DeFi (short for Decentralized Finance) is a new vision for banking and financial services based on peer-to-peer payments via blockchain technology. DeFi enables “untrusted” banking operations over the blockchain and avoids traditional financial intermediaries such as banks and brokers.
What is included for investors? DeFi promises to enable investors to “become a bank” by giving them the opportunity to lend money peer-to-peer and earn higher yields than are available in traditional bank accounts. .. Investors can quickly transfer money anywhere in the world and access their funds via a digital wallet without paying traditional banking fees.
Here’s how to operate DeFi, how to benefit individuals, how to challenge traditional banking, and the risks DeFi poses:
How DeFi works
DeFi’s goal is to provide many of the financial services (loans, interest on deposits, payments) that customers and businesses are currently enjoying, and to do so with decentralized technology. In effect, DeFi makes a big difference in the industry, not what you change, but how you change it. In short, DeFi will create a new infrastructure to offer similar financial products and services.
To that end, we use blockchain technology and smart contracts, among other tools. Blockchain is a type of ledger technology that tracks all transactions on a particular financial platform. Think of it as a running record of all transactions on that particular blockchain, recorded in chronological order. If Person A pays Person B, it will be permanently time stamped in the ledger.
“The component of DeFi is a smart contract. It’s an executable code that can store cryptocurrencies and interact with blockchains according to their rules,” said CEX.IO, CEO and CEO of the company that promotes DeFi and cryptocurrencies. Founder Alexander Lutskevych said.
To enable DeFi, smart contracts automatically execute transactions between participants. When the terms of the contract are met, they self-execute a series of instructions.
“DeFi enables smart contracts on the blockchain to carry out peer-to-peer transactions on behalf of trusted intermediaries such as banks and brokerage firms,” helping investors earn money from cryptocurrencies. David Malka, CEO of YieldFarming.com, said. “These peer-to-peer transactions at DeFi can include payments, investments, loans, whatever.”
In this world, cryptocurrencies are the de facto currency for transactions and records.
“DeFi is a very exciting time in the industry, as it is a natural continuation of the vision of creating electronic cash outlined in the Bitcoin white paper,” says Marca.
The main benefits of DeFi
For individuals, the benefits of DeFi include potentially better security, potentially lower costs, more types of services, and the ability to earn higher incomes through crypto holdings. These and other benefits are realized by distributed apps created by different groups.
“Decentralized applications (dApps) allow you to transfer your capital anywhere in the world (with fast payments and low cost), including peer-to-peer borrowing and lending, crypto exchange services, NFTs, and crypto wallets and storage. Other service solutions for, “says Lutskevych.
“DApps are pre-programmed by developers to execute transactions on specific blockchain networks, resolve agreements between buyers and sellers, and decentralized exchanges to decentralized exchanges, depending on their purpose. You can move your assets to a lending platform, “he says.
So the only limitation is the ability to code apps that execute instructions.
One of the benefits currently popular with crypto investors is their ability to generate income. For example, cryptocurrency staking allows coin owners to earn money by supporting the coin ecosystem and assisting in transaction validation. It is part of so-called harvest agriculture. It proved attractive when bank interest rates have been stable for years.
“Anyone can offer crypto assets as liquidity or loans through so-called yield farming, which pays depositors interest and fees,” said Malka of YieldFarming.com. “Yield farming is a way to make crypto work to earn passive income.”
To provide the service, many dApps require the liquid cryptocurrency available in the app. So they offer to pay income, yield in exchange for investors to put coins for a period of time. In effect, it provides income to those who provide liquidity. This is similar to the interest paid on traditional bank deposits, but at a higher risk (discussed below).
Depending on the type of dApp, cryptocurrency owners can raise yields through a variety of services, including:
Therefore, these methods of generating yields provide investors with another source of return, but like traditional sources of income, they have to pay taxes on the profits of cryptocurrencies.
“Even the lowest-risk yield farms can easily return interest rates that are several times higher than a bank’s savings account,” says Marca. “This is especially important in the bear market, where the prices of cryptocurrencies such as Bitcoin and Ethereum are declining.”
DeFi risk for investors
While DeFi sounds like a brave new world for finance, DeFi presents a variety of shortcomings and risks to prospective attendees.
- complicated: Joining DeFi is not as easy as going to a local bank. “DeFi can be difficult for beginners to navigate due to the large number of DeFi applications and investment opportunities,” says Malka. “Even the onboarding process can be confusing, as you need to move money from exchanges like Coinbase to unmanaged wallets like MetaMask to get access to the world of DeFi.”
- Complete scam: Many scammers are targeting new crypto investors who are fascinated by yields that can significantly exceed those offered by traditional financial institutions. High yields may be too good to be true.
- theft: Besides complete fraud, exploits can steal crypto coins, especially given coding vulnerabilities in some dApps. “These exploits can lead to loss of funds, after which it is up to the core team behind the DeFi project to decide how to indemnify the participants,” said Lutskevych of CEX.IO. I am.
- cost: Communication with smart contracts requires so-called gas charges, such as tokens to run the machine. Multiple steps along the way can easily incur costs, which can prove to be particularly costly for people with moderate bankrolls. “It’s not uncommon for’round-trip’gas prices to far exceed $ 200,” says Lutskevych.
- Volatility: Yield farming helps mitigate the downsides of cryptocurrency’s volatile world, but you still have to withstand amazing fluctuations to get what could be a modest yield. .. In one day, cryptocurrencies can easily lose yields of over a year.
- Fluctuating yields: In addition to fluctuating cryptocurrencies, DeFi participants need to deal with fluctuating yields. Increasing the supply to support a particular app can reduce yields.
- Dying project: A particular dApp can eventually die on a vine because the core team that develops it is pursuing other projects. “One day, if they decide to exit, the protocol logic will continue to run, but no further upgrades will be made,” says Lutskevych.
These are some of DeFi’s biggest risks that investors looking to join need to understand before they are fully committed.
How does DeFi challenge traditional banking?
One of DeFi’s biggest claims is that this new financial technology disrupts traditional banking operations. In extreme cases, they say DeFi will completely eliminate intermediaries in financial transactions and replace peers’ decentralized networks.
But if DeFi is so powerful, why don’t banks simply adopt and offer technology?
“There is no doubt that traditional financial institutions are increasingly leveraging blockchain and distributed ledger technology,” said Malka of YieldFarming.com. “This will really accelerate in the next few years, as all of these traditional institutions are aware of the inherent security of being on the blockchain.”
Malka expects banks to create a variety of DeFi products “to stay competitive and relevant.”
“It’s easy to imagine a scenario where a traditional bank creates a yield farming opportunity for customers to participate,” he says.
However, due to the regulatory burden, such changes are easier on paper than they really are, said Lutskevych of CEX.IO, creating a complex problem for traditional businesses that want to do so.
“Integrating blockchain technology requires revisions to many established processes, which puts them at additional risk,” he says. “In addition, these regulated bodies will require regulatory approval for these activities.”
Anyone who wants to go beyond the basics of cryptocurrency trading to get started with DeFi should be cautious and make sure to work with a trusted partner. The yields offered by DeFi are attractive, but make sure your potential returns aren’t blinded by other risks. Cryptocurrency market downdrafts can quickly wipe out small profits from harvested agriculture, and complete fraud and theft can wipe out your crypto assets even faster.