If you’ve been exploring the decentralized world, you’ve likely come across the term “DeFi.” But what is it? Today’s article will dive into what it is, popular applications, and DeFi’s pros and cons.
DeFi, short for decentralized finance, is a movement that uses blockchain technology and smart contracts to create decentralized, open-source financial products and services that anyone with an internet connection can access. These products and services are built on blockchain networks like Ethereum and aim to provide greater financial inclusion, transparency, and security than traditional centralized finance (CeFi) systems that we are accustomed to, such as traditional banking institutions.
In contrast to CeFi, DeFi markets are always open. The middlemen (i.e. banks) are removed; therefore, no third parties can stop or block transactions. Many consider DeFi safer as it removes much of the human error, vastly increases the speed at which transactions take place, and allows for public inspection of transactions.
DeFi takes place via dapps (decentralized applications) and protocols primarily built on two main blockchains, Bitcoin (BTC) and Ethereum (ETH).
Bitcoin was the OG DeFi blockchain. It was the first of its kind, allowing people to get a taste of true ownership of their money via peer-to-peer transactions. Ethereum takes this concept a step further with its smart contract feature.
Smart contracts allow you to make cryptocurrency transactions programmable on the blockchain. In other words, you can write a smart contract to execute automatically when specific conditions are met. If the conditions don’t get met, the transaction does not happen. Let’s look at a simple example. Bob wants to pay Sue 1ETH on her birthday, June 1st, but only if her local temperature is above 75°F, according to weather.com. These two conditions, date and minimum temperature, are written into the smart contract. Once both conditions are met (It is over 75°F on June 1st), the payment will be executed automatically. If the temperature is only 65°F on June 1st, poor Sue will not receive her gift. This is clearly an arbitrary example, but I’m sure you are starting to get the gist. Also, you may be wondering how the smart contract gets the information from the outside source, in this case weather.com. This is done via Oracles, which is a complex topic for another day. For now just know that Oracles provide Ethereum smart contracts with access to real-world data to determine if or when conditions are met.
Smart contracts can be complex or simple, with no limit to the number of conditions that can be programmed. Essentially, smart contracts replace the third party in the transaction. No one can alter the smart contract once it’s live, and it will always run as programmed.
Popular DeFi Applications
Let’s look at some popular ways DeFi is being applied in the decentralized space.
Decentralized Exchanges (DEXs): DEXs are trading platforms that allow users to buy and sell cryptocurrencies on a peer-to-peer basis. Popular DEXs include Uniswap, SushiSwap, and Curve Finance.
Decentralized Lending Platforms: These platforms allow users to borrow or lend cryptocurrencies on a peer-to-peer basis. Popular platforms include Aave, Compound, and MakerDAO.
Stablecoins: Stablecoins are tokens designed to maintain a relatively stable value over time. Examples of stablecoins include USDT, USDC, DAI, and Tether.
Decentralized Insurance Platforms: These platforms allow users to purchase insurance policies for their crypto assets. Examples of decentralized insurance providers include Nexus Mutual and Opyn.
Decentralized Prediction Markets: Prediction markets enable users to trade contracts that speculate on the outcome of future events, such as an election, without the intermediary found in traditional CeFi prediction markets. Popular prediction markets include Augur and PlotX.
Non-fungible tokens (NFTs). NFTs create digital assets out of typically non-tradable assets, like digital art, videos, and memes. (Read our What is an NFT? article to learn more).
Benefits and Drawbacks of DeFi
DeFi has benefits and potential risks or drawbacks like all financial products. Many of these align with the pros and cons mentioned in our article What is Cryptocurrency?
Trustless and Permissionless: Peer-to-peer transactions remove third-party interference and associated fees.
Speed: Removal of the middleman vastly increases the speed of transactions.
Accessibility: Money can be sent and received across borders. DeFi removes the barriers encountered by groups that traditional financial institutions underserve. Anyone with an internet connection can participate.
Competition: Increases options and competition for lending, insurance premiums, etc. You can borrow from anyone, anywhere in the world.
Transparency: Control and visibility over your money.
Scams/Hackers: Unfortunately, the DeFi space is not free from bad actors trying to take advantage of others. This is a human issue, not one specific to the decentralized space.
Market Volatility- The cryptocurrency market can be volatile, contributing to DeFi companies going under. You’ve likely heard of the FTX debacle, but there have been several others as well. When this happens, you are not guaranteed to get the crypto you have on these platforms back, which leads to our next con…
No Consumer Protections- There are no consumer protections like the FDIC in CeFi, which promises to give you your money back if a bank goes under. There are also no third parties to investigate crimes or scams.
So what do you think? Do the pros outweigh the cons? Many wonder how government regulations (if/when they occur) may impact the space in the future. Regardless, DeFi is expected to expand with new applications and broader adoption worldwide.
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The content is for informational purposes only. Nothing contained in this article constitutes a solicitation, recommendation, endorsement, or offer of a security, token, or application. This is not investment or legal advice. Please do your own research.