Decentralized Finance (DeFi) – what is it?

Idego Idego • Jul 30
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Decentralized Finance, in short DeFi, is a concept which enables entrepreneurs who choose to take advantage of blockchain technology and traditional financial instruments in a decentralized architecture. Two examples of DeFi applications are Bitcoin and Etherum. They are both controlled by big networks of computers and not central authorities. What does that mean and why is DeFi becoming more and more popular in the crypto industry?

Have you heard about blockchain and you are wondering what the possible applications of this technology for business are? DeFi gets so much attention nowadays as it gives more applications to the blockchain than just a simple transfer of some value, hence it enables more complex financial applications. There is usually an institution in the middle of all transactions carried out by two people or organizations. With DeFi there is no need for this third party in between. To understand the actual applications of DeFi, you need to learn more about it, though.

Definition of DeFi

The world of blockchain, bitcoin, and other cryptocurrencies are full of risks, but also full of potential. DeFi stands for “decentralized finance” – it is quite a wide term for various financial applications in blockchain and cryptocurrency and there are multiple fields related to it. These applications may be used to execute financial transactions in a specific way – without the control on the part of central institutions. Simply put, it is about cutting out the middleman (such as a bank) from the transaction and conducting transactions over the blockchain instead.

DeFi apps leverage smart contracts – pieces of code that perform particular actions when individually defined conditions are met. Through these technologies, users may lend and borrow cryptocurrencies without intermediaries (all the user needs to borrow assets through DeFi is the ability to provide collateral with other kinds of cryptocurrency, although this is what makes it riskier than applying for the loan through traditional banking), but many more complex transactions can be carried out using DeFi.

DeFi applications consist of three main elements:

  • A front-end interface in the form of an application or website,
  • A smart contract that stores some programmed conditions,
  • The Ethereum blockchain enables and secures transactions.

Ethereum applications – what are they and how is DeFi related to it?

Generally, DeFi applications run on the Ethereum blockchain which is one of the largest cryptocurrency platforms other than Bitcoin. It has been designed as an infrastructure for developers, enabling them to create decentralized applications.

Ethereum is leveraging the concept of smart contracts, which automatically execute transactions once defined conditions are met. Developers use special Ethereum programming languages (for example Solidity) to build and deploy such smart contracts. The selected rules that need to be met, must be written into them, so a transaction could be completed. Thanks to this solution, there is no need for a trusted third party to control the transactions.

There are some concepts related to the DeFis you should learn more about:

  • Yield farming – experienced users can take the extra risks and scan through various DeFi tokens, searching for additional opportunities to earn.
  • Liquidity mining – a form of yield framing. DeFi applications can give some free tokens to new users to encourage them to use their platform.
  • Composability – DeFi applications are open source. That means that everyone can access the code – it is public. These applications and their components can be leveraged by programmers and used for developing new applications.
  • Money Legos – it is a similar concept to composability. DeFi applications can be compared to Lego blocks. They can be combined to create a new, functional financial products.

What are the risks of investing using DeFi?

Managing transactions through DeFi can be a good choice, but there are of course some risks as it is still a rather new solution and there is no third party in control of the whole system. Investing in DeFi is risky for now, so it is crucial to understand how it works and consider if it is the best way to manage your assets.

Is there any technology risk?

Smart Contracts – one of the most basic elements that make DeFi applications what they are – are bits of code that embody and carry out the set of instructions necessary for performing transactions. Poorly written code can be dangerous for DeFi applications’ users. Errors in the code can prevent transactions from being carried out or cause other problems. Smart contracts may also be hacked.

What about an asset risk?

Once you decide to borrow assets on a DeFi application, you also need to provide collateral. It is usually required for DeFi protocol Maker to have a minimum of 150% of the loan value in other crypto assets to secure the transaction. Users need to understand that the value of cryptocurrencies is very unstable – it changes frequently. There is a cryptocurrency that can be used to secure the value of the assets in a certain way, namely stable coins.

No external control

As cryptocurrencies and transactions performed based thereon are not included in any official regulations, once you invest your money through DeFi, you need to remember that borrowers cannot be held accountable for not paying off the loan. There is no central authority that can support you or provide customer service, so if you have a problem, you are on your own. 

Why is DeFi becoming so popular in the crypto industry?

Though Bitcoin and Ethereum were the original DeFi, there are newer applications that are becoming more and more important for DeFi users. There are many different applications within the network and here are some examples:

  • Decentralized exchanges (DEXs) – those applications make currency exchange possible. Users leverage it to exchange ordinary currencies for cryptocurrencies and later trade cryptocurrencies with other people without any external intermediary, and thus without any additional expense.
  • Lending platforms – they use the above-mentioned smart contracts. This way, there is no need for an external third party to control the transaction.
  • Stablecoins – in their nature, cryptocurrencies are rather unstable. To stabilize the price of a given currency, you may use stablecoins – a stable coin is tied to a traditional asset (dollar or euro).
  • Prediction markets – they can be used for betting on future events. Call it a type of lottery, if you want. It works – again – with no intermediaries, and that is what makes them attractive for many users.

Experienced users can leverage DeFis not only to avoid unnecessary costs of performing transactions but also to earn money. DeFi surely has considerable business potential.

The main benefits of DeFi:

  • it can increase the accessibility of financial services,
  • there is no need for the external third party (intermediaries) to carry out the transactions, so it is handled more efficiently,
  • DeFi applications do not generate massive operational costs,
  • DeFis that we know today may be the beginning of new decentralized financial products and services.

The best choice to start with DeFi is by investing in tested, well-audited and secure applications. Beginners should focus on networking with a big community around it. It is quite possible that you can benefit from investing in DeFi, but before you do this, make sure you understand all potential risks. It would also be wise to ask experts for advice.

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