What is DeFi (decentralised finance)

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DeFi (decentralised finance)


is an ecosystem of applications that provide financial services without management by a central authority, using cryptocurrency. It is based on distributed networks, the most common being Ethereum blockchain, which is ideal for deploying applications. This area of digital technology is now growing rapidly and includes a variety of services - lending, insurance, stackablecoins, derivatives and crypto-exchanges. Profinvestment.com's editorial team offers an in-depth overview of DeFi's features and components.

The difference between decentralised and traditional finance


DeFi can perform all the same functions as traditional banks, but in a much more efficient and convenient way. The movement of decentralised finance makes it possible to use loans, open interest-bearing accounts, and trade without having to trust centralised companies. The services are provided through decentralised applications (dApps), usually deployed on the Etherium platform. You don't have to be an Ethereum expert to use them, though it wouldn't hurt to have a better understanding of the process.

If we compare traditional and decentralised finance by basic criteria:

  • The payment and transfer system. A bank transfer from one country to another can take several days and involves significant fees. It is also a total lack of privacy. The underlying cryptocurrencies of DeFi need no intermediaries, transfers are as fast as possible (on the Etherium network from 15 seconds, with a fee of around $0.02). The benefits are obvious.
  • Accessibility. Banks impose strict restrictions on who can open an account, much less use financial services such as credit. There are now more than a billion and a half people in the world who have no access to banking services, and DeFi is guaranteed to make their lives easier. All they need is the internet to use them.
  • Centralisation. Banks are safe enough to hold funds, but not 100 per cent secure. And the downfall of a major bank necessarily entails a massive financial crisis. DeFi protocols are run by decentralised organisations, and this makes sure that some people cannot make decisions on their own.
  • Transparency. The average investor has no idea how their funds in their bank account are being used. In the case of DeFi, the source code of public blockchain-based protocols is fully transparent to all users and open to audits

DeFi protocols are code, and they always execute exactly as programmed, with the same execution for every participant without exception. Any vulnerabilities or flaws in the code are immediately apparent.

The DeFi movement seeks to address the main problems of traditional finance: slow transaction speeds, regulatory controls, high fees, and limited accessibility. It has the potential to bridge these differences and provide access to financial transactions for everyone without any type of censorship.

The experts at MonolithosDAO identified three key benefits of Decentralised Finances. The first is decentralisation, where control of the ecosystem is shared by all participants, transactions are fast and transparent, and there are no middlemen. The second is governance through smart contracts. And the third is open source code, which can be checked and improved at any time, and used to form other services based on it.

How DeFi is used


Decentralised finance has found use in over a dozen major areas - and there is no doubt that the list will continue to grow. Let's take a closer look at each of them and see why DeFi's principles are most relevant to them.


Stablecoins (stable coins)


Stablecoins are cryptocurrencies whose exchange rate is always equal to fiat currency. They were created to mitigate the high volatility of digital currencies, which can reach 10% in a single day. One of the first centralised Stablecoins was the US dollar-linked Tether (USDT). It is very popular, and yet it has one major drawback - owners have to trust the company issuing the coins that dollar reserves in an appropriate amount actually exist.

Decentralised stackcoins are issued by overcollateralisation ("overcollateralisation") by decentralised, autonomous organisations. They operate on public registers and anyone is absolutely free to check their stock. Stablecoin cannot be called an application, but it is an important component of most applications from other categories, which is why it was considered at the beginning.

An example of a decentralised stabelcoin is Maker (https://makerdao.com/).

Deposits and loans (lending platforms)


Cryptocurrency-enabled loans and deposits are nothing new, but originally such platforms were only centralised, they are still in demand today. Of course, decentralisation has been able to bring a lot of new and useful things to this area.

Traditional financial systems require a person to have a bank account in order to use credit or deposit money at interest. At the same time, a large part of the world's population does not have an account, nor is it possible to open one. This is not the only problem. Getting a loan from a bank also comes with other obstacles: you need a good credit history and a stable official income.

DeFi lending is based on the concept of credit pools - some users invest cryptocurrency there to earn interest, while others can borrow against cryptocurrency, with very favorable interest rates and no credit checks. The collateral itself acts as proof of security.

The largest loan pools are Compound (https://compound.finance/).

Compound Finance

Insurance


The tokens involved in smart contracts are potentially vulnerable - hackers want to access them. Of course, most in-demand projects have their code checked for vulnerabilities, but the risk always remains.

Insurance is needed to cover losses in the event of unauthorised hacking, especially if large sums of money are involved. A decentralised insurance protocol, Nexus Mutual (https://nexusmutual.io/), has been developed that offers insurance for any smart contract running on the Ethereum blockchain.

Nexus Mutual - Buy cover

Derivative contracts/synthetic assets


Derivatives are contracts whose value is determined by the value of the underlying assets - cryptocurrencies, indices, stocks, commodities, bonds, etc. Derivatives are used by traders to hedge the risks of transactions.

Derivatives are now primarily traded on centralised platforms, but DeFi-platforms are already emerging for this purpose. They are protocols for synthetic assets that track the value of the underlying assets and allow access to them without the need for purchase.

The largest DeFi-protocol for derivatives is Synthetix (https://www.synthetix.io/).

Synthetix protocol

Decentralised crypto-exchanges (DEX)


Centralised exchanges, such as Binance or EXMO, both broker trade and store user assets. Customers have no control over their funds, and there is a risk of financial loss if the exchange is compromised.

Decentralised DEX exchanges have been created to solve this problem. Through them, users can exchange assets directly without trusting anyone to store them. Examples of such exchanges are dYdX, Binance DEX, Uniswap. They are blockchain-based, do not store sensitive customer data on their servers and only provide a matching service for buy and sell orders.

Uniswap token list

List of UniSwap Ethereum tokens

Transactions


One of the main values of cryptocurrencies and decentralised systems is the direct transfer of assets from user to user without intermediaries, and therefore without delays or overpayments. With the emergence of DeFi projects, there are even more opportunities to implement various interesting solutions.

One example is the Sablier project (https://sablier.finance/), which reconfigures payments - instead of the usual transactions, they are now streams of sorts. This gives quite a lot of potential, with a high degree of accuracy.

Sablier - screenshot

Issuing tokenised securities


These DeFi projects involve decentralising the issuance or creation of securities in order to eliminate the need for any intermediaries (in traditional financial structures, the role of these intermediaries is usually played by investment banks). The tokenised securities market involves issuing tokens that have the characteristics of securities (called security tokens). Notably, they are fully compliant with securities laws.

Typically, security tokens are backed by assets or entitle the issuer to a share of the issuer's profits. They may also be:

  • Debt instruments
  • Investment instruments
  • Digital shares of an asset
  • Derivatives

One advantage of security tokens over standard shares is their increased liquidity - they can be split into smaller units. Thus, even though the underlying asset has low liquidity, the tokens associated with it can be very liquid.

Securitize, Polymath are examples of platforms that provide the functionality to issue tokenised securities and further manage them, up to and including communication with investors.

Lotteries


An unconventional but reasonable use of DeFi is to hand over control of the lottery prize pool to a smart contract on a blockchain. In doing so, the lottery app can easily be linked to other dApps to create a truly complete structure.

Participants pool their funds together, then the total capital is transferred to the dFi-app for lending. The resulting interest is transferred at intervals to a random winner. Once a winner is determined, the smart contract gives everyone their contribution back - so it's a win-win lottery.

An example of such a protocol is PoolTogether.

Investment portfolio management


Portfolio management involves controlling available financial assets and reallocating them to maximise returns. There are:

Active - when the goal is to get a specific return of at least a given benchmark.
Passive - when the goal is simply to make a possible profit without specific requirements.
Some DeFi projects help to implement decentralised passive portfolio management. Thanks to transparency, the user always sees how their funds are managed and what income and expenses can be incurred.

An example of a service for investment portfolio management: TokenSets (https://www.pooltogether.com/).

PoolTogether - screenshot

Peer-to-peer prediction markets

Augur betting platform

Many jurisdictions prohibit gambling and the betting industry on events (sports matches, elections or other events). Therefore, a kind of decentralised prediction market has developed. An example of such a platform is Augur, where anyone can bet on particular events and sell or buy shares of potential profits. And the Numerai platform uses artificial intelligence and algorithms to predict trades. Any of the predictions can be bet on, and the amount of reward depends on the initial amount and accuracy of the prediction.

Is it difficult to use DeFi services?


Even though applications are open and accessible to everyone, one of the biggest challenges is how users learn to use them. Blockchain developers are currently working on this as a priority. For example:

  • The Argent wallet eliminates the need for a seed phrase to regain access to the wallet, allows free transactions on the Ethereum network, and features integration with Compound and other DeFi projects.
  • Gelato Finance allows customers to program actions, such as specifying the algorithm "buy ETH at $210" or "send 0.5 ETH to so-and-so on 27 August".
  • The DeFiZap app also removes many of the complexities and issues associated with DeFi products and allows multiple services to be accessed on a single transaction basis.
  • Cryptocurrency insurance apps have already been mentioned. This is a good way to increase the security of storing savings in credit protocols, although it slightly lowers returns.
  • There are DeFi yield optimisers that remove the need to switch between different projects to find the best yield. iEarn, idle.finance, etc. allocate assets independently between applications on the Ethereum blockchain
  • Paraswap, DEX.AG and a number of other services solve the same problem, but in terms of liquidity - instead of having to find the best decentralised exchange to trade on their own, customers can rely on these services that aggregate the liquidity of all in-demand venues and automatically allocate orders.
  • Some DeFi-protocols provide the ability to mine in the process. Compound, for example, distributes COMP tokens to all lenders and borrowers. Synthetix distributes SNX for collateral. Balancer distributes BALs to users who participate in creating liquidity pools. There are quite a few such projects. So, using the basic functionality, you can generate passive income as well.

Developments are emerging very actively, and there are already answers to all the common difficulties that users have. There is no doubt that in time an application will appear which combines all the user-friendly functions at once.

The risks of using DeFi


Despite all the pluses, there are also dangers of decentralised finance. This is understandable, as the technology is relatively new. The main risks include:

  • Cracking smart contracts. Code is written by humans, and humans make mistakes. It only makes sense to use platforms that have been verified by reputable auditors (OpenZeppelin, Quantstamp, ZK Labs, etc.), although even then there is a small chance that an important error is missed.
  • Liquidity and credit risks. Cryptocurrency is volatile, and the system can collapse if the underlying asset falls sharply. DeFi-protocols try to combat this problem by over-collateralising loans.
  • Lack of funds for lending. A loan can be obtained against specific collateral at DeFi much more modestly than at a traditional financial institution.
  • Fake oracles. Blockchain protocols obtain data (cryptocurrency rates, etc.) from external systems, often centralised. If the source is unreliable, the smart contract will not be executed correctly either. To eliminate this risk, decentralised alternatives for sources are being developed.
  • Centralised development control. No matter how you look at it, a single team builds the code. In more cases, developers involve users in the process, but this can also cause problems through incompetent interference.
  • It is difficult to find someone responsible. The principle of decentralised management does not always work the way it was originally intended. All users are equal, but there are also users who aim to disrupt the ecosystem, or who are simply passive and do not intend to participate in the process (which is often just as damaging as the actions of attackers).

There is a lot of noise around DeFi at the moment, so some believe it is all a bubble, as was the case in 2017 with the ICO boom. But the direction seems so promising that we must assume the hype will soon subside and the technology will begin to be put into practice in an orderly manner.

DeFi Cons & Pros

Advantages

Disadvantages

  • The speed and cheapness of transactions in decentralised networks.
  • The immutability of the information recorded on the blockchain.
  • Transparency and openness to audit.
  • No centralised control, everything runs on pre-programmed smart contracts.
  • No one can edit the contract in their favour unbeknownst to anyone else.
  • The DeFi market is available to anyone with internet access, regardless of country of residence or other factors.
  • Centralised development, making the quality of smart contracts dependent on a single team..
  • The risk of smart contracts being hacked.
  • A smart contract may contain an error, and once it is triggered, it is technically impossible to undo the erroneous operation.
  • Open source allows hackers to examine the contract and find loopholes for attacks.
  • The scalability of DeFi applications depends on the characteristics of the blockchain on which they reside.

What Are Bitcoin Storm’s Main Features?

Bitcoin Storm has many useful and convenient features that a prospective user should know about. Just a few key features include:
  • A quick and accurate payout system, which ensures users receive their funds as soon as possible after each trade session.
  • A demo feature that allows new Bitcoin Storm users to experience a simulation of the live market without the risk of using real money.
  • Fully- and semi-automated functions, that allow the user to customise the program to suit their experience level.

Conclusion


The topic of decentralised finance is almost endless, we have just gone over the top and covered the main aspects. Today, hundreds of applications in this field have already been created and are running successfully. Some have become very popular in a matter of months, like Compound or Uniswap. The potential of DeFi has not been ignored by large companies, for example, Binance Exchange has seen fit to launch a decentralised marketplace, Binance DEX.

DeFi applications and projects can be extremely useful in countries with weak or unstable economies. In Argentina, for example, it has even been suggested that people should be paid in DAI due to the horrendous inflation of the national currency. The services are also in demand in developed countries as they offer a better and more affordable credit system and open up new opportunities for interest income on investments.

Jack Evans


I became a crypto asset owner in 2014, when the industry was in its infancy. Before that, I was working in the classic US and European stock markets. Since then, I have gained extensive experience in both cryptocurrency investing and day trading. I am happy to share with readers my experience with crypto exchanges, DeFi and NFT instruments.
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