DeFi is the short form of decentralized finance, which refers to all types of decentralized financial services. DeFi is a type of decentralized finance based on blockchain technology and smart contracts in which conventional financial instruments are not offered via financial intermediaries such as brokerages, exchanges, or banks but rather through smart contracts running on a blockchain. The most popular smart contract platform currently used for DeFi is Ethereum.
What Does Defi Mean?
DeFi is an umbrella term that refers to a multitude of apps and initiatives in the public blockchain environment aimed at disrupting the world of conventional finance, primarily through peer-to-peer trading. Some DeFi programs offer high-interest rates but come with considerable risk. As of December 2021, the total value of assets used in decentralized finance was estimated to be over $100 billion.
How Did Defi Start?
The crypto space has seen a lot of spectacular growth in the past few years. DeFi was designed with the goal of creating an open financial system that eliminates the need for reliance on a central authority, especially banks, and it has attracted significant venture investors in the cryptocurrency space due to the wide application of DeFi. Some people argue that DeFi started in 2009 with the advent of Bitcoin, which was the first peer-to-peer digital currency based on the blockchain network.
MakerDAO, a decentralized autonomous organization based in lending stablecoins, is recognized for creating the first widely used DeFi program on the Ethereum blockchain. It allows users to borrow Dai, the platform's native token pegged to the US dollar.
How Does Defi Work?
DeFi eliminates intermediaries in financial transactions. It is centered on decentralized programs, sometimes called DApps, that execute economic activities on distributed ledgers known as blockchains. These DApps are accessible with the aid of a Web3-enabled browser extension or application.
Most DeFi applications are built on the Ethereum network because it is the most mature and stable public smart contract enabled blockchain. But many DeFi applications also integrate with one or more of the other public blockchains or public sidechains that are beginning to gain widespread use, such as Cosmos, Polkadot, Dfinity, and others.
Apps built on a decentralized smart contracts platform execute transactions automatically when specific criteria are satisfied and provide far greater flexibility than human-managed financial services. Typically, these smart contract programs, or DeFi protocols, operate on open-source software developed and maintained by a developer community.
Types of DeFi
Due to the wide application of these smart contracts, DeFi can be used for many purposes. Some of these purposes include:
Lending and borrowing platforms
DeFi provides easy facilitation of peer-to-peer lending and borrowing with privacy. Lenders can lend out their crypto holdings and earn interest per minute, while borrowers can borrow stablecoins by providing collateral like NFTs.
Stablecoins are often tied to the underlying assets in order to mitigate price volatility and are more regulated than other cryptocurrencies.
Decentralized exchanges (DEXs) allow users to trade cryptocurrencies using peer-to-peer interactions. This process is possible through automated smart contracts.
Yield farming is one of the more risky applications of DeFi smart contracts. It involves staking or leasing crypto assets in order to earn a high rate of return or compensation in the form of additional cryptocurrency.
Elements of DeFi
DeFi comprises many different building blocks that form a software stack called decentralized finance. A software stack encompasses all of the components of a DeFi system, and the constituents of each layer are meant to perform a specific function in the design. These layers have to work simultaneously for DeFi to work, meaning if one of these layers ceases to function, the other layers will also stop functioning. The major elements or layers are:
The settlement layer is the foundational layer, also called layer 0. It is the primary layer upon which all other DeFi systems are built. It incorporates both a public blockchain and a cryptocurrency for the smart contracts to run. Ethereum and its native currency ETH is an example of a settlement layer.
The protocol layer defines the protocols and guidelines which all tasks and activities must follow.
The application layer consists of consumer-facing applications, also known as DApps.
The aggregation layer consists of aggregators that combine various applications from the application layer to provide financial services like borrowing and lending.
What are the benefits of DeFi?
DeFi has a lot of benefits over traditional banking. Some of these include:
DeFi platforms are very transparent as everybody can access the code for review. Users can also create wallets easily.
Geographic boundaries do not constrain DeFi networks.
The markets are always open 24/7 to everyone, unlike traditional banks and markets that can be closed down by government or centralized institutions.
DeFi platforms provide a lot of privacy for users, unlike traditional banking, as users don't have to provide their personal information before making transactions.
Fast and efficient
Transactions on DeFi platforms are autonomous; therefore, they are fast and efficient. Unlike traditional banking, you can transfer your funds in minutes and control your own money, where no centralized institution has control over your money.
Disadvantages of DeFi
Like everything else in the crypto space, DeFi has disadvantages and risks that consumers must be careful about. Some of these disadvantages include;
DeFi platforms can sometimes be unpredictable. If the blockchain on which a DeFi project is hosted is unstable, the project will spontaneously inherit the host blockchain's instability.
Low or tight liquidity
Liquidity refers to an asset's or security's ability to be converted into quick cash without impacting its market price. Although the total value of assets in DeFi is now estimated to be over $100 billion, it is still low compared to the value of assets available in centralized finance.
Lack of insurance
Insurance gives consumers financial protection and reimbursement of losses. Unlike centralized finance such as banks and brokerages, there is a lack of consumer protection and insurance in decentralized finance.
Prone to bugs, coding errors, and hacks
DeFi platforms are prone to attacks from hackers and bugs since everything is in code. Due to the irreversibility of blockchain transactions, you cannot readily reverse any inaccurate or fraudulent transaction on a DeFi network.
High volatility and risk
Decentralized finance markets are very volatile, and consumers are always advised to only invest money they are willing to lose.