DeFi: Should You Buy or Stay Away?
If you have been interested in cryptocurrencies for long, you may have come across the term DeFi. That is, Decentralized Finance, or one of the terms associated with it, such as dapps, stablecoins, or smart contracts. It can be confusing to have to learn a whole new jargon, but once it is explained, you can better decide if DeFi is the right choice for you.
What is DeFi?
Decentralized Finance, at its root, simply means taking finance – savings, loans, insurance – out of conventional financial institutions like banks, and distributing it over a decentralized blockchain. This means that financial services are non-custodial – meaning that there is no third party in control of the funds. They’re also permissionless – meaning that there is no need to apply for, say, a loan through a lending institution’s procedures.
To understand this, first, consider how loans are conventionally made. People deposit their money into a bank. The bank holds that money as capital. Someone applies for a loan at that bank, and if the bank approves the loan, the deposited money is loaned out. The bank charges the borrower interest, and the depositor gets a cut of that interest as payment for allowing their money to be lent.
So as a borrower, you are not actually borrowing from the bank; you are borrowing from someone whose money the bank is managing for them. DeFi eliminates the bank from the equation. With DeFi, you borrow money directly from the person whose money it is.
Peer-to-Peer (P2P) is a form of network that allows individual users to interact as equals. In its early days in the 1990s, P2P was used a lot in file-sharing platforms, which, unfortunately, led to problems with piracy, as copyrighted materials were copied and shared. However, abuses such as these need not deter you from legitimate use of P2P networks. Blockchains are inherently P2P networks – each node maintains a copy of the blockchain, and all nodes compare their copies. In effect, this forms a public ledger.
Malicious activity or inaccuracy shows up as a discrepancy in one node, which is rejected by the other nodes. This system allows individuals to lend and borrow without the need for a financial institution to keep records – the transaction is permanently and publicly recorded in the blockchain. This allows you to find the most favorable terms, not dictated by the profit motive of a bank. This also allows you to obtain a loan without a credit score, and to access the service in low-income places that banks avoid.
One disadvantage of P2P lending is that, currently, loans must be over-collateralized. That is, you must lock up assets – typically cryptocurrency – exceeding the amount of the loan. If you had 150-200% of the loan amount, would you need a loan in the first place? There is also little protection if for some reason your smart contract is hacked. DeFi is still an emerging technology, and as it matures, it is likely problems like these will be solved, but until then, it is not the right approach for everyone.
Features of DeFi
Besides the key feature of being built on a blockchain, DeFi has certain other features that make it attractive compared to conventional financial institutions. First, because it is built on a decentralized blockchain with thousands of nodes, it is very difficult for anyone, governments included, to freeze or drain your assets. Anyone who wanted to do this would need to gain control of the majority of nodes – a very difficult and complicated task in a blockchain with thousands of widely scattered nodes. In the same manner, this system prevents third parties from blocking payments.
Another feature of DeFi is the smart contract. Unlike a paper contract, a smart contract is a computer program, with the terms of the contract written into the code. When the specified conditions are met, the contract automatically executes.
Dapps (Decentralized Apps) are the main mode of accessing DeFi. One advantage of dapps is that not only are they open source, but if you have the coding skills, you can build your own, with the features that matter to you.
Transactions Without Borders
From its inception, DeFi was designed to be fully international, equally accessible whether you live in an industrialized nation or a developing nation. Most dapps are accessible to anyone with an internet connection. Also, DeFi was designed to operate based on cryptocurrencies, which are themselves international, since they are not issued by governments.
If you do business across borders – say, your supplier is in another country – you know that international wire transfers take time and often involve fees. In contrast, by borrowing money from a DeFi platform such as MakerDAO or Compound, you can complete an international transaction the same day.
DeFi can also help to protect the assets of people in countries with unstable currencies. Argentina, for instance, has for decades, experienced runaway inflation and devaluation of its currency. Although there is a legal limit to the number of US dollars an Argentine citizen can buy, no such limit applies to the DAI stablecoin, which is pegged to the dollar.
Stablecoins and Tokens
Stablecoins require some explanation. One feature of cryptocurrencies is that they are so frequently traded and speculated, their value can be volatile. For this reason, there are now alternative cryptocurrencies known as stablecoins. One of the best known is called the US Dollar Coin (USDC), whose value is the same as a US dollar.
Stablecoins can also be pegged to commodities such as gold. This captures something of the best of both worlds: the greater stability of fiat currencies, with the speed and low transaction cost of cryptocurrency.
A similar concept used in DeFi is known as tokenization: the owner of some tangible asset – a parcel of real estate, say – will create digital tokens valued at some fraction of the value of the asset.
This allows shares of the asset to be sold to multiple investors without the need for brokers and their fees. The tokens then appreciate or depreciate as the asset itself does.
One DeFi platform, Aave, offers a unique feature known as flash loans. Unlike most DeFi loans, which must be over-collateralized, flash loans require no collateral. This is because if the borrower fails to repay, the transaction simply reverts as if there never was a loan. This means that they are a zero-risk loan, something unheard-of in conventional finance.
Flash loans are primarily a tool for arbitrage, which is, buying cryptocurrencies on one exchange at a lower price, and selling them on another for a higher price. It can also be for refinancing, that is selling a loan with one interest rate for one with a different interest rate.
In a flash loan, the initial loan, the trades, and the repayment all take place in a single transaction, within a single block of the blockchain. Flash loans have become controversial in that some users took out very large flash loans and make huge profits on their trades.
There are now debates as to whether such actions are legitimate, or are to be considered “attacks” or “hacks.” Nevertheless, zero-risk loans can be attractive to someone without collateral.
A Growing Trend
As of this writing, there are US$2.13 billion locked in DeFi, of which the three largest platforms are Compound at US$641.2 million, Maker at US$629.3 million, and Synthetix at US$388.1 million, all using the Ethereum blockchain. Although this is as yet a small fraction of the amount of money still circulating in conventional finance, DeFi shows an overall growth trend since 2017, and the steepest growth so far since April 2020.
At present, there are some obstacles to the growth of DeFi, one of which is that the user experience is not very intuitive to those without technical know-how. Another is that bugs in the code of the smart contract could create irreversible erroneous transactions.
As the technology matures, however, we should expect solutions to these problems, and DeFi will be increasingly attractive as the cashless economy and increasing government surveillance becomes burdensome for increasing numbers of people.
DeFi Video explanation
DeFi is a multifaceted project with many coins and blockchain projects under the DeFi umbrella. We didn’t mention all the details in how they all work together but this video does a great job in covering how all these projects will work seamlessly together to support the DeFi environment.
Decentralized Finance is as yet young, with lots of potential for growth and innovation. Its open-source nature allows creative individuals to join in the action even without large amounts of startup capital, and its public ledger stored on the blockchain eliminates the need for vetting borrowers for trustworthiness.
Because it is permissionless, you do not have to have a good credit score or go through a bank’s procedures. All you need is to buy the initial cryptocurrency (usually Ethereum), and you are set to begin.
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