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Decentralized finance (DeFi): What do I need to know today?

date January 15, 2021 time 6 min read 507 views

Bitcoin and other cryptocurrencies are part of a larger space called DeFi, short for decentralized finance. Now’s a good time to dive into DeFi, so let’s bring you up to speed on what exactly Decentralized finance is all about.

Decentralized finance represents a real chance to create a more democratized and inclusive global finance system
Decentralized finance represents a real chance to create a more democratized and inclusive global finance system

What is DeFi?

Thanks in part to events like the 2020 COVID crisis, DeFi, or decentralized finance, has been gaining a ton of traction. In February 2020, before everyone went into lockdown, the total volume of crypto locked in Decentralized finance protocols was reportedly a little over $1 billion. 

DeFi has certainly come a long way since its relative obscurity in 2017, but now, experts believe that the growing DeFi ecosystem may be a real taste of what’s to come in the world of traditional finance.

Decentralized finance explained

If recent financial crises have shown us anything, it’s that the current financial system can – and frequently does – fail. Centralized finance has many risks like mismanagement, fraud, and corruption, just to name a few.  

Decentralized finance aims to recreate the entire traditional finance system, but without the central authorities subject to human error and profit-seeking. Instead of having a finance system with banks, brokerages, and exchanges, DeFi instead builds its new system with smart contracts on blockchains.

In a decentralized finance system, control and oversight is taken away from central authority figures.
In a decentralized finance system, control and oversight is taken away from central authority figures.

The various building blocks of any financial system– decentralized or otherwise– include:

  • Money/currency
  • The ability to transfer money 
  • The ability to loan or borrow money
  • The ability to save money in an account
  • Insurance
  • Stock markets

DeFi offers the promise of all of these systems without a third party skimming profit off the top or limiting transactions.

Benefits of decentralized finance

  • You don’t need permission to participate. This means no background checks or credit score checks, etc. All you need is a crypto wallet, and you’re good to go.
  • The same rules apply to everyone, whether you have $10, $10,000, or $10 million in assets. The goal of DeFi is to democratize the entire financial process– so even folks who typically don’t have access to traditional banking services can benefit.
  • Liquidity is borderless: you can access the market at any time and from anywhere so long as you have an internet connection. Transactions worldwide happen within minutes for low fees.

How does DeFi work?

When Bitcoin came out, the possibility of decentralizing the financial system as a whole was suddenly a lot more attainable.

People quickly realized the same blockchain technology employed by Bitcoin could be applied to financial services so that they now have no central authority or someone in charge. We now have decentralized exchanges, lending services, insurance companies, and other organizations that don’t have any direct ownership or control.

The infrastructure of a DeFi system

Most DeFi products today run on the Ethereum blockchain.

Ethereum is a blockchain for writing and creating all sorts of decentralized technologies and apps or Dapps. This is made possible through their smart contract system.

Smart contracts are autonomous programs on the blockchain that transfer funds automatically when certain criteria are met like depositing or withdrawing a certain amount into an account.

They form the basis of the entire DeFi financial system today.

The major DeFi cryptocurrencies today

While Bitcoin might be the granddaddy of crypto, as mentioned it is actually Ethereum’s crypto, Ether, that is considered king of the DeFi crypto space. Many DeFi functions like stablecoins such as DAI and lending pools are based on its blockchain.

Stablecoins are cryptocurrencies pegged to the value of a real world asset like the USD. They are gaining more institutional adoption and popularity among investors due to DeFi lending protocols and a low volatility.

In addition to Ether (ETH) Some of the more popular DeFi cryptos include Compound Token (COMP), the DAI stablecoin, Litecoin (LTC), Synthetix (SNX), TRON (TRX), and the Yearn.Finance Coin (YFI), among many others.

Decentralized exchanges (DEXs)

Decentralized exchanges (DEXs) are simply exchanges without strict third party oversight.

DEXs are based on a blockchain network and allow the simple exchange of token pairs like on a normal exchange. However, instead of having a company provide their own liquidity for the platform and take their cut through fees, individuals can provide their own tokens for liquidity for a small share of DeFi interest.

Some of the more popular DEXs include Uniswap, Sushiswap, Venus, Tokenlon, and 1inch Exchange, among many others.

Decentralized money markets

Connecting borrowers with lenders, decentralized money markets allow you to lend and borrow crypto assets. They’re one of the primary tools launching DeFi into popularity.

Like on a DEX, the absence of the traditional intermediaries like banks results in lower transaction costs cutting into interest rates for borrowers and investors.

And usually, borrow orders on money markets like Compound Finance are completely collateralized by crypto which lowers the default risks significantly.

Decentralized insurance

Of course, financial projects without a clear governing entity entail some risks. What happens if a borrower defaults or funds disappear? Who can you call and hold accountable? There is no government-backed FDIC insurance on the blockchain.

DeFi insurance stepped in to meet the new challenges of a growing industry. Decentralized insurance aims to provide complete protection for DeFi deposits, including the risk of theft and hacks. And just like everything else in DeFi, it puts the risks and rewards on the community.

In DeFi insurance, much of the funds used to cover losses are deposited by community members. In exchange people who fill the liquidity pools get large cuts of the premiums paid by the insured instead of the insurance company. These payments offset losses made by people who need to get insurance from the pool.

Top decentralized insurance brands today include Cover Protocol, Etherisc, and Nexus Mutual, among others.

Different DeFi services can be creatively packaged together to form new brands or new solutions
Different DeFi services can be creatively packaged together to form new brands and earning solutions

Can I make money from DeFi technologies?

Yes, you can. Decentralized finance is growing in popularity precisely because of the earning potential.

You can learn more about earning DeFi interest on our blog.

What are the risks of decentralized finance?

With the way the DeFi industry is currently growing, many are concerned that it could be just another bubble. A bunch of platforms and cryptos that are blowing up due to speculation alone.

Other risks involved in DeFi include:

  • Collateral risk: Collateral used to back DeFi loans can be volatile based on the crypto market. Many platforms will immediately liquidate your loan if the collateral value drops too low.
  • Network manipulation: Sometimes, bad actors find ways to hack or exploit a smart contract. While most DeFi players have put in place more effective security protocols and countermeasures, the community controlled nature makes these platforms susceptible to manipulation.
  • Scams: Just like in any other space, you will have bad actors pushing scams– typically in the form of enticing new investors into earning rewards. 

Should you invest in DeFi?

Despite its growing pains, with decentralization comes transparency, interoperability, free services, and great earning potential. 

However, the DeFi space is still in its infancy, and many DeFi interfaces are still confusing to a novice crypto user.

If you’re interested in trying out decentralized finance but want some of the security of a more centralized platform, we may have the solution for you.

Get your start in decentralized finance with MyConstant

MyConstant’s P2P lending platform allows you to earn 7% APR or more on your stablecoins or on your cash savings in a lending pool system similar to DeFi. You can also get loans to buy into DeFi cryptos like YFI or SNX. You can get started on MyConstant with a few simple steps so you can get your feet wet right away.

Some of our features include:

If you want an even deeper dive into the world of decentralized finance, check out the blog for its vast knowledge base of articles on cryptocurrency, investing, and next-generation finance.

Sign up for your free account on MyConstant today and enter a new age of financial freedom for all.

**Disclaimer: This article is for informational purposes only and should not be seen as financial advice. Make sure you do your own research before making any major investment.

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