Financial systems are evolving. Prominent among them is the emergence of Decentralized Finance (DeFi). Cryptocurrency has changed and is still changing the world. It is changing how we view financial transactions and with the emergence of DeFi, it is clear that crypto isn't done with us yet. For a newbie, it can be tricky trying to understand what decentralized finance is all about. Cryptocurrency is already confusing as it is.
If you are familiar with the concept of web3, then you already have an idea of what DeFi is all about. DeFi, which is an aspect of web3, isn't necessarily a cryptocurrency but is influenced by the already established cryptocurrency structures. DeFi allows you to perform financial transactions without needing permission from a third-party. Financial tech companies (FinTech) are starting to embrace DeFi applications for their operations, and from the looks of things, it will play a major role in our financial ecosystem going forward.
What is DeFi?
Decentralized Finance, more often called DeFi, refers to financial systems built on blockchain servers. The idea behind integrating finance systems into blockchain or web3 was to develop an ecosystem that runs independently of intermediaries. These intermediaries store users' data and regulate internet usage.
These third-parties consist of both the companies whose servers house internet structures and the government, which controls financial institutions. For centralized finance, which is the more traditional financial architecture, banks control transactions under government legislation.
With DeFi, users can transact directly with themselves. They no longer need permission as anyone with an internet connection can transfer and receive money in real-time. Money is kept in personal wallets, unlike in centralized finance, where banks keep money and facilitate its movements. DeFi users can perform all kinds of transactions, from peer-to-peer lending, borrowing, and, trading without intermediaries.
How does DeFi work?
Like every web3 infrastructure, DeFi uses a distributed database with information stored on different computers simultaneously. This structure is such that it can exist without the need for a central server. The technology is decentralized, with blockchain serving as the ledger that stores and tracks all transactions of digital assets.
Built into every blockchain (e.g. Ethereum server) by developers are smart contracts. Smart contracts are instructions developers include in the code to ensure that every bargain is fully met before the money is exchanged.
These contracts, which are open for all to view, can't be changed. They act as the major form of regulation in DeFi. Until the conditions of a contract are fulfilled, it will not perform certain functions as stipulated. Once encoded into the blockchain, these instructions operate automatically. Most DeFi projects are built on Ethereum servers. Ethereum is widely used in DeFi, with some accepting other specific assets.
Comparing DeFi with Traditional Banking
It is believed that DeFi reduces transaction costs when compared with what banks and other centralized financial institutions charge their customers. With DeFi, all bank charges are eliminated. However, some may argue that the costs of processing DeFi transactions may be more expensive for smaller transactions. Considering expenses like gas fees and others that are required for digital assets in the blockchain to be transferred, DeFi might not exactly be that cheap.
The jury is still out on the cost, but without a doubt, DeFi offers its users more opportunities to earn compared to centralized finance. Users can earn through crypto staking. Staking involves providing liquidity for DeFi apps. These apps need crypto coins available on their platform to function. They are willing to pay investors who lock their coins with them for a season. Staking allows DeFi apps to validate transactions with the help of its users.
Other yield farming avenues are available in DeFi, with proceeds considerably higher than the interest bank savings will get you. Even the least risky DeFi investment holds the potential to yield more than any kind of banking investment. But keep in mind that what we refer to as low risk in crypto can be considered high risk in centralized financial systems.
One major advantage DeFi has over traditional banking is the high level of privacy. Information stored in blockchains can only be accessed by the user. Not even the owners of the blockchain can access your information. Personal details are also inaccessible to others. A public key is used as a means of identification These security features no doubt have their advantages, but they are not without loopholes that scammers can exploit.
Just how Risky is DeFi
DeFi being new, is largely still experimental, as with the rest of Web3. Blockchain is still evolving, with its level of acceptance rapidly on the rise. Start-ups keep popping up every day. These start-ups are more open to adopting blockchain technology and it is almost impossible to tell which of them will survive. One needs to be careful when investing as DeFi projects could fail and you lose your money.
The Federal Deposit Insurance Company insures all deposits in banks, but with DeFi recovering lost money isn't all that easy. Users have total control of their assets on DeFi platforms, securing them with access keys and other means of authentication. The downside is, once this information is stolen, you can lose all your assets. One can even fall victim to crypto scams. Most transactions on DeFi are untraceable, so once you fall prey to a scam, your money is as good as gone. Beware of platforms promising incredibly high and unbelievable yields.
The crypto market is never stable because it fluctuates often. Depending on several market factors, coins may pump and dip at different times. DeFi users who stake their coins have to endure long spells of uncertainty. The unpredictability of the market means you can either lose or gain heavily from your staked coin. It also isn't uncommon for DeFi projects to be abandoned and left to die as the developers pursue new projects.
DeFi Insurance
Many are aware of how risky investing in DeFi is. To encourage more participation, decentralized insurance apps are becoming available. Groups of individuals pool their coins together, which then serve as collateral. The pooled coins or collateral are then used to protect users who desire insurance from losses. Insured users then pay a premium to those who provide their coins as collateral.
The Bottom Line
The opportunities in DeFi are endless, and so also the risks. Before investing in DeFi, one needs to take out time to do a background check on the project. Investigate the market capitalization or liquidity of the token. Know how much money is available in deposits and how long the DeFi project has been operational. Many people have made money from investing in DeFi projects, but many have also lost money. Even though the yields one can get from DeFi investments supersede traditional banking investments, the numerous risks call for a cautious approach.