Defi stands for decentralized finance. It covers all peer-to-peer financial services on a public blockchain. For many years, financial services have been rendered in a centralized system.
Borrowing and lending, insurance, investments, and tons of other financial services require the banks and similar organizations to serve as intermediaries. The concept of DeFi was proposed to eliminate these intermediaries and enable users to have access to financial services in a peer-to-peer system.
The dominant blockchain used to build the DeFi applications is the Ethereum blockchain. The Ethereum blockchain is preferred to that of Bitcoin solely because it supports multiple financial and even non-financial services.
In recent times, other blockchains have sprung up. The Solana blockchain and the Polkadot blockchain have been used by developers more recently to build DeFi products. The obvious reason for developers turning to these blockchains is the high cost of transaction and scalability issues experienced on the Ethereum blockchain.
Despite the challenges that come with building on the ETH chain, the ERC-20 network has still thrived and is still regarded as king in the world of DeFi. No doubt, a lot of DeFi users can’t wait to finally experience the launch of the highly anticipated Ethereum 2.0. ETH 2.0 is expected to fix most of the problems developers and users currently experience on the Ethereum blockchain.
Features of Decentralized Finance
There are a handful of features in the world of decentralized finance. Interestingly, as each day passes by, more and more useful features are being unlocked. In the meantime, some popular features DeFi is known for include; borrowing, lending, saving, investing, and insurance.
Borrowing and Lending
DeFi protocols today have made it possible for individuals to borrow funds, regardless of a person’s background or status. Users can also lend out funds or assets and get tangible returns.
Borrowing and lending in the DeFi ecosystem are quite different from the framework in traditional finance. For example, users who borrow from banks or other similar financial institutions have a minimum requirement. Personal details like the address and financial record of a user are needed to obtain a loan. Additionally, an individual may be unable to obtain funds from someone in a foreign nation.
With DeFi, users do not need to reveal personal information to have access to loans. Anyone anywhere can obtain a loan as long as the collateral is staked. Additionally, some kinds of DeFi loans do not require collateral. These kinds of loans are known as flash loans but are issued and returned within a very limited time frame. Flash loans are accessible when the transaction is executed within a single block on the blockchain.
Aave protocol is one of the most popular decentralized applications (dApp) for borrowing and lending. On the protocol, loans are usually over-collateralized to prevent lenders from suffering losses due to market volatility. This may not necessarily be an issue for borrowers who return their loans on time.
Saving and Investing
DeFi protocols allow users to save and invest without going through brokers or other intermediaries. Interestingly, DeFi platforms offer users a better-earning percentage for saving and investing. However, this comes with a slightly higher risk because of market volatility.
The banking system gives investors an average annual return of 3-5% per annum. DeFi protocols on the other hand give users better returns. Many DeFi platforms offer an annual percentage yield that is greater than 25% per annum. Additionally, liquidity pools offer users an extremely high APR for a start. For example, Tatcoin offered an APR for staking and farming as high as 20,000% when it just launched.
In cases where the APR of the pool is extremely high, the smart contract automatically adjusts as liquidity is being added to the pool. Early adopters usually gain more rewards from DeFi pools.
Platforms like Uniswap and Sushiswap also make it possible for users to swap tokens from one form to another. Thus, a user can convert a stable token to a DeFi token and gain from the price appreciation over time. It must be noted that investing in DeFi assets comes with some risks and users are not advised to invest without carrying out appropriate research on a project.
Insurance is not left out among the services that DeFi protocols offer to users. Nexus Mutual and cover protocol are two very popular insurance protocols in the decentralized ecosystem. They make it easier for users to have access to funds when losses covered by the insurance platform are incurred.
Decentralized insurance platforms are not controlled by individuals or a specific central body. It is run by its members and members of the protocol have the responsibility of determining which claims are true and which claims are false. The decision of the members is recorded and enforced by smart contracts on the blockchain. Since the protocol operates on the blockchain, it is impossible to falsify information or manipulate results.
The Risks Involved in Using De-Fi Services
Since the concept of decentralized finance is relatively new, it is expected that the technology will be followed by some shortcomings. Also, some features that make DeFi protocols unique have also proven to be a disadvantage in another way. For instance, since DeFi protocols are built on the blockchain, it is impossible to make alterations. This can be a disadvantage when smart contracts are deployed with coding errors.
In the case of a fraudulent financial transaction, corrections cannot be made because blockchain transactions are irreversible. A typical example is the Yam finance protocol. In 2020, Yam finance grew explosively and raised $750 million. Unfortunately, this success was short-lived as the protocol crashed a few days after it was launched. The crash was a result of an error in its code and the negligence of the developers.
Additionally, DeFi tokens are extremely volatile. Much more volatile than fiat currencies. Thus, when individuals borrow, lend or save, there is the possibility of losing a significant value in the asset. Liquidity pool providers may also suffer impermanent loss.
Finally, the fact that DeFi protocols are open-source makes it easy for anyone to copy the code of a protocol and replicate it. Since there is free entry into the DeFi ecosystem, even unreliable individuals or teams can create imitation projects and scam projects and disappear with the hard-earned funds of contributors.
While many early crypto users view DeFi as the future of finance, DeFi projects still have multiple limitations and have not fully synced with the existing financial ecosystem. No doubt, DeFi platforms have solved tons of problems existing in the world of finance. However, the numerous loopholes of DeFi projects have been a cause for concern in the past few years. Until these significant issues are fixed, DeFi will be unable to totally replace traditional finance.