A new alternative to traditional banking has recently gained popularity called Decentralized Finance, also known as DeFi.
What is DeFi?
DeFi or Decentralized Finance is a term that describes an emerging group of financial applications built on the Blockchain or other Distributed Ledger Technology, intending to remove the intermediary. Allow individuals to get involved in complex financial transactions without needing a Bank or any other Financial Service provider. All terms and conditions associated with the transactions are automated with the help of Smart Contracts and executed in decentralized programmable networks like Ethereum.
DeFi builds on top of the initial ideas that make up Bitcoin, allowing individuals to be involved in financial transactions without revealing their identity, providing transparency, and giving people control of their assets. The underlying technology, usually a Blockchain, will provide the necessary security mechanisms and ensure the terms & conditions are executed as agreed upon and programmed.
How does DeFi work?
There are many different DeFi protocols currently that you can use; some of them provide similar products to the ones provided in traditional Finance in a decentralized model, while others explore and provide new innovative financial products. As an example, let’s look into the case of how lending works in Centralized Financed (CeFi) and Decentralized Finance (DeFi). The following example is not currently realistic but rather demonstrates how a typical CeFi case could work on DeFi.
In Centralized Finance, when you want to take a loan to buy a house, you need to go to a local bank, open a bank account, provide them with some personal information, paperwork and the bank has to approve you as a client. Assuming you are approved as a client, you request a loan. Again, you need to provide your bank with even more information about your financial situation and associated documentation. The bank will look into your credit score and whatever other policies they have in place and approve your loan.
Once your loan is approved, you will have to pay the amount you borrowed back to the bank with interest in monthly payments for the next 30 years as agreed. To reduce risk, the bank will then take your loan and issue financial products like Mortgage-backed securities for various interested investors. From the interest you pay, investors will profit as well as the bank. You might also need to provide your house as collateral on the deal. Depending on the terms and conditions, the bank might take your real estate if you don’t make your monthly loan payments to pay the debt.
In Decentralized Finance, in theory, the idea is that you get access to loans or financing without the need of providing any paperwork, formalities, or go through KYC. All terms and conditions are coded with Smart Contracts on the Blockchain. Lenders and Borrowers can lend or borrow money using the Smart Contracts built on the Blockchain.
First, consider an ideal scenario that mimics the one we described above – you need to take a loan to finance the purchase of your house. First, you simply create a wallet on your own, and then you transfer funds to it. A wallet can be seen as your private account at the bank where you store your funds. A DeFi protocol with coded terms allows you to borrow any amount you want; under the conditions that you provide your real estate as collateral, and the collateral will be of equal amount as the amount borrowed.
Furthermore, the contract says that you will have to make your monthly payments of X amount for 30 years. In case you don’t make your monthly payments for a pre-specified amount of time, then the ownership of your house will be transferred to the protocol, and it will be sold to cover your debt and pay your lenders. The lenders use the same protocol to deposit the funds you borrow under the same terms and conditions. The lenders make their profit from the interest payments you make every month.
The big difference between the two cases is that you don’t need an intermediary entity to match lenders and borrowers. Lenders and Borrows can match with each other using Smart Contracts, thus reducing the added overhead and risk of having intermediaries to orchestrate transactions.
As of today, taking a loan on the Blockchain using real assets as collateral is not possible. Instead, the various protocols allow you to deposit another digital asset such as ETH or BTC as collateral only. In case the value of your collateral falls below a certain threshold, you will either have to deposit more assets to maintain your loan, or the smart contract will automatically sell your assets and repay the debt.
Providing a physical asset as collateral on the Blockchain, like real estate, is not a trivial task to achieve. However, we have already started seeing projects like Centrifuge, bringing real-world assets to DeFi. Potentially, one day, we might see DeFi products equivalent to the ones provided by CeFi.
What are the different types of DeFi protocols?
There’s a very long and complicated list of DeFi protocols out there as of March 2022. Below we selected a list of DeFi protocols that resembles products and services of Centralized Finance.
- Payment Solutions: There are many DeFi protocols and blockchains that focus on providing efficient network in making payments seamless. In some cases, the transactions fees can be lower than the ones provided by traditional financial institutions. Bitcoin is the most popular protocol in this category.
- Lending & Borrowing: As we also describe above, users can lend their money and earn interest on them in the various Lending platforms. At the same time, users can borrow assets from Lending platforms by providing another digital asset as a collateral. MakerDAO, Aave and Compound are among the most popular lending protocols on Ethereum Network.
- Trading (Decentralized Exchanges or DEX): That’s potentially the most popular use-case of DeFi protocols, with many subcategories. Decentralized exchanges allows you to trade on the blockchain and exchange one asset for another. Moreover, Decentralized Exchanges allows users to become liquidity provider, deposit their assets on the exchange and earn interest. The most popular DeFi protocols in this category started from Ethereum include: Curve Finance, Uniswap and Sushiswap. Other notable names on this list from other networks include Pancakeswap on Bincance Smart Chain, Trader Joe on Avalanche, Osmosis, Quickswap on Polygon, Solidly on Fantom, etc.
- Insurances: Decentralized Insurance products offer complete protection of DeFi deposits, hedge risk against crypto volatility and flash crash as well as provide security against the risk of theft and attack on crypto wallets. Armor and Nexus Mutual are the two biggest insurance protocols on Ethereum network by Total Value Locked.
- Others: Derivatives and Options trading, Bridges, Launchpads, Reserve Currencies, Stablecoins are among the many types of DeFi protocols in existance today.
What are the benefits of DeFi?
The benefits of DeFi protocols are primarily similar in nature to the benefits provided by the underlying technology, the Blockchain.
- Accessibility: Allows anyone with an internet-enabled device to participate. You don’t need to open an account to participate in the various DeFi protocols. You simply need to create a wallet and transfer funds to it.
- Anonymity: You can participate in most DeFi protocols without providing your personal information or revealing your identity.
- Control: You have control over your assets. You can transfer your assets to anyone at any time without asking for permission.
- Transparent: All actions taken on the network, are recorded on the Blockchain and are immutable. Everyone can go and see all the transactions executed on the ledger.
- Automation: With the use of smart contracts, you can automate many of your processes and transactions.
- New Opportunities: The technology and sector provides new opportunities for investors to invest their money, businesses to automate and improve their processes, entrepreneurs to provide new innovative products.
What are the shortcomings of DeFi?
- Lack of Control: Although blockchain technology gave users control over their assets, it takes away safety. With traditional banking there are mechanisms in place that provide some safety to your assets. In DeFi, if you get scammed or your funds are stolen, there’s not a lot that can be done.
- Technical know-how: Let’s face it, wallets, cryptography, hashes, private keys, smart contracts, blockchains, tokens, pass phrases, etc. The technology, although extremely powerful and useful, it is still in very early stage. The users need a lot of technical know-how to use the various protocols.
- Risks: Being in crypto market, you are exposed to market risk and high volatility. Participating in DeFi protocols, there are many other risks such as protocol exploits by hackers, rugpulls by scammers and many others.
- Regulatory uncertainty: Although we see that regulators have started taking actions in the space, there are still a lot of uncertainties around regulatory frameworks on many aspects of using crypto or DeFi.
- Self-Reliance: Banks & Financial service providers rely on experise, complex financial models and tools to advice their clients. These tools may not be perfect, but can recommend whether an investment product is suitable for you based on your risk profile, or whether a financing deal fits your financial situation. When you use the various DeFi protocols, you have to make these assessments on your own.
Decentralized Finance will continue to grow over time; new protocols will appear that we haven’t seen before, and existing protocols will be improved and expanded to new use-cases. Moreover, we will see more products in Decentralized Finance resemble more than those found in Centralized Finance.
DeFi won’t replace CeFi completely. Building every financial process and product might not be efficient in a decentralized environment. As Vitalik Buterin, founder of Ethereum, said in one of his interviews, the decentralized world will somehow co-exist with the centralized world. Only time will tell how the two worlds will evolve and how close they will come together.
Final remarks for new DeFi users:
- DeFi is not a paradise. In 2021 alone, according to Yahoo Finance, there were 1.3B dollars lost to scams and rug pulls.
- Not everything under the umbrella of DeFi is Decentralized. Many protocols rely on teams who have full control over the decisions associated with protocol changes. How does this sound to you? Centralized. Topic for another article.
- There’s a misconception that DeFi eliminates the fees that banks and other financial companies charge for using their services. There are still fees that you pay for using the network and some DeFi protocols. These fees are used for maintaining and developing the protocols.