An Introduction to DeFi: What It Is, Risks and Benefits

DeFi-meaning

DeFi vs. TradFi

Decentralized finance, or DeFi, is an open platform for anyone to use, exchange, lend, and borrow cryptocurrency without any intermediary. 

In traditional banking systems, which we refer to as TradFi, the process to secure a loan is long. To do so, one will book an appointment at their local bank, wait weeks, sometimes months for paperwork. Finally, the bank will approve the loan depending on one’s credit score, employment history, income, etc. 

For some people (generally the middle and upper class in developed countries), this barrier does not exist. However, for people in emerging economies and lower-class individuals in developed ones, it can be incredibly difficult to access and secure a loan. In fact, some do not even have access to financial services.

General Benefits of DeFi

Accessibility

DeFi solves this problem by allowing users to deposit a collateral such as Bitcoin or Ethereum and borrow stablecoins against their collateral. These loans are called overcollateralized loans. They allow the borrower to only borrow an amount less than the collateral. This is to prevent a borrower’s default. 

These stablecoins are representations of fiat currencies such as USD or EUR. Common stablecoins are USDC, USDT, BUSD which are centralized stablecoins that are backed 1 to 1 with the US dollar. The issuers of these stablecoins are accredited institutions. They have 1 dollar in a bank account for every dollar of USDT or USDC that exists. 

Stablecoins can then be exchanged for local currencies which can be used to pay for goods and services.

Savings opportunity

For people who have readily access to banking, DeFi can still be useful to them. Indeed, the yields in DeFi outperform what traditional banks offer. Especially in high interest savings accounts, by over 100 fold in a lot of cases. 

For example, BNP Paribas guarantees 0.05% interest on Euros, and Bank of America only offers 0.01% interest. For comparison, Anchor Protocol offers 19% interest on UST which is a stablecoin that follows the price of the US dollar one to one. This is 1900 times higher than Bank of America’s interest rate. 

With all global currencies being inflated by over 5+% last year, savers are losing their purchasing power. DeFi can solve this problem because one can earn yields higher than the rate of inflation through lending stablecoins.

Smart contracts

DeFi is designed to be borderless and permissionless which allows virtually anyone with cryptocurrency to start earning yield on their assets today. 

One of the ways DeFi has become permissionless is through the use of smart contracts which enable trusted transactions that do not require an intermediary such as a bank. 

Definition

Smart contracts are simply programmable contracts which fulfill specific rules and agreements. For example, a smart contract can be programmed to exchange Ethereum for Bitcoin at a specified price. This can enable a buyer and a seller to exchange without having to go to a bank, crypto exchange, or legal counsel to perform this transaction. 

Smart Contract Exploits (hacks)

Smart contracts are also open source which means anyone can view the program’s code and verify that it works as intended. The open source nature of DeFi is one of the reasons why over $200B USD is trusted on DeFi platforms. 

However, like any software program, there is a risk that there could be a bug or an exploit (sometimes referred to as a hack) in a smart contract code. There have been DeFi applications that were exploited in the past resulting in theft of users’ funds. 

Since 2020, there has been about $2.3B stolen due to smart contract exploits. This is about 1% of the total amount of dollars that remains in DeFi. Many applications are well audited by multiple third parties which can prevent most exploits. However, this technology is still very new and even audited applications can still be subject to exploitations. 

Blockchain Technology

Another way DeFi remains permissionless and borderless is because DeFi applications and smart contracts are built on blockchain technology. The most common blockchain that powers DeFi applications is Ethereum. 

A great analogy to represent this relationship is the relationship between an operating system such as Windows 10 and applications such as Google Chrome or Microsoft Office. In this analogy, the Ethereum blockchain could be thought of as the operating system of DeFi applications and smart contracts. 

Smart contracts and blockchain network

Coming back to smart contracts, since they are built on blockchain networks, they also inherit the security and decentralization of the blockchain. For example, to deploy or make changes to a smart contract, this requires a transaction on the Ethereum blockchain. Therefore making unauthorized changes to smart contracts are just as difficult as making unauthorized transactions to the Ethereum blockchain.  

Ethereum network

Similar to Bitcoin, Ethereum is decentralized because the network operators are not tied to a single location. If one network operator goes down in the USA, there are thousands of other operators globally that can continue keeping Ethereum online and working. 

Mining Ethereum

Ethereum network operators, often called Ethereum miners or node operators, engage in a process called mining which requires specialized computers to solve complex mathematical functions to verify and post transactions on the Ethereum blockchain. 

When 51% of all Ethereum miners verify that the mathematical function is correct, the block gets posted to the blockchain and is almost impossible to change. This is how Ethereum miners agree on whether transactions are legitimate or not. This process is often called achieving consensus. 

Mining difficulty

Ethereum miners get rewarded in ETH and blockchain transaction fees for participating in this process. The more miners that compete for this reward, the more difficult it is to mine Ethereum. This is called mining difficulty. 

Mining difficulty can represent the decentralization of the network because it makes it much more difficult for bad actors to attack the network. If a bad actor were to attack the network, they would have to control 51% or more of all miners at the same time which is incredibly difficult and expensive. 

Other blockchain networks

All blockchains have some similarities and differences that offer some properties that others do not. For example, Bitcoin does not support smart contracts because it is written in a programming language that could not enable the level of programming that smart contracts require. 

Ethereum is turing complete and is written in the Solidity programming language. This property allows Ethereum to support smart contracts. However, this added layer of complexity can make transaction fees higher and less safe to use than Bitcoin. 

Other blockchains such as Binance Smart Chain and Solana offer much cheaper transactions than Ethereum but at the cost of decentralization. Like with any investment, there are risks associated. Depending on the investors risk tolerance, DeFi and crypto related investments may not be ideal. I hope this blog post helped you fathom some of the risks and benefits of DeFi. Let us know in the comments!or

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