DeFi is an acronym for the phrase decentralised finance, which generally refers to digital assets and smart financial contracts, protocols and decentralised applications (DApps) built on Ethereum. Simply put, it is financial software built on a blockchain that can be linked together like Money Legos.
To find out about the products and services that exist in the Ethereum DeFi ecosystem, you can check the DeFi ranking, which tracks the current value encapsulated in popular DeFi smart contracts.
Computers have disrupted almost every industry over the years. Every innovation builds on the previous one, and digital products and services have become increasingly sophisticated. Thanks to technology, we have provided the world to meet our needs. Software – from digital assistants to home automation – now affects many aspects of your daily life. So why will the money be different?
An opportunities and risks of decentralised finance
Decentralised finance is the next logical step in this adventure. It aims to create financial instruments based on smart contracts that automate transactions without any interference from central authorities.
These smart contracts can be as simple as they are complex. Various decentralised applications offer services such as lending and borrowing money, betting on events without the use of exploitative websites or participating in a win-win lottery.
The potential for this is incredible. Imagine buying a house with a smart contract, which states that if you send a certain amount of money every month and after a certain time, the title of the house becomes yours. No need to borrow from the bank, no need for notaries or lawyers, and if you default on your payments? The title is returned to the seller.
The available research considers the use of DeFi as one possible avenue for developing financial market innovation capacity. The so-called basic set of financial services already has its decentralised counterparts. However, the range in DeFi is constantly evolving and authentic products and services are emerging. According to expert estimates, for users who perceive the concept of a “financial market” in the traditional sense, it is primarily the stability that is valued highly.
This is why the initially high-risk, innovative DeFi industry is being restructured and, in response to user demand, is starting to offer analogues of “stable” services: “deposits” and “bonds” with fixed interest rates. The development of these kinds of products is driven, among other things, by the rising public debt in developed countries, acceleration of global inflation and global financial crises, as well as users’ search for alternative returns.
In addition, services that reduce user risk are being developed: price indices and forecasting services. Decentralised indices operate exchange-traded funds (Exchange Traded Funds, ETFs) on the traditional financial market. The rapid growth of this segment is primarily due to the opportunity to diversify portfolios, saving time and effort for research and asset allocation. Index tokens entitle you to receive a portion of the platform’s profits from the underlying assets’ growth; some protocols also provide investors with management tokens. DeFi allows leveraged trading (protocol specifics determine leverage size).
DeFi applications pose a number of risks, some of which are inherent to DLT-based systems, while others are driven by innovations in the architecture and operation of such markets. DeFi risks are further described from the perspective of monetary, financial regulators, and financial market consumer protection authorities (interpretations of risks vary depending on the specific work of the regulators in the respective jurisdictions).
At present, the scale of DeFi’s application relative to traditional finance is small, so it is not yet a source of systemic risk. However, in the event of significant expansion of DeFi to a scale that is substantial relative to the size of the economy, it will become a source of the same systemic risks that are that are inherent in traditional finance.
As noted in international studies, the current lack of legal certainty regarding DeFi, which should be primarily aimed at protecting investors and consumers, as well as market integrity, and reducing the opportunities for illicit funding creates risks for participants. To date, in DeFi, in the absence of regulation, users bear risks due to the following factors: higher volatility of crypto-assets (including in the automatic liquidation of positions) high leverage, smart contract errors and risk of hacking, insecure or abusive use of administrative keys, errors on the oracle side, loss of keys to their assets by users, and lack of technological and financial literacy.
However, in the event of a breach or failure of DeFi protocol or loss of property as a result of the default, users cannot take legal action against a specific responsible party because there is none. At the same time, it is difficult to implement procedures protocol resolution procedures are difficult to implement (there are no formalised requirements).
Users may also face the risk of strategy – a mass exodus of users as a result of the relative profitability of the protocol in relation to its counterparts, the realisation of risks for a critical mass of users.
Examples of popular DeFi applications
There are many different DeFi products and services , some of which you may find familiar to existing financial services but with a decentralised approach.
Perhaps the most popular and fastest growing sector of DeFi is the borrowing and lending platforms. Like a bank, users invest money and receive interest from other users borrowing their assets. In this case, however, the assets are digital, and smart contracts link lenders to borrowers, enforce the terms of the loans and distribute the interest. And all this happens without the need to trust each other or the intermediary bank. And by eliminating intermediaries, lenders can generate higher returns and a clearer understanding of risk thanks to a transparent blockchain.
Tokens, called stablecoins, are also important to the DeFi ecosystem. You might get the impression that all cryptocurrency is unstable. However, stable coins are tokens designed to hold a certain value, and they are usually tied to a paper currency such as the US dollar. For example, DAI is a stable coin, pegged to the US dollar and backed by ether (ETH). For each DAI, there is $1.50 of ETH encapsulated in a MakerDAO smart contract as collateral.
Another type of popular DeFi application is what is called decentralised exchange , or DEX for short. DEX are cryptocurrency exchanges that use smart contracts to enforce trade rules, make transactions, and process funds securely when needed. When you trade on DEX , you have no exchange operator, registration, identity verification or withdrawal fees.
Today, the largest exchange in DeFi is Uniswap. It is essentially a combination of software based on the Ethereum blockchain. On Uniswap, people can exchange cryptocurrency using smart contracts. Users don’t even need to store their funds on the exchange, they simply allow a couple of participants to use their smart contracts from the security of their private keys and wallets.
The problem DeFi has caused is the extreme use of the Ethereum network, which in turn has led to higher exchange fees. The popularity of Ethereum to create these smart contracts required more network resources and led to higher transaction prices. Now new exchanges are finding creative solutions that do not rely on Ethereum.
Polkaswap is an open-source, decentralised exchange that will put your cryptocurrency into a better fund to earn interest on your investment. The exchange relies on its own network (Polkadot), which is designed to avoid the high transaction fees that have become problematic for Ethereum-based exchanges.
For the developing world, decentralised exchanges will be nothing short of a game-changer, especially for those left behind by the traditional system. But the rest of us will still find affordable interest rates extremely attractive in a global market where many countries are now looking at negative interest rates on their government bonds.
Inevitably, and especially in times of crisis, crypto has attracted a lot of interest, both because of its merits and because of the drawbacks of the traditional centralised financial system.
DeFi is still in its infancy and shows potential to become an important part of the future global economy.