What is Decentralised Finance - DeFi?
It might just be the future of finance!
Is DeFi better than the current financial system? What problems does it solve and does it have the chance to improve or completely replace traditional finance?
The following article answers exactly these questions and much more! For those interested in finding out how the future of finance might look like, this 10 minute read might just be for you!
Short Recap of the Finance History
The financial system as we know it today, went through many years of technological advances. Most early attempts of making finance more efficient, started in the 1920’s, with the introduction of the accounting machines and punch cards. Followed by the rise of mainframe computers, which sped up the banking system dramatically, especially in the 1950’s and beyond. The next revolution was the ATM and Credit Cards, which started growing in popularity from the 1970’s. As important to the financial system, the stock market in the same year started going through drastic changes. From then, slowly but surely, manual trades started being replaced by computers and algorithms. From 1990 onwards, given the explosion of the internet, the computerization of finance expanded exponentially. Then the Fintech revolution really kicked in with Paypal, Robin Hood, Transfer Wise, Revolute, and the list goes on.
Current Banking Issues
The interface of banking is far from being perfect. Some (but not all) aspects of undesirable banking are as follows:
- Settlements of stocks, bonds and other financial instruments can take days to clear and require a massive amount of human capital.
- Key decisions impacting millions are often made behind closed doors by a group of privileged few.
- Also massive inefficiencies and high costs when it comes to international banking and remittent services.
- Unequal access to financial services with billions of unbanked people over the globe. (according to xx 1.7 billion people do not have access to means of banking)
- Banks hiring thousands of employees just to maintain the inefficient processes and being compliant with ever changing banking regulations.
The backbone of the financial system hasn't evolved much since the introduction of mainframe computers decades ago. Here is the moment where DeFi comes in, as we need something new, something better, that can address some, if not all, of these problems.
What Decentralised Finance is meant to do?
In short, the goal of DeFi is to get rid of third parties that are involved in all financial transactions. It leverages the power of cryptography, decentralisation and blockchain to build a new financial system. A system that can provide access to well known financial services such as: Payments, Lending, Borrowing and Trading in a more efficient, fair, open and transparent way. The above specified financial services will be further discussed in following DeFi articles as they are important and each service will be individually discussed.
Efficient: Meaning that operations are settled immediately. It doesn't matter where the counterparty is from in a geographical sense. Most DeFi protocols can operate with minimal or even no human involvement.
Fair: All services are completely permissionless and censorship resistant.
Open: Everyone can open a new DeFi application using open source code and contribute to the ecosystem. In contrast to traditional finance, new applications can build on top of existing solutions, creating room for innovation.
Transparency: The trading volume, the number of outstanding loans, total debt can be checked on the blockchain and no one can alter this information.
What is cryptocurrency to DeFi, how does it work?
Ethereum for example is a cryptocurrency. DeFi is being designed to use cryptocurrency in its ecosystem, so Ethereum as we took it as an example isn't DeFi as much as it is a part of it. That being said, all of this is possible through the invention of Bitcoin and Ethereum and their underlying technology - Blockchain. DeFi uses blockchain technology that cryptocurrencies use. A blockchain is a distributed and secured database or ledger as learned in previous articles. Applications called Dapps are used to handle transactions and run the blockchain.
One of the basic tenets of DeFi is peer-to-peer (P2P) financial transactions. In a P2P DeFi transaction, two parties agree to exchange a cryptocurrency for goods or services without the involvement of a third party. Consider how you obtain a loan in centralised finance to completely comprehend this. You'd have to apply for one at your bank or another lender. If you're authorised, you'll have to pay interest and service fees to use that lender's services. In DeFi, you would enter your loan requirements into your decentralised financial application (dApp), and an algorithm would match you up with peers that matched your requirements. After that, you must accept one of the lender's terms in order to receive your loan.
Keep in mind that P2P lending under DeFi doesn't mean there won't be any interest and fees. What it means is that you'll have many more options since the lender can be anywhere in the world. Because technology is still evolving, it's difficult to say how, if at all, existing cryptocurrencies will be applied. Stablecoins, a cryptocurrency backed by an entity or pegged to fiat currency like the dollar, is at the heart of the concept. Because we need a safe store of value when trading volatile currencies/assets.
DeFi Ecosystems, Various networks
- ETH - The first ecosystem on which projects started to appear is the Ethereum Network. From 2019 on, DeFi brought in hundreds of millions of dollars in value into the ecosystem. ICO’s and raising funds for cryptocurrency projects were Ethereum's successful applications. The Initial Coin Offering - ICO was a game-changing shift in capital raising that fueled a tremendous bull market. The 2017 ICO boom raised billions of dollars, peaked in January 2018, and ushered in the programmable money race as well as the crypto app ecosystem that we have today. Ethereum's second successful application is DeFi. DeFi was the most influential trend in the crypto ecosystem in 2019. Some of the notable Dapps from this network are: Solana, Avalanche, Cronos, Algorand, Uniswap, SushiSwap and many others.
- BSC (Binance Smart Chain) is a blockchain network designed to run smart contract-based applications. BSC works in tandem with Binance's native Binance Chain (BC), giving customers the best of both worlds: BC's huge transaction volume and BSC's smart contract functionality. Notable Dapps on this network include: Pancake Swap, Alpaca Finance, Noft Games, Venus Protocol and many more.
- Polygon - Polygon is a well-known Ethereum layer-2 scaling solution with a thriving DeFi ecosystem. Polygon, formerly known as MATIC network, is a layer-2 scaling solution introduced in 2019 to overcome many Ethereum blockchain restrictions, including transaction speed, throughput, and gas prices. A layer-2 solution is a blockchain that operates alongside a mainnet — in Polygon's case, Ethereum — but processes transactions outside of it, resulting in higher transaction throughput and lower gas prices. To put it differently, layer-2s create a communication channel between the two blockchains and send the information package (transaction data) from the mainnet to the parallel blockchain, allowing the transaction to be completed for a fraction of the cost and at a much faster rate, all without compromising the Ethereum mainnet.
And there are many more ecosystems and Dapps. For a better view of them all, you can visit: https://dappradar.com/rankings
Investing in DeFi Risks
Software Risk: DeFi protocols are internet-based software systems that operate with little or no human control and frequently handle millions or billions of dollars. DeFi platforms, like all software, face two main risks: code flaws, or "bugs," which can cause the software to malfunction, and security vulnerabilities, which in turn, allows criminals, or "hackers," to break in and steal money from the protocol.
Token Risk: Each DeFi investment includes a specific cryptocurrency token. As an example, if one deposits funds into a Uniswap liquidity pool (farm), the investment exposes two tokens in a single pool: the liquidity provider tokens you receive after depositing is a form of IOU which allows you to withdraw your two assets later and receive trading fees from other users trading in that pair. Furthermore, these LP tokens or IOUs’ can be deposited into a smart contract to earn rewards. (can discuss issued token devaluing too fast, and user can’t make back deposit fee)
Stablecoin Risk: If one invests in a stablecoin pool, that pool will contain different combinations of stablecoins. Take the time to investigate each token involved (how long have they been traded? Is the organisation that created them reputable? If you are looking for stablecoin, is it backed by a cash / cryptocurrency reserve designed to maintain their value based on algorithms, or both? If supported by a reserve, how will the reserve be retained and where will it be placed? Each token of DeFi investment has its own characteristics and risks. Take the time to find out what they are.
Regulatory Risk: Currently, the DeFi protocol is in operation with little government oversight or regulation. This situation can change and it is impossible to predict how new government regulations on the DeFi protocols will affect DeFi investments.
Impermanent Loss: The prices of tokens in a liquidity pool are computed differently on decentralised exchanges (DEXs) than on the open market. When the prices of tokens in a liquidity pool vary at different rates – for example, if one token rapidly grows or declines in value while the other remains relatively stable - the DEX will revalue the tokens in the liquidity pool, making them worth less than they would be on the open market. Although you will receive benefits from the DeFi protocol for depositing your tokens in the liquidity pool, you may find that simply keeping your tokens rather than depositing them in a liquidity pool can earn you more money. Because cryptocurrency prices are famously volatile, predicting whether or not the prices of any two cryptocurrencies will climb or fall in the future, or at what rates, is extremely difficult. You can, however, run a "backtest," an experiment to see how your investment would have performed based on past data, by searching the internet for an impermanent loss calculator. Investing in either liquidity pools with only one token is one approach to avoid impermanent loss in your DeFi assets. There is no way for two prices to grow or fall at separate rates and produce impermanent loss if there is only one token in the pool. Investing in liquidity pools made up entirely of dollar-pegged stablecoins is another approach to avoid temporary loss. Because all of these tokens are meant to retain a constant value of $1 per coin, their prices should not vary and the pool should not suffer any temporary losses.
Gas Fees: While DeFi protocols currently function on a variety of blockchains, some of which have very cheap transaction costs, Ethereum is still the most popular. Unfortunately, transaction fees on Ethereum, known as "gas fees," can be very high when depositing funds in a DeFi protocol. This is especially true if, like most DeFi investments, you need to complete more than one phase. Consider whether the cost of petrol will outweigh your expected investment returns. If you plan to make 10% interest on an investment each year and your gas fee is 10% of the investment, it will take you a year to break even.
DeFi is still in its early phases, and the initiative must address a variety of issues in order to overcome traditional funding in every manner imaginable. Nonetheless, this project appears to have the ability to alter how finance operates, with code serving as the regulations. Platforms have already broken ground in terms of lending bitcoins at lower rates than banks. DeFi protocols can also be used for Margin Trading and Insurance. Because these platforms are based on self-executing smart contracts, more possibilities will be available in the future, potentially expanding public prospects.