Invest in DeFi: Decentralized Finance
Decentralized finance, or DeFi, is a system whereby financial products are made available on what is called a public decentralized blockchain network. This means that these financial products are open for anyone to use, rather than via a bank or brokerage. No government-issued ID, Social Security number, or any proof of address is required to use DeFi. There is no need for a middleman.
In recent years, this has been increasingly attractive to users who have grown tired of the mainstream financial institutions, and don’t trust traditional banks anymore. You might be here because you’re interested in investing in DeFi. However, in order to invest properly and steer away from any mistakes that could cost you a lot in the foreseeable future, it’s best to know the basics of DeFi investing before starting. Our thorough guide to Investing in DeFi covers all the DeFi fundamentals. Let’s get started.
How DeFi works
Smart contracts, the financial revolution
DeFi systems use "smart contracts" to achieve distributed consensus on blockchains. Smart contracts are written to perform specific actions when conditions are met. For example:
Let’s say you want to promise you’ll pay $1000 to someone if your favorite sports team loses their next game. Typically, you’d write a smart contract stating the promise. Once the smart contract is on the blockchain, everyone in the network can access and read the contract (or the contract’s code), but no one will be able to change it.
Smart contracts govern decentralized apps, also called “dapps”, and they cannot be owned or managed by any one person, institution, or company. Some cryptocurrency coins use smart contracts, like Ethereum, which was the first platform to develop them. Other platforms use smart contracts, like:
DeFi allows any two parties to perform secure and direct transactions without an intermediary or any central authority. This exists as opposed to other traditional transactions, where you’d need a bank to send funds to your friend if you lose your bet, or money-sharing apps like CashApp or Venmo. This means that anyone can access financial services, without spending any money or having to sign up for any service from a third party. In short, smart contracts are self-executing and self-enforcing contracts. They have the explicit terms and conditions laid out within their very code. They are absolutely public, but can’t be changed by any external user.
The many benefits of smart contracts
The smart contracts of DeFi allow users to benefit from 100% accurate transactions. One of the attributes of smart contracts is that they come with a systematic, explicit and detailed record of all terms and conditions. This avoids any mistakes that sometimes come with manually filling out forms or other common human errors that exist in traditional banking.
Smart contracts offer complete transparency to all parties, because of how all terms and conditions of contracts are fully visible and accessible. They also allow transactions to be executed extremely fast because the system relies on lines of code and the Internet, which nowadays is pretty immediate. This can shave off so much wasted time for many users of traditional banking who have to wait hours for their decisions to be approved by third parties. Documents aren’t processed manually, rather through secure automated processes.
Talking of security, smart contracts use exceptionally secure data encryption, on the same level as the one most crypto-currencies use. This, combined with other parameters, generates the utmost confidence in the execution of smart contracts by users of DeFi. Smart contracts have been proven to be able to significantly reduce or even exclude the need for litigation and legal disputes over financial transactions. Parties involved in DeFi commit themselves to the rules of the underlying code when using smart contracts.
The four layers of DeFi
Like any financial ecosystem, DeFi has components, which are an important feature and part of the reason why it has got so popular in recent years. The DeFi ecosystem was made up of 3 million users, as stated in the most recent studies. So, what are the components, or layers that make DeFi worth the trust of 3 million users?
The Settlement layer
The settlement layer is referred to as Layer 0 because it is the basis of every DeFi transaction. It is basically a public blockchain and its corresponding native digital currency or cryptocurrency. Transactions are carried out using this specific currency, which could also be traded in public markets. One popular example of the settlement layer is Ethereum and its native token ether (ETH). Ether is currently being traded at crypto exchanges.
The Protocol layer
Software protocols are all the standards and rules and regulations written into any specific task or activity, in order to govern said task or activity. The protocol layer of DeFi explains every rule DeFi users must follow to be able to use the platform. DeFi protocols are interoperable, which means that they can be used by different parties at the same time.
The protocol layer is what gives liquidity to the DeFi ecosystem. One example of a DeFi protocol is Synthetix, which is used to create synthetic versions of real-world assets in Ethereum.
The Application layer
The Application layer is one of the most notorious features of DeFi. It is where the consumer-facing applications are housed. Decentralized applications are protocols translated into consumer-oriented services. All the most popular applications in the crypto ecosystem can be found on this layer, like decentralized cryptocurrency exchanges and lending services for example.
The Aggregation layer
The aggregation, quite unsurprisingly, is made of aggregators. The aggregators connect applications to provide a service to DeFi users. For example, aggregators can enable the transfer of money between different financial instruments. In a physical setup, such trading actions would entail considerable paperwork and coordination. Lending and borrowing also occur on the aggregation layer.
Why are people interested in DeFi?
Understanding DeFi by comprehending the mainstream financial ecosystem
Using technology for financial services is definitely not something new. Most banks and financial institutions rely heavily on technology to perform their services and operations. However, these institutions only use tech as a facilitator of transactions, not as the very core of their activity.
Modern financial ecosystems use a “hub and spoke” model. New York and London, which are key economic focal points of activity, act as hubs of operation for the financial services industry. They influence economic activity at regional centers, otherwise called financial powerhouses and spokes, such as Mumbai and Milan.
Economic shifts and sent out from hubs to spokes, then toward the rest of the world’s economy, which is a gauge of interdependency. This model worked well in the last century. However, financial crises such as the Great Recession exposed huge flaws in its infrastructure. The hub and spoke model is inherently prone to the domino effect of economies crumbling one after the other, as soon as one large financial institution fell.
On the other hand, decentralized finance uses technology to dissolve interdependency. Financial services can be provisioned anywhere and by anyone of all ages, ethnicities, and cultural identities. DeFi services and apps (dapps) are constructed on public blockchains, which provide users with immensely more control over their money with personal wallets and trading services that are turned more towards individual users than institutions.
DeFi - a popular alternative
In July 2021, the market capital for DeFi was around $80 billion. DeFi is very accessible: it is especially attractive to users who would be unable to open a traditional bank account or receive loans. Anyone who has an internet connection can have access to DeFi - it has no geographical restrictions.
Because DeFi allows financial transactions between any two parties, without an intermediary, transaction fees are very much lower than traditional banking or brokerage. The parties themselves are able to decide on interest rates. Likewise, users have been attracted to how secure DeFi is, thanks to its smart contracts.
How risky is it to invest in DeFi? Risk VS Reward
Like any investment, DeFi presents a relationship between risk and reward. There are different types of risks to consider when investing in DeFi:
Technology risk
Smart contracts, which are the basis of DeFi platforms, are collections of code that carry out instructions into the blockchain. If ever an issue occurs with the code, there could be a weakness within a DeFi protocol.
Hardware is the foundation of the infrastructure needed to run decentralized financial services. The hardware risks related to DeFi are those of sensitivity, incompatibility, and power issues. All of these change the consistency of services when they don’t operate properly. When they fluctuate, they affect the performance of DeFi platforms.
Asset risk
When you borrow on a DeFi app, other crypto assets are offered up as collateral. For example, the DeFi protocol Maker requires that borrowers collateralize their loan a 150% minimum of the loan value. Because crypto is volatile, its value fluctuates often. The crypto used as collateral could lose value very quickly, so positions can be liquidated at once.
Product risk
There’s no regulation or any type of insurance on DeFi. Even if crypto assets are used as collateral for loans, ultimately borrowers cannot be held accountable for unpaid loans. That’s why it’s important to invest only what you could potentially afford to lose.
The rewards of DeFi
Compared to traditional finance, DeFi transactions have the potential to be more efficient, flexible, secure, and automated. Because anyone can use DeFi, the potential rewards are universal. DeFi runs on open-source software code, it can be combined and modified in an infinite number of ways. That’s why DeFi’s growth has been so exponential, because of its potential for innovation. In May 2021, over $80 billion worth of cryptocurrencies were tied up in DeFi contracts. The $20 trillion global financial sectors suggests there is room for growth.
What are Decentralized Finance (DeFi) Applications?
Decentralized Finance Applications, or DeFi applications, are decentralized open-source technologies. A DApp runs on a peer-to-peer network of devices, thanks to which users no longer depend on one central computer to establish financial transactions.
Decentralized applications have many different use cases. Some examples include:
Payments
Lending
Stablecoins
Tokenization
Decentralized Exchange
Payments: Counterparty is a DeFi protocol that uses the Bitcoin blockchain. It allows any user to generate and trade their own tokens. DeFi applications like these usually use their own native currency for users to transact with, as well as a wallet where users can hold their digital currency.
Lending: DeFi lending applications democratize loans by creating a wide pool of willing lenders. One example of DeFi lending is Dharma, which is built on the Ethereum blockchain, gives participants the opportunity to lend and borrow collateralized debt (the collateral is usually a cryptocurrency).
Stablecoins: A stablecoin is an asset that grants price stability characteristics. This makes it suitable for certain purposes like a medium of exchange, a unit of account, or even a store of value. Stablecoins have been target to increased interest lately, because they are able to provide price stability to volatile assets like Bitcoin, Ethereum, and other digital assets. Tether was the first stablecoin, and now others like MakerDAO, Gemini Dollar (GUSD), and Circle (USDC) have been launched.
Tokenization: Tokenization occurs anytime blockchain technology is utilized in order to digitize a good or service in the material world. Security Token Offerings (STOs) use tokenization to digitize ownership of financial assets like stocks and bonds. Harbor is a DeFi application that uses its R-Token to facilitate the trading of tokenized securities. It was created using the Ethereum platform.
Decentralized Exchange: Decentralized exchanges are platforms that give users the opportunity to trade digital assets like Bitcoin and Ethereum. Decentralized exchanges are a strong alternative to centralized exchanges and their lot of issues, like having no control over the funds deposited because users don’t own private keys. 0x is a DeFi application built with the Ethereum blockchain and it allows users to trade digital assets while being in control of their private keys.
Three Dapps to look out for
UNISWAP
Uniswap is a decentralized exchange (DEX) that was created by Hayden Adams, who is a mechanical engineer from New York. The idea for Uniswap stems from posts written by Ethereum founder Buterin about the development of an automated market maker and decentralized exchange. Nowadays, Uniswap expedites $1 billion or more in daily crypto trading. Its governance tokens, UNI, have a market value of about $12 billion.
AAVE
Aave was created by law student Stani Kulechov in 2017, and it was originally called ETHLend. The platform allows users to lend and borrow crypto tokens. Users of Aave have put around $14 billion worth of collateral on the network to this day.
MAKERDAO
MakerDAO is a platform that allows users to lend and borrow thanks to Dai, which is a stablecoin linked to the US dollar. MakerDAO was initiated in 2014 by co-founder Rune Christensen. Users have put up around $6 billion of collateral to this day.
The rise of DeFi
DeFi is built using a blockchain. The blockchain is usually regarded as infrastructure, and DeFi can be seen as a group of second-layer applications. Because of this, DeFi’s core benefits are those of blockchain:
Resistance to censorship
Potential worldwide participation of any user regardless of parameters like social status, cultural identity, gender, etc.
Fast low-cost transactions and settlement
Immutability of financial contracts
Contract automation
Users remain in possession of private keys
Users are in full control of funds
Users don’t have to place their trust in a third-party
Ecosystem transparency
Price and market efficiency
The least principal-agent risks as possible
Personal interests are guaranteed and governed by a transparent protocol
In the traditional financial industry, huge resources are allocated to create trust. This creates banks that are too big to fail. During the 2007 crisis, the world realized that financial institutions crucially lacked transparency. In many countries, financial institutions are prone to censorship and discrimination. Lastly, systems in place in the mainstream economy are unable to keep up with the fast-moving pace of the digital epoch. For example, a cross-border transaction takes 3 working days on average and usually costs around 6.8% in fees.
Why is DeFi not more popular by now?
The obstacles faced by DeFi
The DeFi theory is promising. However, the adoption of DeFi still lacks. There are major obstacles to overcome before DeFi can be adopted on a broad scale.
The DeFi ecosystem is the sum of constant experiments and innovation. Access to DeFi is global, but in terms of User Experience (UX), things remain painfully under-developed. Because DeFi runs using cryptocurrencies, users have to convert their own currency to crypto before they can use Dapps.
DeFi products are usually overcollateralized. There is no credit scoring or shared collateral in the DeFi space at the moment, so many products must be overcollateralized - sometimes as high as 150%. This significantly reduces the advantages of using DeFi for professional traders or the access to capital that users do not own.
The technical risks of DeFi, like potential bugs in smart contracts or layers of blockchain, are quite difficult to detect because of how novel the approaches are. Because of its core principles, false or fraudulent transactions on the blockchain are irreversible. There are also some operational risks, because of how complex governance protocols are and how hard or even impossible price feeds (or oracles) are to manipulate.
Problems encountered with Ethereum could have an impact on DeFi, and create underlying issues, such as:
Network congestion
Transaction costs
Timing issues
What should beginners know about DeFi?
If you’re looking into investing in a DeFi application, we advise that the first thing you should do is check that the applications you’re exploring are safe, secure, and well-investigated. A blockchain, protocol, or exchange shouldn’t be controlled by a restricted group of players. The platform should be able to handle heavy user demand and should definitely have affordable transaction fees.
Applications should always share their code and should cater to concerns, especially regarding security, on their forums and social feeds. Transparency should be assured. A good rule of thumb is that if something feels weird, it’s usually because it is.
DeFi is growing at a remarkably fast pace. Yields are high, and opportunities can sometimes feel too good to be true. If you don’t know how to thoroughly review code, ask for someone with the technical expertise required to do so. Trust your gut. Research is the best way to prevent mistakes.
The future of DeFi
What’s next for the space?
Predictions are that DeFi applications will keep replicatig structures in the financial landscape like high-yield savings accounts, that are so heavily used in mainstream banking and investment. New decentralized financial products will likely come to life.
DeFi has the potential to completely transform the global financial ecosystem by taking away transaction costs and offering top efficiency and speed. DeFi means more security, and no middlemen needed to operate.
DeFi is most likely not a simple disruption for traditional banking, but a true threat. DeFi is borderless, anyone can use it. It has the potential to reach users on an utterly huge scale. It solves financial problems that mainstream finance fails to. As DeFi matures, services from different blockchains will interact with each other and grow more powerful, unfolding endless possibilities.
The bottom line
DeFi applications are open-source technologies that were created to get rid of the middleman and democratize the mainstream financial landscape. Payments, lending, stablecoins, and many other systems like derivatives and indexing could change the financial structure worldwide. Anyone can use DeFi, however, it does present its own set of risks and rewards. It’s important to thoroughly research DeFi apps before embarking on an investment.