Decentralized finance (DeFi) is a set of specialized applications and financial services based on a blockchain (a continuous, sequential chain of blocks containing information, built according to certain rules).
The main idea of DeFi is to create an independent and transparent financial ecosystem, which is not subject to the influence of regulators and human factor.
Simply put, DeFi makes finances available to anyone: users conduct transactions and solve financial issues directly with each other, not through intermediaries like banks, brokerage houses, etc., but with the help of DeFi. Decentralized ecosystem software allows buyers, sellers, lenders and borrowers to interact.
The difference between centralized (CeFi) and decentralized financial systems is how their users achieve their goals. In CeFi, users rely on the people behind the business and the regulatory laws. With DeFi, users rely entirely on technology, software code, and encryption algorithms.
An example of usage:
“The largest theft in the history of decentralized finance occurred on August 10, 2021. The Poly Network interconnect protocol was hacked in a major hacker attack. A hacker under the nickname Mr. White Hat managed to steal $611 million.”
The DeFi boom occurred in the midst of the coronavirus pandemic. In 2020, the decentralized finance market was growing steadily, adding several billion dollars each month. “The very idea that anyone, anywhere in the world can access a system where you can make transfers and choose your own financial risks is very powerful. It’s something that until now has not been available to many people,” Vitalik Buterin, the founder of the cryptocurrency Ethereum, said in 2020.
The nuances of
What shapes the DeFi ecosystem:
Stablecoins – cryptocurrencies whose value is tied to an underlying asset (e.g., Tether USDT is tied to the U.S. dollar exchange rate).
Farming – any action aimed at obtaining tokens for some activity, usually – providing its computing power to perform blockchain calculations.
Issuing tokenized shares. These are essentially analogous to traditional securities, but with the benefits of blockchain. There are several ways to use such tokens: a debt or investment instrument, a derivative, a digital stake. There are also token baskets, that is, the decentralized equivalent of an ETF.
Decentralized Exchanges (DEX). They have no exchange operator and no need for registration, identity verification and fees. Instead, payments are processed by smart contracts. The platform does not access funds or store its customers’ assets, meaning there is essentially a real exchange without an intermediary.
Cryptocurrency loans. Some users lend their coins and others take them. Decentralized platforms automatically enforce the terms of the loans and distribute the interest. To borrow money, you will need to provide the platform with collateral.
Synthetic assets are the creation of derivatives (derivatives) on the blockchain. These include contracts that mimic the price behavior of the underlying asset (stocks, bonds, options, futures, currencies, interest rates, etc.).
Prediction markets – platforms that allow betting on the results of events, games, elections, etc.
Advantages of DeFi:
Easy access to financial services, especially for those who for some reason are isolated from access to the current financial system.
The rules for business transactions are written in a smart contract. Once it’s up and running, the DeFi-application can operate independently with little or no human intervention.
Control over the ecosystem is evenly distributed among all participants in the network.
Transactions are performed quickly and without a chain of intermediaries, reducing commission costs.
The source code of applications is open for review, allowing anyone to understand the functionality of a contract or identify vulnerabilities.
Anyone can create an application and use it. New services can be created by combining other products.
Unlike the traditional financial sector, there are no supervisory dispatchers and no accounts that require complex forms to work with.
Disadvantages of DeFi:
No financial institution in any jurisdiction in the world is responsible for the actions of participants within the system. Therefore, there is no way to ask for help or service. If the user loses the password or does something wrong, it is solely his/her problem.
High volatility, including interest rates.
Uncertainty of regulation: Authorities clearly do not like the inability to control financial flows, so they can impose bans or otherwise interfere with DeFi.
Lack of funds. Compared to loans in the traditional finance sector, the amounts available against suitable collateral are relatively small.
Infrastructure failures and smart contract hacks. If a critical error occurs in any of the protocols, there is a risk of a system-wide vulnerability through which any point in the chain can be penetrated.
Fraud. In 2021, attackers stole more than $10 billion in investments using decentralized finance technology. Fraudsters issue pacifier tokens and lure investors with promises of extremely high returns. The standard scheme is to wait for trading in the pool to “heat up” and the token price to jump, then withdraw all the liquidity and disappear with the money.
Excessive hype. An overheated market risks bursting sooner or later.
Low performance in accumulating a large number of transactions. Blockchains are inherently slower than their centralized counterparts.
Cluttered ecosystem. Finding the most appropriate application can be quite a challenge.
The high cost of commissions for launching smart contracts, which can “eat up” all the profits.
DeFi-services have relatively few users. According to the service Dune Analytics, the total number of unique addresses in DeFi was slightly more than 3 million at the end of July 2021. Moreover, according to the research conducted by Chainalysis, more than 60% of the decentralized finance market transactions were over $10 million, carried out by large investors. In other words, in the early 2020s, the decentralized finance market is rather a closed club than a product for the masses.