In the wake of the DeFi Summer of 2020, DeFi continues to scale in popularity in the financial services world. Up until March of 2021, the total value of DeFi contracts accounted for over $41 billion. The disruptive financial technology aims to democratize financial services through a permissionless open source system. DeFi holds a significant appeal for individuals who may not have access to funding sources or traditional banks and financial institutions.
What is DeFi?
DeFi or decentralized finance refers to a system of dapps or decentralized apps, protocols, smart contracts and digital assets built on top of a decentralized public blockchain like Ethereum. DeFi is essentially the space where financial products and services exist without the oversight of intermediary financial institutions such as banks, credit unions, insurance funds and brokerages. Dapps are building blocks of DeFi and refer to the digital programs or web services that run on a blockchain. Ethereum is the most widely used blockchain that supports the majority of dapps in existence.
DeFi enables users to invest, trade and conduct peer to peer transactions through cryptocurrencies and smart contracts, or codified agreements that are enforced when predetermined conditions are fulfilled. The DeFi movement aspires to create borderless, transparent and open source financial service ecosystems untethered by central authorities and regulators. DeFi users retain financial autonomy over their digital assets and interact through dapps which users can audit themselves.
What is it used for?
DeFi is used for a host of financial services parallel to those occurring in traditional finance contexts and institutions. Trading, lending, borrowing and payment transactions are commonplace in DeFi settings.
Decentralized exchanges or DEXs offer consumers peer to peer transactions and grant users financial control over their funds. Popular DEXs include AirSwap, Liquality, Mesa, Oasis, and Uniswap. Stablecoins such as DAI are used in DeFi for remittance payments and lending platforms like Compound, Dharma and Aave. DeFi supports tokenization, or the creation and management of digital assets on a blockchain such as Ethereum based tokens which are used worldwide.
What are the benefits of DeFi?
DeFi allows users to conduct financial processes irrespective of geographic location and access to legacy financial services. Instant or fast transfer capabilities and the absence of middlemen or abiters charging high fees for facilitating financial transactions and services save users considerable costs.
High yield trading or yield farming enables users to borrow and lend cryptocurrencies at higher rates than those offered by traditional banks and investment firms. The stand out takeaway from DeFi is the greater accessibility it affords due to reduced fees and charges otherwise stacked on by traditional financial systems and exchanges.
What’s the catch?
DeFi technologies are new and still prone to risks and potential drawbacks. DeFi’s core reliance on software programs and technologies creates vulnerabilities which can be manipulated by hackers and scammers.
Lack of financial regulations and legal oversight can broaden opportunities for unchecked criminal activity. An overall lack of consumer protections can lead to unregulated financial disputes. Software disruptions and bugs within smart contract agreements can present additional functional challenges especially considering their unregulated frameworks. Despite DeFi’s seemingly equitable nature, DeFi loan requirements dictate the use of collateral 100 percent equal to the value of the loan, which drastically limits eligibility.