DeFi stands for decentralized finance, representing a financial ecosystem that is not subject to a central authority and is built on the block chain. While conventional finance models depend on central institutions like banks, DeFi protocols function seamlessly in a decentralized manner.
Smart contracts enable DeFi protocols to run smoothly without the need for human interference. The automation afforded by smart contracts makes financial models in the decentralized world function more efficiently, with less friction and fewer human errors than centralized finance (CeFi) models.
The DeFi ecosystem has recorded tremendous growth in recent years, with a current market cap of $171 billion and a cumulative TVL of $227 billion in liquidity pools. The current total value locked (TVL) and market cap are pointers to how DeFi is revolutionizing finance.
Liquidity pools are stacks of funds locked in smart contracts by investors. While TVL can indicate interest in particular protocols, an overall high TVL surely serves as a display for growing interest in DeFi solutions generally.
User-provided assets that are locked in liquidity pools make it possible for other users to swap tokens in a decentralized ecosystem. To attract user participation in this ecosystem, they are rewarded with other tokens, voting rights or other incentives.
Some key areas in which DeFi has caused a paradigm shift in the financial ecosystem include; peer-to-peer transactions, investing, or borrowing and lending. Let’s explore some of these.
In the past, it was almost impossible to transact with total strangers or foreigners in a trustless way without using intermediaries. Today, smart contracts have enabled secure peer-to-peer transactions without an intermediary.
DeFi makes P2P transactions more seamless. A regular individual can barely transfer huge sums through the banking system without raising eyebrows. Also, sending funds across countries can be painfully slow and expensive.
However, in DeFi, users can freely transfer as much money as they wish. More interestingly, transactions executed on the blockchain are usually instant, and one can send funds across borders within the blink of an eye. For their transactions and payments, users can choose either a centralized or decentralized exchange.
Contrary to Decentralized Exchanges (DEXs), centralized exchanges like Binance and Kraken require users to complete a know-your-customer (KYC) verification before buying or selling cryptocurrencies to curb illegal activities like stealing and money laundering.Eventually, this may become a relevant topic for DEXs on their way to mainstream adoption.
Traditional investing allows brokerage firms to serve as a bridge between investors and stocks or commodities.These middlemen usually get their commissions in between. However,decentralization removes these intermediaries, as it allows you to buy digital assets directly and without the need of a broker. Investors can buy Bitcoin or Ethereum directly on decentralized platforms to make tangible returns on investments. In addition, users can feel more secure investing, knowing they own their private keys.
DeFi platforms like Yearn Finance and Bancor offer great investment opportunities. Yearn Finance is a protocol for yield farming where users can stake their tokens in liquidity pools to earn an annual percentage yield for a fixed period.
Bancor protocol is similar to Yearn Finance; users earn tangible profits from staking tokens on the platform.However, the staking structure of the Bancor protocol is different as it allows users to gain an APY from a single token rather than a pair of tokens. Hence,the Bancor protocol is less risky than Yearn finance, as the single token exposure protects investors from impermanent loss.
Although investing in DeFi platforms involves some level of risk, the yields from staking and farming are relatively high compared to traditional finance models. DeFi investors can earn as much as 15%-100% annually by providing liquidity to decentralized protocols.
Borrowing and lending in DeFi have a slightly different framework from traditional finance. Borrowers do not need a credit report to obtain loans. They only need to deposit another crypto asset as collateral.
Aave protocol is the most popular DeFi platform used for borrowing and lending. Lenders can deposit Aave tokens and earn interest on the tokens deposited when borrowers repay a loan.To protect lenders from losing, borrowers can take loans valued at up to 75% of their deposit collateral. If the borrower fails to repay the loan, the lender automatically gets the collateral deposited. Bullish investors may also utilize this mechanism of borrowing and lending to establish a leveraged position in an asset.
Flash loans are another fantastic feature present in DeFi but absent in traditional finance. Borrower scan obtain flash loans without the use of collateral. However, they must return the loan within the same transaction. Arbitrage traders take advantage of flash loans and profit from price instability in the market. Opportunities like this are absent in traditional finance.
Decentralized finance allows individuals to access financial services without third parties or mediators.Admittedly, DeFi has some downsides, including complex protocol interfaces and bad user experience, high risks due to volatility of assets, and scalability issues in numerous block chain protocols.
Despite these shortcomings,decentralized finance has proven to be more beneficial than harmful. Upcoming innovations in block chain will surely fix the flaws DeFi users currently experience. Undoubtedly, DeFi is the future of finance, and now is the time to start utilizing DeFi solutions for borrowing, lending, investing, and transacting.
