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What Is DeFi? Your One-Stop Guide To Decentralized Finance
You’ve heard it over and over: DeFi this, DeFi that, but what is DeFi? And can it really remove the financial institution that sits between you and every business you transact with?
Decentralized finance, commonly known as DeFi, has its crosshairs firmly sighted on traditional finance. It intends to disrupt the entire financial industry by using blockchain technology and crypto assets to enable peer-to-peer markets to emerge. These provide financial services, from banking and loans to asset trading and more complex financial transactions.
As DeFi matures, it looks set to overcome its current difficulties and allow us to finally wave goodbye to the majority of centralized institutions in the current financial system. But let’s slow down a sec: De-what?
What is DeFi?
If you’re looking for a DeFi definition, you should know that it stands for “Decentralized Finance.”
Still none the wiser? We’ve got your back.
What is decentralized finance?
Decentralized finance (DeFi) uses blockchain technology and cryptocurrency assets to disrupt the traditional finance sector. It aims to put a stop to centralized finance and return power to the people through peer-to-peer networks. DeFi utilizes smart contracts for automation to cut the middleman out of complex financial transactions.
Essentially, if you look at the centralized finance market, you must rely on other people or financial institutions to grant you access to financial services. In some countries, it’s an uphill battle just to open a bank account. This is because there is an authority figure that oversees – with its man-made laws and regulations – which person should or should not have access to the financial system.
Decentralized finance and DeFi protocols understand that it’s a human right to have banks and access basic financial services. Through blockchain technology, it’s possible to automate and decentralize financial transactions in a way that’s impossible to censor or control. Read about the advantages of decentralization to learn more about how this is possible.
It must be noted that despite the inability to stop a decentralized peer-to-peer network, it can be banned. This makes it illegal, but it does not terminate the network unless all the nodes go offline simultaneously. As crypto and DeFi protocols are global movements, even if one country bans crypto assets, there would still be plenty of other countries that allow or even encourage their growth.
What is traditional finance?
Traditional finance is made up of centralized systems that act as authority figures. Whether you want a loan, a mortgage, or to trade stocks and bonds, you will need to deal with financial middlemen before you can get access. This is why it is also called centralized finance – and it’s what decentralized finance aims to end.
In the U.S., there are plenty of regulatory bodies that you will have heard of, such as the Federal Reserve, notorious for removing the gold standard and thinking inflation is the way out of any recession; and the Securities and Exchange Commission (SEC) who regulate traditional financial markets and have since dipped their toes into crypto to accuse the entire trillion dollar industry of illegally selling securities.
Because of the financial institutions present in centralized finance, we – the people – have no means of accessing financial services directly. There is always somebody regulating our financial transactions, telling us what we can and can’t do with our own money.
Why is decentralized finance better?
Decentralized finance aims to give you power over your own money.
If you adhere to the dream of financial freedom proffered by Bitcoin, then DeFi takes it a step further. Instead of simply owning your own money and being your own bank, you can now take out loans (with collateral) without middlemen. In fact, if CreDA gets its way, you will be able to leverage the power of DeFi to take out loans without middlemen and without collateral.
Decentralized finance also enables you to take out a loan instantly, without any prerequisites. These are referred to as “flash loans” and they’re never offered by traditional financial institutions.
Another perk that DeFi offers is lending. By using lending platforms, you can lend out your crypto in a peer-to-peer fashion and earn interest and rewards updated by the minute, rather than by the month.
Decentralized finance also offers much larger interest rates than regular banks. If you want to save crypto for the future, you can use DeFi as an alternative to savings accounts.
On newer DeFi projects, the interest rates can seem almost too good to be true. This is because there are often risks involved with untested DeFi platforms. Over time, the interest rates will drop, but still remain significantly higher than your traditional bank.
Also remember to do your due diligence when researching which DeFi projects to put your money in. Not all of them are trustworthy. Some are less secure than others, while some may be outright scams. Always thoroughly research each DeFi platform (and cryptocurrency in general) by reading the whitepaper, examining their socials, reading the open source code (if you are able to access and understand it), and checking it out from the perspective of unbiased sources. If there is very little information out there, be wary.
In addition to all these DeFi benefits, decentralized exchanges (DEXs) also decentralize simple trade. If you want to swap one asset for another, you can do so in a completely peer-to-peer manner with a user interface that’s often more streamlined than a centralized equivalent. Behind the scenes, you are leveraging liquidity pools and automated market makers (AMM), but at face value, you are simply clicking “swap”. You don’t have to trade OTC or with somebody you know, rather by using smart contracts, you can transfer digital assets from one person to another instantly, automatically, and without the need for a broker.
There are other reasons that DEXs are better than their centralized counterparts too.
Centralized exchanges vs decentralized exchanges
Even in the crypto world, there are many centralized bodies. You need only look at a centralized exchange to see how they operate within the blockchain world. Binance, for example, owns any coins that you keep on the exchange. This isn’t without its perks. Binance has top quality insurance and security (though be careful: not all CEXs do), making them difficult to hack and likely to repay their losses if there was an attack. However, neither of those things should be taken for granted.
All CEXs are able to add coins from any chain without the need for interoperability. This is because they own the coins in their own wallets and thus the chains don’t need to directly interact with one another. Interoperability isn’t needed because there is a central authority overseeing the transactions behind the scenes.
Compared to a decentralized exchange, a centralized exchange can be easier to use as it requires less of a learning curve if you are new to crypto. You simply make an account, register your details, and away you go. However, this is largely due to the complexity of creating a digital wallet for newcomers, and the amount of DEXs that may need to be used in order for you to get the tokens you desire. In addition to this, you’ll usually need to use a CEX to transfer FIAT to get started in the first place.
While there is only a small learning curve for a CEX, some might argue that decentralized exchanges are even easier to use. Once you already have a wallet and some cryptocurrency, connecting to a DEX and making a trade takes just a few clicks. There is no need to create an account on a decentralized exchange as users retain control over their funds. In swap DEXs, you don’t even need to make bids or fiddle with more complex trading processes. You simply swap one coin for another.
Another benefit of DEXs is that there is no listing fee. So long as the coin is on a compatible blockchain, liquidity can be added and it can be traded. However, this means that anybody can add a coin, including scam coins that can even use the same name as legitimate ones. This can be confusing for newcomers when they want to buy a microcap coin and need to find the correct contract address beforehand. CEXs have somewhat vetted their listings and thus have a slightly more trustworthy selection. That’s not to say that shady projects can’t be listed on big centralized exchanges however. They definitely can.
One of the other downsides to DEXs is interoperability. While you have complete control over your cryptocurrency, most decentralized exchanges only operate on one or two blockchains. For example, Uniswap, the biggest DEX in the world, only operates on the Ethereum blockchain. This means you can only trade ERC-20 tokens. It is also harder to implement a FIAT on-ramp to decentralized exchanges than it is for centralized exchanges.
There are some DEXs that are designed to be interoperable, with the long-term goal of replacing CEXs completely. Injective Protocol is one. Demex, made by Switcheo Labs, is another. Demex is a decentralized spot trading and derivatives exchange that’s interoperable with Ethereum, Binance Smart Chain, Neo, Ziliqa, and Cosmos IBC, with more chains on the way. The problem with interoperable DEXs at the moment is liquidity and volume. It’s a chicken and egg situation, but traditional CEXs have liquidity and volume in abundance.
Advantages of centralized exchanges
- Allows many coins from many different blockchains
- Usually has more liquidity and less slippage
- FIAT on-ramps (buy crypto directly from your bank)
Advantages of decentralized exchanges
- You own your coins and they never leave your wallet
- No sign-up or KYC required
- Swap DEXs have a simple user interface
What does DeFi look like today?
Powered by decentralized applications (dApps) that utilize smart contracts, DeFi platforms are already starting to tackle more advanced financial transactions.
The following is a list of ways in which DeFi applications are already being used.
- Decentralized exchanges. As mentioned earlier, DEXs take advantage of peer-to-peer networks to facilitate decentralized trade. Coins never leave your wallet.
- Prediction markets, options, and derivatives. These types of financial services are usually for more experienced traders. You can gamble on the price movement of certain digital assets in a decentralized manner.
- Financial transactions. Payments, trading digital assets, and insurance are currently in use through various DeFi applications.
- Stable coins. Stable coins are usually tied (or tethered) to non-cryptocurrencies like the US dollar. This helps them maintain stability as opposed to the volatile price movements of other cryptocurrencies.
- Yield farming. Borrowing and lending platforms are already in place. Also known as liquidity mining, this empowers speculative investors to stake or lend their tokens in the hope for big rewards. Some of these DeFi lending platforms have come under scrutiny in recent weeks for struggling to remain liquid during a market downtrend. For more information on yield farming, check out our guide.
- Digital Wallets. Digital wallets store digital assets – both cryptocurrencies and non-fungible tokens. The best of these wallets (Elastos Essentials) also acts as a gateway to web 3.0 – or web5 as Jack Dorsey likes to call it – and this enables you to play blockchain-based games, access DeFi applications, decentralized social media, and other dApps all directly from your wallet.
- Non-fungible tokens. NFTs are simply proof that you own digital assets. If you’re new to NFTs, check out the top 10 NFT use cases.
- Flash loans. Flash loans enable you to borrow and repay digital money in the same transaction. Working like decentralized arbitrage, borrowers enter into a smart contract that hopes to take advantage of price fluctuations in a trading pair. If the transaction will be at a loss, the funds are automatically returned to the lender.
Is DeFi risky?
In a word, yes.
With limited regulations, there is no real safety net if something goes wrong. There are also many potential scams that can appear to be the real deal. Always double check where you are sending your tokens and what the reputation of the DeFi applications that you’re using are.
Another risk of using DeFi applications is that they are susceptible to hacks. Programmers that are familiar with the code of the smart contracts may be able to find flaws in the code that have been overlooked by the team. They can (and often do) take advantage of these flaws to steal funds from everyday investors. In 2021 alone, over $2 billion was stolen from DeFi platforms.
What is TVL?
If you’ve taken a deeper look into any DeFi apps, you’ll have probably noticed the term TVL.
TVL is an acronym that stands for “Total Value Locked”.
It refers to the amount of crypto (usually measured in $USD) that is locked within the DeFi protocol. This can be from people lending, staking, providing liquidity and more. It’s the sum total of all crypto that is within the DeFi smart contracts at any one time.
Generally speaking, the higher the value of the TVL, the more trustworthy the DeFi application. However, this should not be used as the only yardstick.
What are the pitfalls of DeFi?
As DeFi is an emerging digital financial infrastructure, it is not going to be perfect straight away. There are some downsides to using DeFi apps – some that could be very costly to the uninitiated.
- No consumer protections. Briefly mentioned above, DeFi projects operate with minimum interference from regulatory bodies (for now). This means users have no support if there is any foul play. Some DeFi platforms voluntarily try to make things right, repaying any losses out of their own pocket. Such platforms tend to receive a boost in trust from their users. This happened to Elastos’ native DEX, Glide Finance, after a small exploit during its first few days.
For comparison, traditional banks are required by law to hold capital in reserve so that people can freely withdraw their money. No such law exists in the DeFi space. This is one of the reasons for the potential decimation that awaits some DeFi projects over the coming months. If the majority of people decide to withdraw because of fearful market conditions, today’s DeFi projects will likely not be able to handle it. Celsius, a DeFi platform on the Ethereum network, has notoriously halted withdrawals recently because of problems with liquidity.
- Hacks and exploits. As smart contracts use open source code, anybody can read them. If there is even the slightest error (one number instead of another), then they can be exploited and the funds from the entire smart contract can be drained. While blockchain is immutable, smart contracts are very much open to exploitation.
- Private keys. They might be secure and impossible to guess, but as there is no centralized authority, you cannot access your crypto assets without private keys. Lose your private keys and you have lost your cryptocurrency assets. End of story.
- Collateralization. You are restricted in the amount you can loan by how much you can afford to put down as collateral. In the vast majority of DeFi applications, the value of the collateral is 100% or more of the loan you wish to take out. In this case, it’s impossible to take out a loan unless you lock away the equivalent.
While this reduces the amount you can loan, CreDA is working on a solution that will enable credit score to be minted on the blockchain and used as a substitute for collateral. Their aim was for users to be able to take out decentralized loans without collateral, using only your credit score and decentralized identity.
How to invest in DeFi protocols
There are several ways you can invest in DeFi protocols. You can buy the underlying asset (the DeFi tokens for the platform of your choice), or you can utilize the smart contracts of the DeFi platform to lend, borrow, stake, trade, or provide liquidity.
There are several DeFi applications on the Elastos Smart Chain (ESC) so far, with FilDA being one of the largest. At its peak, FilDA had over $1b TVL. As a fork of one of the most popular Ethereum-based lending apps, Compound, FilDA originally launched on the HECO chain, but has since returned to its home on ESC.
If you have Elastos Essentials and an internet connection, you can access the decentralized apps of ESC (and the other 10 compatible chains) directly from your wallet. FilDA can be found there.
You will need:
- A digital wallet. Download Elastos Essentials here. It can store cryptocurrencies from over 10 different chains, including native Bitcoin. In July 2022, ledger support will allow you to use your Elastos Essentials wallet for cold storage.
- Cryptocurrency. You will need some crypto to get started with DeFi. You can stick with stable coins like USD coin or opt for native DeFi tokens like $FilDA; the choice is yours.
- An internet connection. You must be connected to the internet to access decentralized financial services.
If you want to start easy, we suggest you use an amount that you are fully prepared to lose. Most likely, this won’t be the case, but the mindset is essential for investing, trading, and tinkering with DeFi applications, especially for the first time. If you invest too much, you may let emotions cloud your judgment.
Staking is a relatively safe option to start with. It requires minimal action and minimal risk. You can stake $ELA in Elastos Essentials so long as it’s on the Main Chain. Simply click on “DPoS voting” and cast your votes.
You can also use Glide for staking, liquidity mining, and other DeFi services. The user interface is intuitive and easy to use.
What does the future hold for decentralized finance?
Whilst DeFi is still in its infancy, the potential is there for it to revolutionize the traditional financial markets. As crypto stabilizes and becomes more adopted, DeFi will innovate and grow. Platforms will rise and fall. Smart contracts will evolve and new transactions will be automated.
Only time will tell, but the future certainly looks bright for this booming new sector of finance.
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