DeFi: a financial dream come true without financiers

By Crypto4light | crypto4light | 30 Mar 2023

Bankers have always been in charge of banking. They set up everything from savings accounts to secured loans. But what if they are replaced by computer code? This is what Decentralized Finance, or DeFi, is all about. People who support DeFi say they can make a world where money moves more quickly and fairly. Critics say that all DeFi does is bring back hype, unfounded speculation, and the chance of losing money on cryptocurrencies.
1. What is it?
DeFi is based on programs called "decentralized applications" (dapps) that run financial tasks on digital ledgers called "blockchains." Blockchains are a technology that was made for bitcoin but is now used by many other things as well. Dapps let people lend or borrow money from other people, go long or short on a variety of assets, trade coins, or earn interest on a savings account. Smart contracts are pieces of software that have rules built into them that control how transactions work. Many of these apps can also talk to each other and work together to make complex financial services.
2. How do smart contracts work?
You can think of an automatic payment at a regular bank as a smart contract. It will take money out of your account on the first of every month and send it to your mortgage company until you tell it to stop. Contracts for DeFi can be a lot harder to understand. DeFi applications are made to work on their own by connecting counterparties directly, so they don't need a central middleman. Once a smart contract is up and running, it is usually impossible for anyone to change it or mess with it. A blockchain called Ethereum runs many of the smart contracts.
3. What is the most common example?
All DeFi apps work a little differently, but in general, people can connect a cryptocurrency exchange account to a DeFi app and then lend or borrow some of their coins. Many typical DeFi transactions are much more complicated. For example, some people buy "wrapped Bitcoin," which is a token on the Ethereum network that is backed 1:1 by Bitcoin and is meant to speed up DeFi transactions. These users sign complicated contracts and use multiple DeFi applications to make more money.
4. What's the difference between this and "fintech"?
There are companies that allow so-called "peer-to-peer" (P2P) lending, which connects investors and borrowers directly instead of going through a bank as usual. However, these companies are still in charge of the process. The people who make dapps try to make a platform that is not controlled by them and where users can talk to each other directly.
5. What is the importance of DeFi?
Analysts keep track of the growth of dapps by looking at how much money is locked in the DeFi ecosystem. This is because many smart contracts require collateral from counterparties as a guarantee. The DeFi Pulse tracker shows that by the end of August, people had put in more than $7 billion worth of collateral into DeFi applications. At the same time, the amount did not go over $1 billion at the end of May. Even with this growth, DeFi is still a long way behind the $360 billion cryptocurrency market as a whole. There are more than 200 DeFi applications, and more are being made every week. MakerDAO, which came out in 2015, was the first dapp that caught on with a lot of people.
6. Why is DeFi getting so much attention at the moment?
This summer, a number of DeFi apps, like Compound, came out and promised triple-digit returns. Dozens of speculators were drawn to this right away. Long-term, the idea of financial services that can be used anywhere in the world and don't depend on banks and other companies that could go bankrupt because of the COVID-19 pandemic is becoming more appealing.
7. Who benefits from this, besides people who bet on it?
Still, more than a billion people around the world can't use basic banking services. DeFi says that anyone with an internet connection and a mobile phone will be able to use a full range of banking services, which means that they can use their savings to make money.
People who "mine" bitcoin and other cryptocurrencies are one group that is turning to decentralized apps. Mining is a process that uses computers to check the transactions of a currency and is paid for with that currency. Miners often can't get loans from banks or other traditional lenders.
8. What could go wrong?
Hackers can get into DeFi accounts, just like they can get into any other digital currency or software account. Funds can be lost because of a simple mistake in the code. One example is the Yam Finance project, which quickly raised $750 million but then failed a few days after it was released because of a bug in its code. The internal logic of dapp can also change the value of the coin by making it more or less available in the future. This is exactly what happened to Ampleforth over the summer, when its market capitalization fell by almost two-thirds in less than three weeks. There is no deposit insurance for DeFi applications, but this could change if development teams like Nexus Mutual start building something similar to insurance in the DeFi ecosystem.
9. Why do you think the possible disaster might happen?
Since there are no banks or other middlemen to keep an eye on things, people who use DeFi applications have to be very careful about what they do, because the transactions they make can't be taken back. Users of DeFi should also read the relevant white papers and tutorials to learn exactly how a service works. If they don't, they might be in for some unpleasant surprises. Another risk factor is that many DeFi ideas are so new that it's not clear if they follow the rules.
Many analysts think that DeFi is just another fad that won't last. It has the same chance of failing as any other trend that gets a lot of attention. But now, the main pool of projects is growing quickly, which means that many people can make good money on the new trend. The fast-growing decentralized financial system is attracting more and more people who want to use it and make new applications and protocols. But keep in mind that despite everything, DeFi is still the same high-volatility and unstable financial instruments as everything else. Even though decentralized finance is the safest and most open system, these risks are not in any way lessened by it. Before you start investing your money, you should learn more about the system, study a certain protocol, choose a strategy, and decide how much risk you are willing to take.