From borrowing and lending to simply maintaining liquidity—DeFi platforms open up a range of possibilities for crypto usage.
Decentralized financing (DeFi) is a blockchain-based financial system that does not rely on traditional financial institutions like banks. Decentralized financing platforms allow users to trade cryptocurrencies and make available other financial services, like borrowing and lending. In 2021, DeFi industry has grown to US$80 billion, with an expected ten-fold growth by 2022. Â
Let’s look at how DeFi works and its benefits and risks to understand why it is growing at such a tremendous rate.
How does DeFi work?
DeFi is based on blockchain technology. A blockchain is a decentralized digital ledger that stores details of all transactions taking place on it. Several entities have access to information stored on a blockchain as opposed to a central authority. This means that, unlike a bank, information on a DeFi platform is not controlled by a single central source. DeFi platforms are instead governed by protocols, which are sets of rules that all users of the platform must follow.
DeFi replaces financial intermediaries with smart contracts. A smart contract is a program on the blockchain that contains all the terms and conditions of a transaction and is executed automatically once said conditions are met.
Transactions on DeFi platforms are done through stablecoins. These are cryptocurrencies whose value is pegged to a traditional “fiat” currency to prevent fluctuations. Think of it this way, if you lend someone 20 ETH (Ether), it is possible that the value of that lent amount and the interest will fluctuate. However, if you use your 20 ETH to buy a stablecoin, and then lend someone the stablecoin equivalent, your interest rate will remain unaffected by crypto market volatility.
Some well-known DeFi platforms include Maker DAO, Uniswap and Compound.
Benefits of DeFi
The lack of intermediaries is one of the biggest advantages of DeFi. This makes transactions quicker and more efficient.
Another benefit that DeFi offers its users is providing them access to liquidity pools. These are crowdsourced pools of crypto assets locked in with a smart contract. Liquidity pools allow crypto assets to be traded automatically without the buyers and sellers agreeing on a specific price. The more assets in the pool, the higher its liquidity and the easier it is to trade crypto. Liquidity is important because it makes the market easy to enter and exit.
Based on the concept of liquidity pools, crypto investors can practice yield farming. Yield farming is the practice of staking crypto assets into liquidity pools and generating a profit by receiving a percentage of the transaction costs. Investing on DeFi platforms guarantees you a much higher interest rate than those paid by other kinds of financial institutions. Moreover, both lending and borrowing parties can negotiate the interest rate, which isn’t possible with traditional financial institutions.
Risks posed by DeFi
Crypto investments on DeFi platforms have significant risks attached to them. The risks can be broken down into three main categories:
Technological risks
While smart contracts are essential to the functioning of DeFi platforms, they can also pose a major risk to the safety of crypto transactions. A mistake in the code of the smart contracts could weaken the DeFi protocol.
Crypto volatility
Crypto assets are transacted on DeFi platforms, so naturally the risks inherent to cryptocurrencies would apply to the platforms as well. When you borrow on DeFi platforms, you need to offer crypto assets as collateral. Since crypto assets are volatile, the value of the collateral could drastically change. This is why it is important to use stablecoins on these platforms to prevent the volatility of crypto from influencing the safety of your investment.
Lack of accountabilityÂ
Due to the lack of centralization, there is no regulation or insurance when you use crypto assets on a DeFi platform. Borrowers on DeFi platforms cannot be held accountable if they are unable to pay back their loans.
In spite of these risks, many invest in DeFi platforms. Trading volume on DeFi exchanges has surged by 8000% in 2021. As DeFi services run on open-source software and can be combined and modified in various ways, we are only scratching the surface of what it has to offer as it continues to develop further.
Header image courtesy of Freepik
