A Complete Guide for DeFi Beginners
Decentralised Finance, or DeFi, has seen the biggest growth in the blockchain space since 2020. The amount of money locked in DeFi protocols is currently around $187 billion. This guide will give you a high-level overview of everything you need to know about DeFi.
What you will learn when you read this article:
- What is DeFi?
- What are the use cases of DeFi?
- What are the advantages of DeFi?
- What are the challenges faced by DeFi?
- How is DeFi different from the current financial system?
What is DeFi?
Decentralised finance is a term for financial applications and protocols that operate in a peer-to-peer fashion. They are built on blockchains, mostly on Ethereum. DeFi's goal is to create a better financial infrastructure to replace the current unfair and inefficient system. DeFi aims to do this by creating an open-source, permissionless, and transparent financial sector that is open to everyone and operates without a centralised authority. The main difference between DeFi and the current financial system is that DeFi eliminates intermediaries such as banks and financial institutions. Instead, users interact with each other in a peer-to-peer manner using smart contracts. A smart contract is deterministic software code that can be used to build financial applications, among other things.
What are the use cases of DeFi?
The DeFi sector is growing at a feverish pace due to its wide range of use cases. Almost everything that exists in the current financial system can be built in a decentralised way. For this reason, DeFi has attracted a lot of attention and has become the most creative area in the blockchain industry. Below are the most common use cases of DeFi.
Lending protocols
Lending protocols allow you to borrow and lend money in cryptocurrencies. Essentially, they allow you to take on the role of a bank. If you have cryptocurrencies as collateral, you can borrow money against that collateral at a certain interest rate. You can also lend your collateral as liquidity to others and earn interest on it. Unlike centralised peer-to-peer micro-lending platforms, there is no central authority that approves or rejects loans. You also provide collateral not to a single party, but to a pool of liquidity that borrowers can access for funding. Therefore, DeFi lending protocols are permissionless, cheaper, and reduce counterparty risk compared to existing solutions.
Stablecoins
Stablecoins are cryptocurrencies pegged to real-world currencies, usually dollars. They are always tradable at $1 and serve as a safe-haven asset in the cryptocurrency space. Stablecoins can be backed by fiat currency reserves, other cryptocurrencies, or operate as algorithmic stablecoins governed by a smart contract.
Decentralised exchanges (Dexes)
Decentralised exchanges allow users to exchange different cryptocurrencies in a peer-to-peer and permissionless manner without giving up custody of their coins. The digital equivalent of trading booths, only more efficient and secure.
Derivatives
Derivatives are contracts that derive their value from an underlying asset. Options trading is an example of a derivative. Derivatives can also be traded on DeFi platforms directly from your own cryptocurrency wallet without authorisation.
Margin Trading (Credit Trading)
Margin trading describes using borrowed funds to increase your position in a particular asset. As with derivatives, decentralised exchanges allow you to buy and sell assets directly from your wallet.
Insurances
Certain protocols in the DeFi space provide insurance against loss of funds through smart contract failure and exchange attacks. As with traditional insurance, you can secure your funds for a premium payment.
Oracles
Oracles are not limited to DeFi, but offer many services related to the DeFi space. They are data streams that connect real-world data, such as price streams in financial applications, to the blockchain. Without Oracles, many DeFi protocols would not exist.
What are the advantages of DeFi?
DeFi is Decentralised
Unlike traditional financial institutions, DeFi applications have no central point of failure. They are hosted on blockchains hosted on a global computer network. Therefore, server downtime and opening hours do not exist. DeFi applications also reduce the risk of collusion between financial institutions. For example, there are no banks that can collude to increase fees or manipulate interest rates.
DeFi is Unauthorised.
Traditional finance requires providing your identity and verifying your source of funds if you want to participate in the financial system. Moreover, it is not even accessible to many people in developing countries. DeFi has no KYC requirements and does not require permission to onboard new users.
DeFi is Efficient
DeFi transactions are settled instantly and there is no processing time. There are no regulations and surcharges for cross-border payments. Also, since DeFi protocols work with smart contracts and a fraction of the employees and expenses that banks have, making payments through blockchains reduces human involvement and physical infrastructure costs.
DeFi is uncensored
DeFi protocols cannot be unilaterally censored like governments because no single party controls the protocols and they are managed by the community. This also means that no transaction can be censored at the whim of a centralised authority. And because blockchain transactions are immutable, they cannot be backdated.
Defi is public
Ultimately, market forces will decide whether a project is viable or not.
DeFi is transparent
All transactions, the number of outstanding loans and the volume of transactions are visible on the blockchain and cannot be censored or manipulated. As such, DeFi is a more transparent system than the current financial system.
What are the challenges facing DeFi?
Smart contract bugs
Since DeFi is open and permissionless, there is a central authority that approves the standard of a DeFi protocol. Smart contracts may contain buggy code that can be exploited by hackers. Also, unless the user insures their funds independently, the funds are not insured in case of exploitation.
User Errors
Since transactions on blockchains cannot be reversed, the responsibility for correct transactions lies with the user. Coupled with the general public's poor financial literacy, this could be a serious obstacle for DeFi to overcome on its way to mass adoption.
Poor UX
Currently, the user experience on DeFi apps is still poor. Many are clunky and require more work to gather a critical mass of users. Also, there is no easy way to find a solution to a problem you have. Users have to look for apps instead of protocols that actively try to lure more users, as in traditional finance.
DeFi applications are slow
DeFi applications are slower than their more traditional counterparts. This is because blockchain technology is still less advanced than centralised software applications.
Network fees and congestion
The Ethereum network is currently struggling with high network fees that make many applications unusable for retail investors
Scaling
In the future, the DeFi space will need to find a solution to aggregate millions and potentially billions of users. Currently, more users lead to higher fees, which in turn leads to a worse user experience.
Lack of Centralisation
Not all DeFi implementations are equally decentralised. For a newcomer, it can be difficult to distinguish between trusted protocols and protocols where founders may have the admin key to shut down the entire protocol, leading to a death spiral for liquidity in the protocol.
Cascading effects caused by using other protocols
Since DeFi is still a new field, sometimes the emergence of new projects can lead to unusual user incentives. For example, a protocol may incentivise users to take on a lot of debt by offering large rewards for their native tokens. However, this could have a spillover effect on other protocols and lead to unnecessary risk-taking.
How is DeFi different from traditional finance?
Unauthorised and Authorised
Anyone with an internet connection, regardless of professional or geographical background, can join a DeFi app. Traditional finance may be inaccessible to users in developing countries or completely refuse to use their services for real or arbitrary reasons.
Open and Closed
In DeFi, anyone can play any role, whereas in the traditional system, institutions are always financial service providers and recipients of citizens. You are also free to contribute to innovations in the system by creating new applications or building on existing ones.
Uncensored and Censored
Governments or regulators are free to censor financial services based on objective or arbitrary grounds in traditional finance. DeFi is built on software code and cannot be constrained by country borders or even international regulators.
Costs
Traditional finance, which adds up all expenses such as infrastructure, capital cost, and labour cost, is largely more expensive than DeFi. While DeFi's user experience and capital efficiency lag behind conventional finance, you should consider that the oldest projects in this space were only established in 2018.
Building blocks
Traditional finance is still basically a brick-and-mortar industry, although it has moved towards more digital innovation over the last decade. DeFi is a digitally native version of finance built entirely on blockchain and has no physical representation like the cryptocurrencies it uses.
Solution
DeFi is undoubtedly one of the most exciting growth areas in the crypto space today. It brings promising innovations to the table that could change today's financial system for the better. However, it still faces enormous challenges and is nowhere close to competing with traditional institutions as blockchain enthusiasts would like to believe. Do you think DeFi will soon rival banks or will it remain a financial experiment for tech enthusiasts? We'll have to wait and see.
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