What is DeFi?

DeFi (short for Decentralized Finance) has been a very popular trend since 2020, with many well-known DeFi coins namely Alpha, Uni, KLC, … Many may be aware of this type of coin, but do not fully understand what it is basically. Therefore, this article may spread the light on the foundation knowledge about the DeFi trend, and guide the investors to make more precise decisions.

Definition of DeFi

Before going into the definition of Decentralized Finance, it is important to get a brief understanding of Fiance. Basically, finance represents the process of managing money from the one who has to the one who needs it. This process is traditionally controlled inside the society by an organization or government, such as banks, or funds, who act as an intermediary. This type of finance is called Centralised Finance (CeFi).

However, with the development of blockchain, the technology behind the digital currency bitcoin, people can now operate the financial system without the control of these intermediaries. That financial system is called Decentralized Finance (DeFi). With DeFi, the markets are always open and there are no centralized authorities who can block payments or deny you access to anything. Services that were previously slow and at risk of human error are automatic and safer now that they’re handled by code that anyone can inspect and scrutinize.

In DeFi, a smart contract replaces the financial institution in the transaction. A smart contract is a type of Ethereum account that can hold funds and can send/refund them based on certain conditions. No one can alter that smart contract when it’s live – it will always run as programmed.

Benefits of DeFi

Compared to the traditional financial system, DeFi has several advantages that can be listed as below:

DeFi Traditional finance
You hold your money. Your money is held by an intermediary.
You control where your money goes and how it’s spent. You have to trust intermediaries not to mismanage your money, like lending to risky borrowers.
Transfers of funds happen in minutes. Payments can take days due to manual processes.
Transaction activity is pseudonymous. Financial activity is tightly coupled with your identity.
DeFi is open to anyone. You must apply to use financial services.
The markets are always open. Markets close because employees need breaks.
It’s built on transparency – anyone can look at a product’s data and inspect how the system works. Financial institutions are closed books: you can’t ask to see their loan history, a record of their managed assets, and so on.

(Source: Ethereum.org)

Classification of DeFi projects

DeFi can be classified according to its usages:

  • Decentralized Exchange (DEX): (e.g. Uniswap) is a type of cryptocurrency exchange that allows for direct peer-to-peer cryptocurrency transactions to take place online securely and without the need for an intermediary.
  • DeFi Stable Coin: (e.g. MakerDao): A decentralized cryptocurrencies that attempt to offer price stability and are backed by a reserve asset
  • DeFi Insurance (e.g. Nexus): Decentralized insurance aims to make insurance cheaper, faster to pay out, and more transparent. With more automation, coverage is more affordable and pay-outs are a lot quicker. The data used to decide on your claim is completely transparent.
  • DeFi Lending: (e.g. Compound)
  • DeFi Derivatives (e.g. Perp)

And the list keeps going on …

 

Future challenges to DeFi

With this new development, it can be expected to be a new era in the financial industry, with new coins and projects built on DeFi technology. However, this new crypto coin has its own challenges which make it hard to self-enlarge:

  • Complexity: The goal of any financial system is to provide a scattered application that can be used by everyone to borrow and to lend without much complexity. However, based on a new technology that requires a basic knowledge of crypto to jump in. Therefore, the convenience is what prevents DeFi from reaching a larger number of users.
  • Software risk: DeFi is still in the beginning stages of its evolution, so bugs related to software are unavoidable. Software systems can malfunction due to a wide variety of factors. For example, what if an incorrect input causes a system to crash? Or, if a compiler (which is responsible for compiling and running code) errs. Who is liable for these changes?
  • Manipulation risk: DeFi, as being said above, is not being controlled by any government and organization, all the transactions are borderless in DeFI. So this means that the current law is inapplicable, and it raises questions inside its regulation. For example, who is culpable in a financial crime that occurs across borders, protocols, and DeFi apps? Also, until this moment, all the rules are written on smart contracts (law represents a set of rules that are written and enforced through immutable code). That is why the DeFi ecosystem is still riddled with infrastructural mishaps and hacks. Scams also abound in the rapidly evolving DeFi infrastructure. DeFi “rug pulls,” in which hackers drain a protocol of funds and investors are unable to trade, are common.

These and many other questions need to be worked out before DeFi becomes a mainstream system used by the masses. The opportunities and challenges of DeFi are still ahead for upcoming projects to solve and prove to be trustworthy for the public.

References:

Decentralized finance (DeFi) https://ethereum.org/en/defi/#defi-use-cases

‘People have been participating without understanding the risks’: Here’s what to know about cryptocurrency-based DeFi https://www.cnbc.com/2021/06/18/whats-defi-crypto-based-decentralized-finance-explained.html

Decentralized Finance (DeFi) Definition https://www.investopedia.com/decentralized-finance-defi-5113835

What Is DeFi? https://www.coindesk.com/learn/what-is-defi/

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