DeFi, short for decentralized finance, is a new vision of banking and financial services that is based on peer-to-peer payments through blockchain technology. Through blockchain, DeFi enables “trustless” banking, bypassing traditional financial intermediaries such as banks or brokers.
What’s in it for investors? DeFi promises to allow investors to “become the bank” by providing opportunities to lend money between peers and earn higher returns than are available in traditional bank accounts. Investors can also quickly send money anywhere in the world and can access their funds through digital wallets without paying traditional banking fees.
This is how DeFi works, how it can benefit people, how it challenges traditional banking, and the risks it presents.
How DeFi works
The goal of DeFi is to provide many of the financial services that customers and businesses currently enjoy (loans, interest on deposits, payments), but use decentralized technology to do so. In effect, DeFi changes the industry not so much by changing the what but rather the how. That is, DeFi creates a new infrastructure to offer similar financial products and services.
To do this, it uses blockchain technology and smart contracts, among other tools. block chain it is a type of ledger technology that tracks all transactions on a given financial platform. Think of it as a continuous record of all transactions on that specific blockchain, recorded chronologically. If Person A paid Person B money, that would be permanently recorded in the ledger.
“The building blocks of DeFi are smart contracts, which are executable codes that can store cryptocurrencies and interact with the blockchain according to its rules,” says Alexander Lutskevych, CEO and founder of CEX.IO, a company that facilitates DeFi and cryptocurrencies.
To enable DeFi, smart contracts automatically execute transactions between participants. When the conditions of the contract are met, they auto-execute their set of instructions.
“DeFi enables smart contracts on the blockchain to replace trusted intermediaries, such as banks or brokerage firms, for peer-to-peer transactions,” says David Malka, CEO of YieldFarming.com, which helps investors earn income from cryptocurrency. . . “These peer-to-peer transactions in DeFi can include everything from payments, investments, loans, and more.”
In this world, cryptocurrency it becomes the de facto currency for transactions and records.
“DeFi is the natural continuation of the vision outlined in the Bitcoin white paper on creating electronic cash, so it’s a very exciting time in the industry,” says Malka.
Key Benefits of DeFi
For individuals, the benefits of DeFi include potentially higher security, potentially lower costs, more types of services, and the ability to earn higher income through their cryptocurrencies. These benefits and others are enabled through decentralized applications created by various groups.
“Decentralized applications, or dApps, allow people to transfer capital anywhere in the world (with fast and low-cost settlement), loans and peer-to-peer loans, cryptocurrency exchange services, NFTand more services like crypto wallet and storage solutions,” says Lutskevych.
“DApps are preprogrammed by developers, and depending on their purpose, they can execute transactions on a specific blockchain network, set up buyer-seller agreements, or move assets from a decentralized exchange to a decentralized lending platform,” it says.
In short, the only limit is the ability to code an application that executes your instructions.
A currently popular benefit for cryptocurrency investors is the ability to generate income. Crypto staking, for example, allows owners of a coin to help support that coin’s ecosystem and earn revenue by helping to validate transactions. It is part of what is called yield farming. That has proven attractive when bank interest rates have been at their lowest point for years.
“Anyone can provide crypto assets as liquidity or loans through what is called yield farming that pays the depositor with interest and fees,” says Malka of YieldFarming.com. “Yield farming is how you put your crypto to work to earn passive income.”
To provide their services, many dApps need liquid cryptocurrencies available in the app. Therefore, they offer to pay income, a yield, in exchange for investors depositing their coins for a period. In effect, they provide an income for those who provide liquidity, similar to the interest paid on deposits in traditional banks, but more risky (as discussed below).
Depending on the type of dApp, cryptocurrency owners can earn returns through various services, such as:
So these yield generation methods provide another source of profit for investors, although you will owe taxes on crypto profits just as you would with traditional sources of income.
“Even the lowest risk return farms can easily return interest rates several times higher than savings accounts at banks,” says Malka. “This is particularly important during bear markets, where the price of cryptocurrencies like Bitcoin or Ethereum are trending lower.”
DeFi risks for investors
Although DeFi sounds like a brave new world for finance, DeFi presents several drawbacks and risks for potential participants:
- Complexity: Participating in DeFi is not as simple as going to a local bank. “DeFi can be challenging for beginners due to the sheer number of DeFi applications and investment opportunities out there,” says Malka. “Even the onboarding process can be confusing for some people because you need to move money from an exchange like base of coins in a non-custodial wallet, such as through MetaMask, to start accessing the world of DeFi.”
- Direct scams: Many scammers seek to ensnare new crypto investors lured by returns that can drastically exceed those offered by traditional financial institutions. High performance may well be too good to be true.
- Theft: Beyond outright scams, it is possible for cryptocurrencies to be stolen through exploits, especially given the coding vulnerabilities in some dApps. “In these exploits, funds can be lost, and then it’s up to the core team behind the DeFi project to decide how to compensate the participants, if at all,” says CEX.IO’s Lutskevych.
- Cost: Interacting with smart contracts requires what is called a gas fee, like a token to run a machine. Multiple steps along the way could easily add to costs, and that could prove especially costly for those with modest funds. “It’s not uncommon for a ’round trip’ to cost more than $200 in gas fees,” says Lutskevych.
- Volatility: While yield farming can help mitigate your downside in the volatile world of cryptocurrencies, you will still have to put up with surprising fluctuations to reap what could be modest returns. In one day, the cryptocurrency could easily lose the performance of a year and more.
- Fluctuating returns: In addition to fluctuating cryptocurrencies, DeFi participants have to deal with fluctuating returns. Yields can drop as more supply supports a given app.
- Dying Projects: Ultimately, a given dApp can be left to die on the vine as the core team developing it pursues other projects. “If, someday, they decide to drop out, the protocol logic will run as-is, but no further updates will be made,” says Lutskevych.
Those are some of the biggest risks in DeFi and ones that investors thinking about getting involved need to understand before fully committing.
How does DeFi challenge traditional banking?
One of the biggest claims made by DeFi proponents is that this new financial technology will disrupt traditional banking. In the extreme case, they say DeFi would completely disintermediate (cut out the middleman) in financial transactions, to be replaced by decentralized peer-to-peer networks.
But if DeFi is so powerful, why don’t banks just co-opt the technology and offer it?
“We’re definitely seeing traditional financial institutions take advantage of blockchain and distributed ledger technology more and more,” says YieldFarming.com’s Malka. “You will see this really accelerate in the next few years as all these traditional institutions recognize the inherent security of being on the blockchain.”
Malka expects banks to create various DeFi products “to remain competitive and relevant.”
“You can easily imagine a scenario where a traditional bank creates yield farming opportunities for its clients to participate in,” he says.
But such a switch would be easier on paper than in practice due to the regulatory burden, says CEX.IO’s Lutskevych, creating complications for traditional companies that even want to do so.
“Blockchain technology integration would require review of many well-established processes and open them up to additional risks,” he says. “Furthermore, subject to regulation, these institutions would need approvals for these activities from regulators.”
Those looking to get started in DeFi, beyond the basics of cryptocurrency trading, should proceed carefully and ensure they are working with a trusted counterparty. Although the returns offered by DeFi are attractive, don’t let the potential return blind you to the other risks. A downdraft in the crypto markets could quickly wipe out any small gains from yield farming, and outright scams or theft could wipe out your crypto wealth even faster.