What is DeFi?

What does DeFi stand for?

DeFi is short for ‘Decentralized Finance’. It is an umbrella term for peer-to-peer, autonomous, pseudonymous/anonymous and open-to-all financial services on public Blockchains, mainly Ethereum, the world’s second-largest cryptocurrency, after Bitcoin.

A brief history of Decentralized Finance

The technological foundations of decentralized finance came about in 2008, when the first Blockchain was used for Bitcoin transactions.

In 2013, Ethereum was created by programmer Vitalik Buterin and the network went live on 30 July 2015. One of the pioneers of the decentralized finance space on Ethereum is ‘Maker’ – a protocol that allows for creating a decentralized stablecoin linked to the US dollar called DAI – created by founder Rune Christensen. Maker was funded by Venture Capital and was fully launched in 2017.

The term was introduced in August 2018 when Ethereum developers and entrepreneurs who wanted to open up finance applications from traditional systems were brainstorming ideas for a name. Suggestions included ‘Open Horizon’, ‘Open Financial Protocols’, and ‘Lattice Network’, but they finally settled on ‘DeFi’ (partially because it sounds like ‘defy’).

Between 2019 and 2021, DeFi volume grew from $100M per year to $1 trillion per year.

Why DeFi is important

Not everyone has easy access to bank accounts or is able to use financial products and services in their own countries. However, users can use DeFi wherever they are in the world. It removes the control that banks, government agencies and other institutions have on financial services and products; in DeFi, no one but you has access to your money.

It creates a digital alternative to Wall Street, but without the associated commissions and fees, and with benefits that are accessible to anyone with an internet connection – increasing access to financial services to people regardless of who or where they are. Other goals are to reduce transaction times (funds can be transferred in minutes or even seconds) and costs by banks and other financial companies.  

Users engage with DeFi via a software called dApps (‘decentralized apps’), most of which currently run on the Ethereum Blockchain.

DeFi applications give users more control and autonomy over their money as they hold it in a personal secure digital crypto wallet instead of keeping it in a bank. There is no need to fill out an application or open an account, and they do not need to get approval by anyone.

How does it work?

Decentralized finance uses the Blockchain (a distributed and secured database or ledger) technology that cryptocurrencies use.

Some ways to use DeFi are:

  • Trading: you can make peer-to-peer trades of certain crypto assets (like buying and selling stocks but without an intermediary).
  • Getting a loan: you can get a loan immediately and without filling out any forms.
  • Decentralized exchanges (DEX): exchanging currencies for other currencies, for example, trading Ether for US dollars.
  • Lending out your cryptocurrencies: you can earn interest multiple times a day (not once a month/year like in traditional finance).
  • Saving: you can put some of your crypto into savings account alternatives and typically earn better interest rates than you would normally get from a bank.
  • Buying derivatives: the crypto version of stock options or futures contracts.
  • Yield farming: yous can scan through various DeFi tokens in search of opportunities for larger returns.

DeFi vs Bitcoin

As we have seen above, decentralized finance uses the Blockchain technology that cryptocurrencies use. Bitcoin is a decentralized digital currency that operates on its own Blockchain; DeFi is a concept that describes financial services that are built on public Blockchains, such as Bitcoin and Ethereum. DeFi is designed to use cryptocurrency in its ecosystem, so Bitcoin, as a cryptocurrency, is part of DeFi.

What are the advantages of DeFi?

There are several benefits that make DeFi attractive. Here are some of them:

  • You can be anywhere in the world and still use it.
  • Users do not need to apply for it or open an account. You simply get access by creating a wallet.
  • You can move your digital assets without asking for authorisation or paying costly fees.
  • Users do not need to provide any personal information such as name, email address, or postal address.
  • Interest rates and rewards usually are updated much more rapidly than in tradition finance.

What are the disadvantages of DeFi?

Of course, just like with other kinds of financial tools, DeFi has its set of disadvantages, including fluctuating transaction rates on the Ethereum Blockchain (which can make active trading expensive), high risk and volatility, and the fact that you must keep and provide your own records for tax purposes.

Using DeFi does not mean that there are no transaction fees at all; you have to pay gas fees, which are the charges levied by developers to process transactions on the Ethereum blockchain. As the number of DeFi users goes up, growing congestion is making gas fees rise steeply, as well as leading to slower transaction times.

Since there is no governing body, you can lose your assets if you forget your password (or it is stolen), and there is also no consumer protection safety net should there be a problem. Fraud and crime are also a significant issue. Since Blockchain transactions are irreversible, this means that incorrect or fraudulent DeFi transactions cannot be easily fixed.

What is a Smart Contract?

DeFi uses cryptocurrencies and smart contracts to provide various financial services under certain conditions, without the involvement of banks. But what exactly is a Smart Contract?

A Smart Contract is an irreversible, immutable, self-executing agreement written in computer code and executed on a Blockchain, without the need for an intermediary or third party. They allow for borrowing, lending, and more. For example, you could write a smart contract stating that you will pay $100 to someone if England wins this year’s Eurovision Song Contest. Once the Smart Contract is published on the Blockchain, everyone in the network can access and read it, but no one can change it.

Why DeFi is the future

DeFi is looking to replace the role of conventional financial systems through smart contracts. It creates a unique opportunity for anyone with an internet connection to take part in the global economy.

How to invest in DeFi

There are a number of ways to invest in DeFi. The simplest option is to prepare a wallet and buy Ether or another coin that uses DeFi technology, and deposit it with a DeFi lending platform in order to earn interest.

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