Decentralized finance, abbreviated as “DeFi,” is a novel concept for banking and other financial services that is predicated on the concept of peer-to-peer payments made possible by blockchain technology. DeFi enables “trustless” banking by removing the need for traditional financial middlemen like banks and brokers through the use of blockchain technology.
Table of Contents
- What Kind of Return Might Investors Expect?
- How DeFi Works
- Principal Advantages of Using DeFi
- Risks of DeFi for Investors
- How Does DeFi Differ From Conventional Banking Practices?
What Kind of Return Might Investors Expect?
DeFi makes the promise that it will provide investors with the opportunity to “become the bank” by providing them with the means to engage in peer-to-peer lending of funds and obtain returns that are greater than those offered by conventional bank accounts. Additionally, investors can instantly send money anywhere in the world, and they can access their accounts via digital wallets without having to pay the costs that are associated with traditional banking.
The way that DeFi works, the ways in which it can be beneficial to individuals, the ways in which it challenges traditional banking, and the hazards that it presents are as follows:
How DeFi Works
Loans, interest on deposits, and payment processing are just some of the financial services that individuals and businesses now have access to. The mission of DeFi is to provide these services but to do so through the utilization of decentralized technology.
In practice, DeFi transforms the industry by shifting focus from the what to the how rather than changing the nature of the products themselves. To put it another way, DeFi establishes new infrastructure in order to provide comparable monetary goods and services.
In order to accomplish this, it makes use of a variety of techniques, including blockchain technology and smart contracts. The blockchain is a type of digital ledger that may record all of the transactions that take place on a particular financial platform. You can think of it as a running record of all of the transactions that have taken place on that particular blockchain, recorded in chronological order. If Person A gives money to Person B, the transaction will be recorded in the ledger along with the current time and date.
“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 Oleksandr Lutskevych, CEO and founder of CEX.IO, a company that facilitates both DeFi and cryptocurrency transactions. CEX.IO is a company that specializes in facilitating both DeFi and cryptocurrency transactions.
To enable DeFi, smart contracts automatically perform transactions among participants. They are responsible for their own execution of the set of instructions after the criteria of the contract have been met.
David Malka, CEO of YieldFarming.com, which assists investors in generating income from cryptocurrency, says that “DeFi allows for smart contracts on the blockchain to take the place of trusted intermediaries” in peer-to-peer transactions. Trusted intermediaries include financial institutions such as banks and brokerage firms. “These peer-to-peer transactions in decentralized finance can encompass anything from payments to investments to lending and much more,”
In this version of our world, Bitcoin replaces fiat money as the standard medium of exchange and record-keeping.
“DeFi is the natural continuation of the goal indicated in the Bitcoin white paper of establishing electronic cash, so it is a very exciting time in the business,” adds Malka. “DeFi is the natural continuation of the vision outlined in the Bitcoin white paper of generating electronic cash.”
Principal Advantages of Using DeFi
Individuals stand to benefit from DeFi in a number of ways, including the possibility for increased safety, decreased expenses, expanded service options, and the opportunity to increase their income via the value of their cryptocurrency holdings. These benefits, along with others, are made possible via decentralized applications developed by a variety of entities.
Decentralized applications, or dApps, “allow people to transfer capital anywhere in the world (with fast settlement and at a low cost), peer-to-peer borrowing and lending, crypto exchange services, NFTs, and more services like crypto wallet and storage solutions,” says Lutskevych. “DApps” stands for “decentralized applications.”
“DApps are preprogrammed by developers, and depending on their purpose, they can execute transactions on a particular blockchain network, settle agreements between buyer and seller, or move assets from a decentralized exchange to a decentralized lending platform,” he says. “DApps are also known as “decentralized applications.”
In a nutshell, the only limitation is your capacity to write code for an application that carries out your orders.
The potential for financial gain is one of the most appealing aspects of investing in cryptocurrencies at the moment. The practice of crypto staking, for instance, enables owners of a coin to earn revenue while also contributing to the maintenance of the ecosystem associated with that coin by validating transactions. The practice belongs to a category of agriculture known as yield farming. This has proven to be appealing in light of the fact that interest rates offered by banks are currently around historic lows and have been for some time.
According to Malka, who works for YieldFarming.com, “anyone can supply crypto assets as liquidity or loans through something that’s called yield farming,” which compensates the depositor with interest and fees. “Putting your cryptocurrency to work in order to produce passive revenue can be accomplished through the process of yield farming.”
Many decentralized applications (dApps) require their users to have access to liquid cryptocurrencies within the app in order to offer their services. Therefore, in order to entice investors to put their coins up for some amount of time, they promise to provide an income, also known as a yield. In practice, they offer individuals who provide liquidity a source of income, which is analogous to the interest that is given on deposits at conventional banks but is subject to greater volatility (as discussed below).
Depending on the kind of decentralized application (dApp), owners of cryptocurrencies can farm yield by using a variety of services such as:
- Providing buying and selling power in a cryptocurrency exchange
- Lending money to a borrower on a peer-to-peer basis via a smart contract
- Taking out loans against holdings and then farming the money that was borrowed
- Investing in a proof-of-stake cryptocurrency like Ethereum through staking.
Consequently, investors now have access to an additional source of earnings thanks to these methods of yield generation; however, you will be required to pay taxes on cryptocurrency gains in the same manner that you would on profits from traditional sources of income.
According to Malka, “even the farms with the lowest risk yields can readily provide interest rates that are several times that of savings accounts at banks.” “This is of utmost significance during bear markets, which are characterized by a general downward trend in the price of cryptocurrencies like Bitcoin and Ethereum,”
Risks of DeFi for Investors
Despite the fact that DeFi may seem like a revolutionary step forward for the financial industry, it does come with a number of potential downsides and threats, including the following:
Participating in DeFi is not as easy as going to a conventional financial institution like a local bank. According to Malka, “beginners may find it difficult to traverse the DeFi space due to the overwhelming number of DeFi applications and investment options now available.” “Even the onboarding process can be perplexing for some people because in order to start accessing the world of DeFi, you need to move money from an exchange such as Coinbase into a noncustodial wallet such as through MetaMask,” the author writes. “This step is required.”
2. Fraudulent schemes:
There are a large number of con artists on the lookout for new cryptocurrency investors who may be drawn in by returns that are far higher than those offered by conventional financial institutions. A high yield might be an indication that something is not quite right.
Beyond the obvious cons, it’s feasible that cryptocurrency money could be stolen using exploits. This is especially possible given the flaws that exist in the coding of some decentralized applications (dApps). “Funds can be lost in these exploits, and then it comes down to the main team behind the DeFi project to decide how, if at all, to recompense the participants,” adds Lutskevych of CEX.IO. “If compensation is offered at all, it will be decided by the core team.”
The use of smart contracts comes with a cost, in the form of something called a gas fee, which functions similarly to a token in the operation of a machine. Multiple steps along the road could easily drive up expenditures, and this could be especially problematic for individuals who have limited financial resources available to them. According to Lutskevych, “it is not unheard of that a ’round trip’ can cost well over $200 in total gasoline expenses.”
Even though yield farming might help limit your downside in the very volatile world of cryptocurrencies, you will still need to be prepared to withstand spectacular volatility in order to earn what may be considered to be moderate returns.
A cryptocurrency may easily lose more than a year’s worth of yield in just one day.
6. Yield fluctuations:
On top of dealing with shifting cryptocurrency prices, participants in DeFi have to contend with yield fluctuations as well. As more supply is supported by a particular app, yields may decrease.
The core team that was creating a particular dApp may eventually go on to work on other projects, which may result in the dApp being allowed to wither and perish. “If one day, they decide to quit, the logic of the protocol will execute as it is, but there will be no further improvements,” adds Lutskevych. “If one day, they decide to quit, the logic of the protocol will execute as it is.”
These are some of the most significant dangers associated with decentralized finance, and prospective investors need to be aware of them before making a full commitment to the sector.
How Does DeFi Differ From Conventional Banking Practices?
One of the most prominent claims made by supporters of decentralized finance is that the newly developed financial technology will shake up conventional banks. In the most extreme scenario, they claim that DeFi would completely disintermediate the financial transaction process by eliminating the need for a middleman, which would then be substituted by decentralized peer-to-peer networks.
But if distributed ledger technology is so powerful, why wouldn’t financial institutions just adopt the technology and start offering it?
According to Malka of YieldFarming.com, “We are clearly seeing traditional financial institutions increasingly embrace blockchain and distributed ledger technologies.” “You’ll see this really accelerate in the next years as these traditional institutions all appreciate the intrinsic security of being on the blockchain,” he said. “You’ll see this really accelerate in the coming years.”
Malka anticipates that financial institutions will develop a variety of DeFi solutions in order to “remain competitive and relevant.”
“You can easily envisage a scenario in which a typical bank develops chances for produce farming for its customers to participate in,” he says. “You can readily imagine that happening.”
According to Lutskevych of CEX.IO, a shift of this kind would be simpler on paper than it would be in fact because of the regulatory weight. This would create challenges for traditional enterprises that even desire to make the move.
“Integrating blockchain technology would necessitate revising many well-established procedures while also exposing them to additional dangers,” he argues. “This would open up the processes to further threats.” “More importantly, subject to regulation, these institutions would require approvals from regulators in order to engage in these operations.”
Those who are interested in going beyond the fundamentals of cryptocurrency trading and getting their feet wet in decentralized finance should continue with caution and make it a priority to collaborate with a counterparty that can be trusted.
Do not let the possible return on your investment blind you to the other risks simply because the rewards that are promised by decentralized finance are appealing. Your bitcoin riches could be wiped out much more quickly by blatant scams or theft than by a sudden downturn in the market for cryptocurrencies, which could swiftly wipe out any little gains made by yield farming.