DeFi 101: A Guide to Decentralized Finance

By April 30, 2021DApps
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DeFi, or decentralized finance, is a new way to execute financial transactions through applications. It cuts out traditional financial institutions and intermediaries and is conducted over the blockchain. Think of it as removing brokerages, exchanges, banks and other intermediaries from the equation.

"Purists claim DeFi must have no centralized control but run autonomously on a blockchain through the use of smart contracts – bits of code that perform actions once certain conditions have been met," says Chris Roper, a spokesperson for peer-to-peer lending site MyConstant.

These contracts self-execute when specific outcomes come to fruition. For example, you could create a contract with someone else that pays you one bitcoin if the Charlotte Hornets beat the Los Angeles Lakers, as revealed by the ESPN website. If the Lakers win, you would pay out one bitcoin. You can imagine such contracts being tied to all sorts of obscure conditions.

"In reality, however, DeFi has become the general term for any application or business that uses blockchain technology or cryptocurrency to create alternative financial products," Roper says.

Removing the middleman (like a bank), which can incur onerous expenses, take up unnecessary time, halt or reverse transactions or even cause clients to lose everything in bankruptcy or fraud, is a key benefit of DeFi.

So conventional transactions can be done through this unconventional manner. Direct purchases, loans, derivatives, crowdfunding, insurance and other contracts can all be utilized with DeFi as well.

DeFi is closely related to Ethereum and the cryptocurrency that incentivizes its use, Ether, which is second only to Bitcoin in market capitalization.

That's because Ethereum was designed more as an infrastructure that enables developers to build decentralized applications, or dApps, on top of it, with these self-regulating "smart contracts" being coded to work on the Ethereum network.

There's also no need for a trusted third-party with decentralized finance, says Kent Barton, head of research and development for ShapeShift, a firm which offers global trading of a variety of digital assets.

The Bitcoin network, which was the first blockchain and emerged in 2009, was not built to facilitate smart contracts, although smart contracts that direct Bitcoin transactions can be coded. Ethereum, for its part, was specifically designed to include smart contract functionality. Since going live in 2015, it has become the most widely used blockchain in the world for precisely that reason.

There are countless ways to make money in the field of DeFi, just as there are in the field of traditional finance.

Something called yield farming is a common strategy that's unique to DeFi.

"As DeFi has matured, new investment tools have risen such as yield farming, which switches your investments between different lending and liquidity pools so you're always earning the best rates," Roper says. Imagine obsessively checking for the highest-interest savings accounts, switching your capital between accounts to maximize your interest earnings. Yield farming is similar to that, but with much higher yields.

A liquidity pool is a concept used by decentralized exchanges, where users deposit an equal value of two different cryptocurrencies or stablecoins, ensuring an adequate supply will be available when traders want to exchange one for the other. In exchange for providing liquidity, the users who deposit currencies into the pool share a reward proportionate to their stake in the pool.

There are also more traditional lending services available in the world of DeFi.

"There are millions of cryptocurrency-holders around the world holding their assets for the long term in anticipation of price increases. At the same time, many want to borrow against these assets to finance new trades," Roper says.

"Where these interests overlap, new DeFi products emerge, such as cryptobacked lending. You invest (U.S. dollars) or a stablecoin in a borrower who stakes cryptocurrency as collateral and in return receive interest," Roper says.

Although decentralized finance as a concept is extremely attractive, in practice there are risks some users, especially beginners, might not even consider.

"Power and control rest with you, the user. There is generally no 'central authority' to go to for help or customer service. If you lose your password or damage your computer, you're out of luck. It's imperative that you develop a strong contingency plan for using, storing and backing up your account information," says Dan Simerman, head of financial relations at the IOTA Foundation, a nonprofit working to build a standardized network protocol for the Internet of Things. In the world of cryptocurrency, getting locked out of your wallet means losing your entire investment.

On top of that, the level of volatility in some of these prominent DeFi strategies can be "unlike anything you've ever experienced," Simerman says.

You won't just be dealing with the traditional financial and operational risk factors in the world of decentralized finance – technical and security risk factors also creep into the calculus.

"There are countless opportunities for a perfectly sound investment with strong fundamentals to suffer from technical or financially engineered hacks completely outside of your control. You must mitigate these risks by understanding, at a bare minimum, the tools required to interact with decentralized applications," Simerman says.

And that, arguably, is the most important caveat for curious investors to know about DeFi in this day and age: It's a vast, rapidly evolving field with a lot of unfamiliar jargon and arcane technicalities. If you're not fairly tech- or crypto-minded or willing to invest the time required to understand the contours of the space, it's not wise to jump in blind.

Over time, many early pitfalls in this field should be gradually ironed out through improved code, security and increasingly established ways of operating.

"Just like the internet, DeFi will gradually emerge from its Wild West days to become more secure and dependable – something millions of people can use every day," says Barton, who expects DeFi to continue what has been a meteoric rise to date.

That's because "so many of the problems with traditional finance – whether it's a lack of transparency that makes it hard to assess risk, centralized institutions that can change the rules of the game in their favor or just the slow and clunky user experience of dealing with old banking technology – can be resolved by decentralization," Barton says.

DeFi, which burst onto the scene in 2020, has only become more relevant in 2021. Robinhood's sudden and widely unpopular move to restrict the purchase of many of the hottest Reddit stocks amid the mania earlier this year is a prime example of how centralized financial institutions can fail users when the going gets tough.

While certainly not appropriate for everyone, DeFi is a promising area that curious investors would be wise to start learning about while the disruptive field is still in its infancy.

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