DeFi is short for
Decentralized Finance, and does away with traditional financial institutions like banks and credit unions. These middlemen are forced to charge high rates as they have the overheads all large organizations are exposed to, from salaries to office rentals.
Instead DeFi allows people to lend, borrow, transfer, invest crypto currencies in a peer-to-peer fashion by making use of smart contracts. No intermediary is needed here as these smart contracts execute automatically when certain conditions are met.
Some Examples of Smart Contracts:
- If John works 40 hours, pay him his salary into his wallet.
- If the Team A beat Team B in football, send 2 ETH from Victor to Jose.
- If the weather in Chicago goes above 32 and the Dollar goes above .75 sterling, execute a trade.
The Problem with Middlemen
In a middleman scenario the bank becomes a single point of failure. If their system gets hacked, or their mainframe loses track of your last deposit, or they change your monthly fees, you are directly exposed.
Your info is replicated for every bank you bank with, in other words with every middleman. In a DeFi world, your info is recorded once, stored securely, and only shared to the entities that you authorize.
Another problem is that many people do not have access to bank accounts due to strict vetting criteria. With DeFi, the minimum requirement is an internet connection.
Popular DeFi Applications
Decentralized finance has found many application areas in the finance industry. Cryptocurrency developers are building solutions around the basic concepts of DeFi. These concepts are still taking hold of the market with unpredictable outcomes.
Decentralized Exchanges: These applications allow for the conversion from currencies to other currencies. The applications link the users directly. This is so they can trade without trusting an intermediary with their money.
Stablecoins: These are cryptocurrencies associated with a foreign asset that stabilizes the price. They are designed to avoid the sharp price fluctuations experienced by cryptocurrencies. They are also seen to stabilize currency prices.
Lending Platforms: These are upcoming applications designed using the smart contract concept. They get rid of intermediaries to provide better lending rates. They connect borrowers to the lenders and need collateral to take out a loan. Users are not required to give out their identity or credit score to get a loan. Interest rates are set algorithmically. The Compound protocol is built for developers. It enables them to calculate interest rates for various assets. Thus, developers can integrate interest directly into their application. As such, they are providing more functionality to their users. Applications such as Cointracker, Lumina, and Tokentax work on this protocol. They assist with various taxing functionalities that involve cryptocurrency. People that are saving money receive better returns from DeFi than high-street institutions.
Wrapped Bitcoins: This is one of the ways of sending bitcoins to an Ethereum network. The bitcoins sent will be used directly. Wrapped bitcoins allow users to gain interest in the bitcoin.
Prediction Markets: These are markets used to bet on future events and can be used for elections. DeFi prediction markets will offer the same functionality without the use of intermediaries.
The Ethereum Platform
Most of the popular DeFi applications are built with Ethereum as the base. Ethereum is the second-largest cryptocurrency platform in the world. It is different from the Bitcoin platform by being easier to extend. Developers can build other applications that provide more than simple transactions.
The platform is flexible for smart contracts. It will automatically carry out transactions provided some given conditions are met. Programming languages that work with Ethereum, such as Solidity, can deploy such contracts. Rules that dictate whether a transaction will go on can be written in the form of a smart contract. The agreement will only execute if the conditions specified in the rules are found to be true.
However, Ethereum has some issues which we’ll look at below.
Is DeFi Safe to Invest?
DeFi is still very risky at the moment. This means that newcomers will find it hard to separate good ventures from bad ones. Some DeFi applications such as the meme coin YAM crashed and burned; bugs are still common. The smart contracts might be robust and useful. Yet, they are unchangeable once baked into the protocol. As such, the bugs become a permanent feature of the currency, which adds to the risk.
The Problem With the Ethereum Platform
Unfortunately the Ethereum platform was not built with speed in mind. The platform as a whole can only manage 15 transactions per second. This is due to its “consensus” architecture where all nodes need to agree before proceeding, which brings down the speed of the decision to the speed of the slowest node.
Kurt Wuckert Jr is of the opinion that Ether it is a network built by developers for developers, and does not take into account any scaling for business purposes. The second phase plans of Ethereum also look half baked, with plans of a sharding system to scale. The idea of sharding is to break the blockchain up into multiple shards that can process concurrently. The risk of this approach is a shard takeover, which might introduce a security risk.
Another downfall of Ethereum is the cost of a transaction on the Ether network, which hit an average of $23 in early Feb 2021. One transaction was recorded at over $100.
But Wait, There is Another…
Binance Smart Chain (BSC) was launched in September 2020 to host smart contracts and is compatible with the Ethereum Virtual Machine. Built on a consensus algorithm, the Binance Smart Chain employs a Proof of Stake Authority (PoSA) algorithm to validate the BNB unit.
The main advantages BSC bring to the table is improved transaction speed and greatly reduced cost – a transaction on this platform is charged between $0.01 to $0.05. Currently more than 60 apps are hosted on the BSC network, all focused on decentralized finance solutions.
Conclusion
Hype or not, it looks like DeFi will be the fastest growing industry of 2021. Transaction values flowing through the DeFi network have already grown from $2.2 billion in March 2020 to over $68 billion in early 2021. That is a growth of over 31000%.
Sources
- What is DeFi? Everything you need to know
- I just solved DeFi
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