The whole of decentralized financial services established with blockchain technology is defined as DeFI. In other words, DeFi are financial structures that are not dependent on any center or authority.
Among the financial systems we mentioned, we can list functions such as obtaining loans, lending, decentralized stock market, insurance, shopping, marketplace. The purpose of DeFi’s emergence is actually to build a more democratic financial system, as well as to enable people who do not have access to traditional financial systems to make financial transactions.
DeFi is inspired by the blockchain, the technology behind the digital currency bitcoin that allows several assets to keep a copy of the transaction history, meaning it is not controlled by a single central source. This is important because centralized systems and human gatekeepers can limit the speed and complexity of transactions while giving users less direct control over their money. DeFi is different because it extends the use of blockchain from simple value transfer to more complex financial use cases.
Bitcoin and many other digital assets are departing from legacy digital payment methods such as those run by Visa and PayPal, as they have removed all intermediaries from transactions. When you pay for a hamburger at a restaurant by credit card, there is a financial institution between you and the business that controls or has the power to stop the transaction and record it in its private ledger. With Bitcoin, these institutions are disabled.
Direct purchases are not the only type of transaction or contract overseen by large companies; Financial applications such as loans, insurance, betting and more are also under their control. Removing middlemen from any transaction is one of the main advantages of DeFi.
Most of the apps that call themselves “DeFi” are built on top of Ethereum, the second-largest cryptocurrency platform in the world, which distinguishes itself from the Bitcoin platform in that it is easier to use to create other types of decentralized applications beyond simple transactions. These more complex financial use cases were even highlighted by Vitalik Buterin, the creator of Ethereum, in the original Ethereum whitepaper in 2013.
This is because Ethereum’s smart contracts platform, which automatically executes transactions when certain conditions are met, offers much more flexibility. Ethereum programming languages such as Solidity are specifically designed to create and deploy such smart contracts.
For example, let’s say a user wants their money sent to their cousin next Thursday, but only if the temperature drops below 30 degrees, according to weather.com. Such rules can be written in a smart contract.
The most popular types of DeFi apps include:
Decentralized exchanges (DEXs): Online exchanges help users exchange currencies for other currencies, whether it’s US dollars for bitcoin or ether for DAI. DEXs are a type of hot exchange that directly connects users so they can trade cryptocurrencies with each other without relying on a middleman.
Stablecoins: A cryptocurrency that is tied to an asset other than the cryptocurrency (e.g. dollar or euro) to stabilize the price.
Lending platforms: These platforms use smart contracts to replace middlemen such as banks that manage loans in the middle.
“Wrapped” bitcoins (WBTC): A way to send bitcoins to the Ethereum network so that bitcoin can be used directly on Ethereum’s DeFi system. WBTCs allow users to earn interest on the bitcoin they lend through the decentralized lending platforms described above.
Prediction markets: betting markets on the outcome of future events, such as elections. The goal of the DeFi versions of the prediction markets is to offer the same functionality without the middleman.
Lending markets are a popular form of DeFi that connects borrowers to lenders to cryptocurrencies. A popular platform, Compound, allows users to borrow cryptocurrencies or offer their own loans. Users can earn money from interest to lend their money. Compounding algorithmically determines interest rates, so if there is higher demand to borrow a cryptocurrency, the interest rates will be higher.
DeFi loan is collateral-based, meaning that in order to get a loan, a user must provide collateral — usually ether, the token that powers Ethereum. This means that users do not provide their ID or associated credit scores to obtain a loan; this is how normal, non-DeFi loans work.
Another form of DeFi is stablecoin. Cryptocurrencies often experience sharper price fluctuations than fiat, which is not a good quality for people who want to know how much their money will be worth a week from now. Stablecoins peg cryptocurrencies to non-cryptocurrencies such as the US dollar to keep the price in check. As the name suggests, stablecoins aim to bring “stability” to the price.
One of the oldest DeFi applications to live on Ethereum, users ask, “Will Donald Trump win the 2020 presidential election?”
Although prediction markets can sometimes predict results better than traditional methods such as polling, participants’ intent is clearly to make money. Centralized prediction markets that do well in this regard include Intrade and PredictIt. DeFi has the potential to increase interest in prediction markets, as it has traditionally been unwelcome by governments and is often shut down when centrally operated.
How do I make money with DeFi?
Users can earn “passive income” by using Ethereum-based loan applications, lending their money, and generating interest on loans. It allows users to leverage the lending aspect of DeFi to put their crypto assets to work to generate the best possible returns. However, these systems tend to be complex and often lack transparency.
Is it safe to invest in DeFi?
It is considered to be risky as it is a new technology and studies are still being carried out on it. Many believe that Defi is the future of finance and investing in this technology early can lead to huge returns. The decision is yours.
However, it is difficult for newcomers to distinguish good projects from bad ones. And there are so many bad projects on the market.
As DeFi grew inactivity and popularity throughout 2020, many DeFi apps like the meme coin YAM crashed and burned, sending its market cap from $60 million to $0 in 35 minutes. Other DeFi projects, including Hotdog and Pizza, suffered the same fate, and many investors lost a lot of money.
Also, DeFi errors are still very common, unfortunately. Smart contracts are powerful, but once rules are added to the protocol, they cannot be changed, which often makes bugs permanent, thus increasing risk.
When will DeFi be popular?
With more and more people falling under the spell of these DeFi apps, it’s hard to say where it will go. Much depends on who finds them useful and why. Many believe the various DeFi projects have the potential to become the next Robinhood by making financial practices more inclusive and open to those who have not traditionally had access to such platforms.
This financial technology is new, experimental, and not particularly trouble-free in terms of security or scalability.
The developers hope to eventually fix these issues. Ethereum 2.0 can overcome scalability concerns through a concept known as sharding, which is a way to break up the underlying database into smaller, more manageable chunks for individual users to run.
Once these solutions are in place, Ethereum’s DeFi experiments will have an even better chance of becoming real products, potentially even mainstream.
Ps: It is not investment advice.