In 2018, a group of software developers and entrepreneurs was trying to decide what name to give to their movement of new-breed financial services that would be automated, built on blockchains, and capable of competing with traditional banks…
Three years later, decentralized finance (DeFi) is a large business: a user with a crypto wallet can easily trade digital assets, get loans, or take out insurance. Today, DeFi is a financial technology movement aiming to build new-breed financial services on a blockchain.
But how do DeFi applications work? Do they involve any risks? Keep on reading to learn all the essentials of decentralized finance.
Table of contents:
- What is DeFi?
- How is DeFi different from Bitcoin?
- DeFi use cases
- Does DeFi involve any risks?
- Advantages and disadvantages of DeFi
- The future of DeFi
What is DeFi?
Decentralized finance is a complex term, so the best way to approach its definition is by focusing on its unique characteristics.
Trait 1: Decentralization
Decentralized finance refers to many types of blockchain-based assets that are traded on decentralized exchanges and other platforms. This is one of the core tenets of DeFi that makes it so different from centralized finance.
Financial transactions on a blockchain network are recorded in the blockchain. These nodes are secured with cryptography, keeping tabs on each other to ensure nothing has been altered or tampered with.
DeFi aims to build a financial system that is completely decentralized and can function even in the face of different regulatory regimes.
To achieve it, DeFi uses blockchain technology.
The most well-known blockchains are Bitcoin and Ethereum.
Trait 2: Governance
The decision-making processes at DeFi organizations are decentralized as well. When a decentralized application gains traction and attracts more users, it can be programmed to transfer control from a small group or individual to the community.
A decentralized autonomous organization is a blockchain-based entity that has its rules embedded in programming code and may issue governance tokens, giving holders of those coins a say in decisions.
This is a common scenario across many DeFi products.
Trait 3: Peer to peer
One of bitcoin’s key innovations was enabling digital payments directly between two users without having to go through a bank or other payment company. There are no third parties whose services could potentially be censored by the government for political reasons. It was designed to be a digital form of currency for peer-to-peer payments.
Decentralized finance applications can also be peer-to-peer.
In a traditional stock transaction, an order may pass through a series of intermediaries – like a broker or exchange – while the shares are held at a custody bank, which users expect to keep the securities from getting lost or stolen by storing them securely. By contrast, a DeFi exchange doesn’t have those intermediaries.
Suppose you use a decentralized exchange built on the Ethereum platform to trade crypto tokens. In that case, those assets will end up in your wallet, facilitated by the exchange’s automated programs called smart contracts. That means fewer parties take a cut of your transaction.
How is DeFi different from Bitcoin?
Bitcoin is a decentralized digital currency with its own blockchain that is primarily utilized as a store of value. In contrast, DeFi describes financial services that are built on public blockchains such as Ethereum.
- Bitcoin = digital currency with its own blockchain
- DeFi = financial services built on top of public blockchains
These services enable users to enjoy various benefits – for example, generating interest or borrowing against their cryptocurrency holdings. DeFi is a collection of various applications for financial services such as trading, borrowing, lending, and derivatives in line with smart contracts and DeFi protocols.
DeFi use cases
DeFi uses various mechanisms to deliver financial services without the involvement of banks. As the decentralized apps (dApps) market grows, DeFi covers more and more use cases.
The most popular use cases of DeFi include:
- sending money to any user in the world fast and affordably,
- storing money using crypto wallets,
- borrowing and lending on a peer-to-peer level,
- trading cryptocurrencies anonymously,
- a broad range of tokenized versions of investments such as stocks, funds, other financial assets and non-fungible tokens (NFTs).
Other common uses of decentralized finance are: crowdfunding, insurance, and lending apps, where users can generate interest from loans (for example, flash loans).
Decentralized exchanges (DEXs) facilitate peer-to-peer financial transactions and let users retain control over their money. Digital wallets in this space may operate independently of the largest cryptocurrency exchanges and give users access to everything from cryptocurrency to blockchain-based games.
Another interesting DeFi use case is stablecoins. While cryptocurrencies are notoriously volatile, stablecoins attempt to stabilize their values by tying them to non-cryptocurrencies, like the dollar.
Finally, there’s yield harvesting or farming. This is a riskier practice by more advanced users that scans through a myriad of DeFi tokens in the hopes of finding opportunities for larger returns from lending.
Does DeFi involve any risks?
Like all other new blockchain networks trading in cryptocurrencies, DeFi applications are risky – especially for novice users lured by the potential gains of yield farming and passive income.
Ethereum has security and scam prevention guidelines due to broader potential risks. Unfortunately, fraud and crime continue to be persistent issues in this space as well. All security lies with smart contracts that support a given application. Most of the fraud or thefts use errors in this area.
Advantages and disadvantages of DeFi
DeFi pros
A decentralized financial platform (DeFi) is a financial system for sending and receiving digital tokens that doesn't rely on a central authority. Decentralization makes DeFi difficult to censor or manipulate, but it requires some heavy-duty computing power. Maintaining a database and records across a network of many computers slows the process down and makes transactions more expensive.
Ethereum is the most popular blockchain for DeFi applications, but a large amount of computing now taking place increases fees and impacts the network. As developers try to find ways to make it more scalable, alternative chains like Solana and Avalanche are picking up momentum.
What is more, you and your passcode are the only things keeping your assets safe. If you lose your passcode (or someone steals it), your crypto assets are gone for good. While DeFi services like loans and trades are accessible to anyone with an internet connection, the freedom to use them without traditional financial credentials – like identification or a credit score – may prove dangerous.
DeFI cons
While this promises to extend financial services to parts of the world that are underserved, or where such services are expensive or prone to fraud or confiscation, there is a downside to consider. If there is no entity keeping track of who is using a service or where they are located, criminals could use such a financial system or run counter to sanctions.
The code in DeFi applications is typically open-source, which means it’s there for everyone to see and to innovate with. However, that also makes it easier for hackers to attack. A growing number of people understand the need for formal verification – the process that uses algorithms to analyze other algorithms for glitches.
Then there’s the question of compliance. Current regulations were crafted based on the idea of separate financial jurisdictions, each with its own set of laws and rules. DeFi’s capability of borderless transactions presents new challenging questions to regulators.
DeFi pros:
- Difficult to censor or manipulate
- Accessible to anyone with an internet connection
- Extends financial services to parts of the world that are underserved
- Typically open-source
DeFi cons:
- Requires some heavy-duty computing power
- If you lose your passcode or someone steals it, your crypto assets are gone for good
- Criminals could use such a financial system or run counter to sanctions
- Compliance issues
The future of DeFi
Decentralized finance is still in its infancy but is growing thanks to the advancements in blockchain technology and other innovative developments in the space.
But as more and more people adopt technologies such as smart contracts and blockchain-based currencies, this regulatory structure will be reevaluated.
There are many concerns about the decentralized finance ecosystem, including system stability and energy requirements.
Before DeFi can be considered safe to use, many questions must be answered, and advancements applied. It’s also likely that traditional finance institutions will become part of the DeFi system as they are already investing in solutions and startups in this exciting area.
Are you looking to build a blockchain-based app or other financial software? Contact us for consulting or fintech software solutions, we’ll be happy to talk about your business needs and product vision.
In the meantime, take a look at some of our fintech case studies:
- B4 Investigate – Codete’s specialists in software development assist B4 Investigate in creating and developing a SaaS platform for financial fraud detection, starting with a Minimum Viable Product (MVP)
- Raisin – Dedicated team formation and a detailed IT audit for a new fintech company in Europe, based on our extensive knowledge of the industry.
- Wells Fargo – A fintech giant needed our assistance in selecting the best tech stack and establishing a suitable approach for developing a real estate renting platform.
