There is no coincidence that Decentralized Finance (DeFi) is pronounced as defy because the purpose of its creation is to ‘defy’ the traditional Centralized system. 

The whole point of innovation is to disrupt our usual ways of doing things. Just like how currency replaced the barter trade system, DeFi seeks to replace the traditional banking system by giving control to the regular user without involving intermediaries.

Building on this foundation of innovation, Decentralized Finance pictures a world without banks and financial intermediaries and seeks to recreate how we carry out financial transactions. That would be a beautiful sight to see. Wouldn’t it? 

Well, let’s have this conversation about Decentralized finance to see how it works and why it is worth your attention. 

Centralized Finance

Photo by Michael Steinberg: https://www.pexels.com/photo/accessories-on-table-342943/

Before we delve into DeFi, let’s briefly understand Centralized Finance for context. 

Centralized Finance operates through central exchange platforms, similar to traditional banks, where a third-party entity controls user assets and transactions. 

However, this system has limitations such as single points of failure, higher fees, and concerns over data privacy and security.

Decentralized Finance

Photo by Tima Miroshnichenko: https://www.pexels.com/photo/hands-holding-a-smartphone-with-data-on-screen-7567443/

DeFi addresses the single point of failure issue by removing the middleman and delegating the functions of the centralized system to regular people.

 It operates on a distributed ledger system called blockchain, where users can carry out financial transactions in a peer-to-peer network. It uses Smart contracts, a self-executing program that enables fast, secure, and accurate transactions.

Imagine, instead of having a single financial institution, like a bank, that controls your finances, everyone decides to keep their money in a network that allows them and other members to access it on the condition that all rules apply. 

Characteristics of DeFi

DeFi is decentralized.

DeFi is built on a distributed ledger system. It is a peer-to-peer network that allows users to carry out financial transactions. The whole point of a DeFi system is to replace a central institution with a network where everyone has equal control.

DeFi uses Smart Contracts.

A smart contract is a replacement for central authority and third parties. It is a self-executing code that only allows transactions when all agreements are in place. 

They are faster, more secure, and more accurate. Ethereum effectively uses Smart contracts as an intermediary during its transactions.

Interoperability

It is the property of the blockchain to allow transactions from other blockchains. It increases the liquidity of assets and enables an easy flow of resources between blockchains. Polkadot and Cosmos are good examples of Blockchains which allow communication with other open blockchains. 

How Decentralized Finance Works

A DeFi transaction starts with a request authenticated using private and public keys. The transaction data is then added to a block and sent to nodes for validation. 

The block is added to the blockchain after a majority of users approve the transaction. The rest of the users can see the changes made after the transaction.

Proof of work 

Cryptocurrency tokens are created through mining, a process of solving complex mathematical equations. The reward is the digital currency whose transaction is verified, and the blockchain is updated. The mining process is difficult to limit the number of transactions added to the blockchain.

Proof of stake

It is a consensus mechanism that allows you to process transactions and create new blocks.  You earn rewards when you validate transactions before they make entries into the distributed database and as you help keep it secure.

What is the point of using DeFi?

The truth is that the Centralized Finance system is getting more efficient and more secure by the day. So the big question is, why should we shift to a decentralized Finance system?

DeFi is a cheaper, faster, and more efficient alternative. 

• Cheaper

You can set up a successful financial system without building a bank office and worrying about how you will transport the money.

• Efficient

All you need to join is an internet connection and a digital wallet. You do not need to open a bank account or something of the sort. 

• Secure

The DeFi system is secure since it uses blockchain technology.  You would need to change thousands of computers called nodes to manipulate a transaction.  

Additionally, you do not need to worry about your personal information privacy since it is not required when signing up for DeFi.

DeFi transparency is on a whole new level. Once you complete a transaction, everyone can access the information through blockchains.  Would you get that kind of access in a Centralized Financial system? I don’t think so.

Shortcomings of DeFi

Despite its potential, DeFi faces challenges. The limited regulations of DeFi raise concerns about security and protection for users. 

Additionally, hackers exploit Smart Contract vulnerabilities, while the complexities of DeFi may limit mainstream adoption.

Lack of proper regulation

The absence of proper regulation is a point of concern for users and investors. Limited legal oversight leaves users vulnerable to cyber attacks, scams, and losses. 

This lack of legal framework makes it difficult to seek a possible course of action after the loss of assets. The thought of losing all your money and not knowing who to ask is scary. 

Tax records 

Governments are slowly recognizing crypto and are looking for ways to tax it. Therefore, you need to maintain your record to pay taxes. The good thing is that there are apps in the market to help you in this area.

Smart contract vulnerability 

DeFi relies heavily on Smart Contracts which are simply programs that run on a blockchain when certain conditions are met. Programs are written using codes. 

Hackers look for loopholes or bugs in this code to exploit them and use them to steal money. A SushiSwap Smart Contract bug was used to drain almost $3.3 million worth of Ethereum in a single user’s account.

Uncertainty 

It takes a long time to grasp how crypto and blockchain work, and we are still exploring this new world of digital currency. A layman would find it hard to indulge in  DeFi when they need to fully understand its technicalities.

Interacting with dApps is easier for tech-savvy individuals since it requires understanding how digital wallets work, how to interact with the interface, and what fees you need to pay. This type of complexity limits the mainstream adoption of DeFi.

Low liquidity

We cannot compare the value in currency locked in DeFi to that in CeFi. The Market Cap for CeFi and Defi is approximately $324 billion and $16 billion, respectively. Simply a pinch of salt, you can say.

Interoperability 

This is the ability of blockchains to interact with one another to increase the range of assets and tokens at the user’s disposal. At the moment, you can only be able to carry out transactions in the Blockchain you chose in the first place. Only a few blockchains can allow cross-chain interactions.

Insurance

People are still warming up to the idea of DeFi systems. Likewise, only a few Insurance companies are offering their services to DeFi clients. DeFi is a high-risk investment and you could lose your assets in cyber attacks or hacks.

How to invest in Defi

Photo by Pixabay: https://www.pexels.com/photo/grey-metal-case-of-hundred-dollar-bills-164652/

Before investing in Decentralized Finance, you should familiarize yourself with how the system works, blockchains, wallets, crypto exchanges, and market trends. The next step would be to select a reliable cryptocurrency exchange like Coinbase or Binance to create a wallet. 

You can then diversify your portfolio by staking, Yield framing, or trading stable coins as mentioned below.  

Staking

Staking is locking up your assets to support blockchain operations and secure the system. You are then given a reward in exchange for your support. 

You will receive tokens or fees generated by the network as a reward for staking. You are allowed to withdraw your stake and rewards after the staking period is over.

Yield Farming

The process allows you to earn interest or reward after providing liquidity for DeFI platforms. DeFi platforms permit you to add your tokens to a liquidity pool, which are smart contracts, that lets users deposit their tokens and allow others to trade against them. You’ll get  Liquidity pool tokens in exchange. 

Stablecoins 

DeFi systems allow users to trade stablecoins, similar to how currency on foreign exchange platforms takes place. Since the value of Stablecoins is pegged to a particular currency, they offer some form of stability when crypto prices keep changing.

What the future looks like for DeFi

Photo by Tara Winstead: https://www.pexels.com/photo/black-and-white-photo-of-human-hand-and-robot-hand-8386422/

In the book ‘DeFi and The Future of Finance‘, the authors believe that DeFi and Crypto currently have few economic uses, and they call them instruments of Speculation. There is a little bit of truth in whatever they are saying. The question is, what does the future hold for DeFi?

To realize its full potential, DeFi needs to address its shortcomings. Implementing proper regulations, increasing cross-chain interoperability, offering decentralized insurance coverage, and leveraging technologies like Zero-Knowledge-Proof can propel DeFi toward a promising future.

The shortcomings of DeFi need to be solved before we experience growth in the DeFi sector. 

• About regulations

In this conversation about regulation in DeFi, the elephant in the room is financial crime, money laundering, and cyber attack. To stamp their credibility, DeFi stakeholders need to do a risk assessment,  identify solutions to mitigate them, and share these with regulatory bodies for implementation. 

• Cross-chain transactions

We are also looking at a future that allows cross-chain transactions of tokens. It will increase liquidity pools available for investment.

Insurance is a tool to counter risk. In the case of DeFi, risk falls into two categories: economic and technical. We are looking at a future where insurance policies cover both risks.

 It can cover impermanent losses or slippage of Automated Market Markers for economic risks. It can also cover technical risks: smart contract vulnerabilities that could lead to irreversible losses.

Projects like Nexus Mutual offer decentralized insurance coverage for Smart contract risks. Users can purchase insurance to protect against Smart contract vulnerabilities and hacks, providing an extra layer of security for DeFi users.

• Technology

Technology such as Zero-Knowledge-Proof, which is making strides, could ensure data integrity, improved security, and privacy. It would reduce cases of identity theft. ZKP would allow users to carry out transactions without revealing sensitive information.

Conclusion

DeFi presents a cheaper, faster, and more efficient alternative to Centralized Finance. However, it requires overcoming challenges and building trust among users. As the technology evolves and regulations become clearer, DeFi has the potential to revolutionize the financial landscape.

What is stopping you from starting your defi journey? If you don’t know where to start, we can help you here.