DeFi is rapidly getting accepted by people, especially in the crypto space. DeFi products are accessible to anyone who has an internet connection. By far, there is a billion-dollar worth of cryptocurrency that is currently flowing through the DeFi applications and is still expanding every day.
DeFi is a term set to decentralized financial services like decentralized insurance companies, decentralized money markets, decentralized exchanges, and a lot more. The markets with DeFi are 24/7 accessible, and there are no centralized authorities that can deny you access to anything.
The previous services were at high risk to human error, but DeFi made them safer through a code that anyone can scrutinize and inspect. It’s an alternative to those systems that are tightly controlled and held by a decade-old process. Unlike banks and other centralized infrastructures, DeFi gives your transparency and control over your money. This allows you to gain exposure in the global market and a replacement for your local currency.
Decentralized Finance (DeFi) and Bitcoin
DeFi was first used in Bitcoin. Bitcoin is an established digital currency that is not under the control of the government or any bank. This allows anyone who has access to transfer funds worldwide without the need to consult a third-party financial institution like banks.
The transfer was possible through a decentralized system where participants need to agree on a ledger account.
No one has the power and authority to change Bitcoin’s rules. Unlike traditional finance, the company’s rules are embedded into technology, where companies can shut down their markets and governments can devalue savings.
This very day, the world’s financial system and its services are still centralized. Evey financial institution, insurance company, stock market, and banks have someone who holds authority over your finances.
However, the centralized system, CeFi, which is well-accepted all over the world, is vulnerable to fraud, mismanagement, and corruption. But what would happen if all financial companies would decentralize their system the way Bitcoin did?
You might also want to read: How to Buy Bitcoin
DeFi Components
Through decentralized money such as cryptocurrencies that can be used for automated activities, we can build insurance companies, lending services, exchanges, and other financial institutions that anyone cannot control and have no owner. This can take place with the following DeFi’s components:
Component #1: Infrastructure
To build up a decentralized financial system, an infrastructure for running and programming decentralized services is needed, which Ethereum can do.
Ethereum is designed as a “do it yourself” platform for creating decentralized programs, known as Dapps, in short for decentralized apps. Using Ethereum, an automated code called smart contracts can be written to manage any financial service people would want to build in a decentralized manner.
This only means that if you already determine the rules as to how you want a certain service to work, they can deploy those rules to Ethereum so they would become immutable, not allowing people to have control over it.
Once you have a system in a place like Ethereum, you can start building your own decentralized financial system.
Component #2: Stable Money
Every financial system needs money. There’s no question about that. You need to use a stable currency to operate in a decentralized system.
Although Bitcoin is decentralized, it is not entirely compatible with Ethereum and only has basic programmable functionality. On the flip side, there’s Ether, which is programmable and compatible, but it’s extremely volatile.
This is where stable coins would come in. Stable coins are digital currencies that are fixed to the value of a real-world asset, for instance, the US dollar. To follow the sole purpose of DeFi, it is not advisable to use fiat money reserves since this will stand in need of a central authority.
The preferable currency you could use is DAI, a decentralized cryptocurrency set against the value of the US dollar. Each DAI is equivalent to the US dollar. Far from other stablecoins whose value is directly backed by US Dollar, DAI is supported by cryptocurrency collaterals that can be viewed on the Ethereum blockchain publicly.
DAI is collateralized, so if you put up a $1 Ether deposit, you can immediately borrow DAI up to 66 cents. If you want to get your Ether back, you just have to pay what you owe then your ETH will be released.
You can buy DAI on an exchange if you don’t own any Ether you could use as collateral. Although Ether is extremely volatile, the value of Ether backing the DAI will remain the way it is or more because DAI is overly collateralized.
The stable coin DAI is basically a smart contract that is established on the Ethereum platform.
DAI is the currency for DeFi services as it is a decentralized stable coin that cannot be censored nor shut down.
Component #3: Financial Services
After finalizing stable decentralized money, services come next.
DEX, or decentralized exchange, operates based on smart contracts or rules that enable users to sell, buy or trade cryptocurrencies. Like DAI, DEX is established on the Ethereum platform, so they operate without the need of a central authority.
There are no sign-ups, identity verification, exchange operator, and withdrawal fees needed to trade on DEX. Instead, smart contracts implement rules, secure funds, and execute trades when it is necessary.
Dissimilar to centralized exchanges, there is no need for you to deposit a fund to an exchange account in order to carry out a trade, which destroys the risk of exchange hacking that mostly happens on centralized exchanges.
Another financial system that can also be decentralized is the money market.
An Ethereum-based lending and borrowing decentralized application automatically links the borrowers to lenders, enforcing the terms of loans and interest.
In Compound, you can lend your crypto and gain interest in it. For instance, you need money to buy groceries or pay house rent, yet the only fund you have is crypto. You can deposit the cryptocurrencies you have at hand as collateral to borrow against it.
Advantages and Risks
Now, you might have realized the advantages DeFi can provide. From interoperability to transparency to decentralization, offering a flexible user experience with free services. Surely, DeFi could change the course of the financial system globally. However, no matter how good it is, you still need to be wary about some risks.
DeFi is still at its development stage, and this only means that things could still go out of control. There are previous smart contracts where people were not able to define proper rules for certain services, allowing hackers to steal money by coming up with a way to exploit loopholes
The ecosystem of DeFi is still infested with hacks and structure mishaps. There are also scams that abound in the fast-growing DeFi infrastructure. There are cases of “rug pulls” in which technocrats clear out protocol funds and unable investors to trade are common. Yet, with well-established protocols, people can prevent these things from happening.
Moreover, a decentralized system is a clear example of the “code is the law” rule. The algorithm of smart contracts is encoded with needed terms of use and constructs to execute a transaction between two parties. This sounds quite good, but software malfunction is always a possibility because of some factors.
For instance, what if there’s an incorrect input? Or what if a compiler is in error? Who will be accountable for these mistakes?
There are aspects that need to be grounded before DeFi finally becomes a system used by masses.
There is no doubt that the DeFi revolution in the world’s financial system would benefit a huge fraction of the population that suffers from high transaction fees, inefficiencies, and financial discrimination. However, the coming years are yet to tell if it will cross the bridge to mass adoption.
