as incentives for users to participate in various DeFi protocols e.g Ethereum, Abitrum etc.
Decentralized exchanges (DEXs):
DEXs allow users to trade cryptocurrencies directly with one another without relying on a central intermediary. These exchanges operate through smart contracts, ensuring transparency and eliminating the need for a trusted third party e.g Pancakeswap, Sushiswap etc.
Lending and borrowing platforms:
DeFi offers decentralized lending and borrowing platforms that enable individuals to lend their cryptocurrencies and earn interest or borrow digital assets by collateralizing their existing holdings. This eliminates the need for traditional lending institutions and provides greater accessibility to financial services.
Stablecoins:
Stablecoins are cryptocurrencies pegged to a stable asset, such as a fiat currency like the US dollar. They provide stability within the volatile cryptocurrency market and facilitate easier transactions and value preservation within the DeFi ecosystem e.g USDT, USDC.
Automated market makers (AMMs):
AMMs are protocols that utilize smart contracts to facilitate liquidity provision and token swaps. They enable users to provide liquidity to a pool and earn fees, while also allowing others to trade between different tokens within the pool e.g Curve, Balancer.
Yield farming and liquidity mining:
Yield farming involves providing liquidity to DeFi protocols and earning additional tokens as rewards. Liquidity mining incentivizes users to contribute liquidity to specific pools, driving adoption and liquidity within the DeFi ecosystem.
Insurance and derivatives in DeFi:
DeFi also offers insurance protocols that protect users against smart contract vulnerabilities and other risks. Additionally, decentralized derivatives platforms enable users to trade and hedge against price fluctuations without relying on traditional financial institutions.
Benefits of DeFi over Traditional Finance
Low Fee Transactions: Decentralised Finance offers a very low transaction fee compared to what traditional finance charges per transaction and stamp duties.
Fast transaction rate: DeFi platforms are well known for jet speed execution and return rate. Since no third party is required, processes in DeFi are repeatedly executed by smart contracts compared to delays and sometimes denials from banks.
Transparency: Records on the blockchain technology are accessible by the public using dedicated tools and since blockchain powers DeFi, it also shares these benefits.
Security: The blockchain is open to the public but this has not made it vulnerable. Blockchain data is uniquely verified before being stored on the blockchain and it would take a deep understanding of how these codes work before being able to hack into the systems.
High-yielding interest rates: Bank interest rates are relatively low compared to what Decentralised Finance Solutions offers.
Risks of Decentralised Finance
Every working system has benefits and risks, DeFi is not excluded, and some of these risks are listed below.
Price volatility: The Decentralised Finance market is known for high fluctuations in crypto prices. The movement in this price affects DeFi investors.
Little to no regulation: The DeFi market has been under the scrutiny of major governments across the world with the operations of several DeFi startups banned. Due to the lack of regulation, nefarious characters use this as an opportunity to scam inexperienced investors.
Vulnerable to hackers: It takes a coding expert to understand how blockchain technology works. This has given an advantage to hackers who can dedicate all their time and resources to exploit the vulnerabilities of the DeFi platforms. Also, DeFi users can be victims of phishing links, thereby losing assets to scammers.
Loss of private keys: Wallets that require private keys to secure digital assets inform their users to keep their private keys safe. The danger is that assets can be permanently lost, and also anyone that has access to the private keys can transfer the assets without notifying the original owner.
Windup
The DeFI ecosystem is constantly evolving. More solutions are being created to enable users to interact with dApps that have UX and UI designs similar to that of traditional Finance. Also, the Decentralised Finance regulatory landscape is still subject to scrutiny by the government of different countries with regard to regulations. However, it is crucial to understand that the goal of DeFi is to challenge the status quo of traditional finance, eliminate the middleman creating excess fees and promote the use of peer-to-peer systems in transactions.
