DeFi – Decentralised Finance
Decentralised finance (DeFi) is an open financial system that operates without interference from traditional institutions like banks. DeFi products and services are typically built on blockchain technology, such as Ethereum, and help facilitate trading in cryptos and NFTs. This page sets out the definition of DeFi, explains its role in the crypto market, and lists the respective pros and cons.
The aim of decentralised finance is simple – cut out central institutions and hand financial control back to the user community. It offers a collaborative financial ecosystem accessible to all.
The DeFi market takes its inspiration from blockchain, the technology behind Bitcoin tokens. In this innovative system, money markets are always open with no central banks to block and profit from transactions. Payments through DeFi are considered secure with questionable crypto contracts and prices coming under community scrutiny.
Where Initial Coin Offerings (ICOs) were all the rage in 2017, DeFi is the latest crypto trend. In June 2020, $1 billion worth of assets were locked up in DeFi protocols, according to the DeFi Pulse Index. Today, over $20 billion worth of crypto stock sits in smart contracts with volumes increasing daily.
How DeFi Works
Products are built on blockchains using smart contracts which negate the need for a central bank and allow individuals to request, verify and process transactions. A smart contract cannot be altered when it’s live – it will always run as programmed. DeFi protocols ensure no single person can change the investment contract or add another party, meaning that nobody can siphon off crypto assets.
There are multiple DeFi use cases. Programmable money is a default feature of decentralised Ethereum tokens, for example. These let you do things with cryptos that you can’t do with Bitcoin, such as lending and borrowing, scheduling payments, plus investing in index funds.
Another popular product in the DeFi space is stablecoins. These altcoins help protect against the high volatility seen in traditional cryptos. Their value is pegged to another asset, such as a fiat currency like the GBP. This provides longer-term investors with a more stable trading product.
DeFi Vs Traditional Finance
Here we list the key differences between decentralised finance and traditional financial systems:
- You hold your own money versus it being held by companies or banks
- Transactions are pseudonymous versus payments being tightly linked to your identity
- You control where your money goes versus having to trust companies not to mismanage funds
- Transactions happen in minutes versus the days it can take with traditional financing solutions
- The DeFi market is open to anyone where traditional financial companies may restrict certain services
- The DeFi market is always open where traditional financial systems often close over the weekend, for example
- DeFi is built on transparency – anyone can look at financial data and inspect how it works versus traditional institutions that are closed books
Merits Of DeFi
- Rapidly send money around the globe
- No human error or mismanagement
- Fast & secure access
- Borrow with privacy
- 24/7 market
Criticisms Of DeFi
Since over 90% of DeFi projects are based on Ethereum, a lot of the challenges Ether faces decentralised finance does too:
- The slightest flaw in the code of a smart contract can lead to loss of funds
- The Ethereum blockchain is still being developed with more changes to come
- DeFi transactions and lending rates can be expensive when the market is congested
- Over $20 billion is locked in the DeFi market but this is a drop in the ocean compared to traditional financial systems
- Insurance is rare in the DeFi market but common in traditional financial systems, which ensures protections for the end-user
- Bitcoin, Ethereum and Binance Smart Chain use different blockchains, each with its own DeFi ecosystem and community. As a result, many projects are siloed
There are several ways you can start investing in the DeFi space, from day trading cryptos to yield farming. Trading popular digital currencies like Bitcoin, Ethereum and Neo are available at platforms like Coinbase, Binance or Kraken. Traders can also head to decentralised exchanges (DEX) to swap tokens via digital wallets without an intermediary.
Lending apps are also popular. Lenders receive interest payments while borrowers gain access to capital loans. With DeFi, borrowers can use their funds as collateral and borrow without a credit score.
Another example is staking. Some blockchains are based on Proof-of-Work (PoW) systems like Bitcoin while others are based on Proof of Stake (PoS). Staking is where you are rewarded for locking your assets in a network in exchange for providing security and confirming transactions on the blockchain.
You can also start trading NFTs which have gained popularity due to heightened media and news coverage. NFTs allow for the identification and authentication of virtual arts, gaming items, online collectables, and other digital assets.