What is DeFi ? A beginner's guide

Decentralized finance, or DeFi, utilizes blockchain and cryptocurrency to facilitate financial transactions. Its goal is to democratize finance by replacing traditional centralized institutions with peer-to-peer interactions, offering a wide range of financial services, including banking, loans, mortgages, and asset trading.

What characterizes centralized finance in the present day?

In today's financial landscape, centralized systems overseen by regulatory bodies and intermediaries dominate banking, lending, and trading operations. This setup requires regular consumers to interact with numerous financial middlemen to obtain services such as auto loans, mortgages, and securities trading. Regulatory bodies like the Federal Reserve and the Securities and Exchange Commission (SEC) in the U.S. establish rules for centralized financial institutions, while Congress periodically adjusts these regulations. Consequently, consumers have limited options to access capital and financial services directly, as they are unable to bypass intermediaries like banks, exchanges, and lenders, which profit from each financial transaction. Thus, everyone is required to engage with these intermediaries to participate in financial activities.

The emerging paradigm: Decentralized Finance

DeFi disrupts the centralized financial model by diminishing the influence of intermediaries and granting ordinary individuals control through peer-to-peer transactions.

"Decentralized finance essentially breaks down traditional finance," explains Rafael Cosman, TrustToken's CEO and co-founder. "DeFi transfers the fundamental functions performed by banks, exchanges, and insurers—such as lending, borrowing, and trading—into the hands of everyday individuals."

Consider this scenario: Currently, you might deposit your savings into an online savings account and earn a 0.50% interest rate. The bank then lends out your money to another customer at a 3% interest rate, keeping the 2.5% profit. Through DeFi, individuals can directly lend their savings to others, eliminating the 2.5% profit margin and earning the full 3% return.

You might argue, "But I already do this when I send money to my friends through PayPal, Venmo, or CashApp." However, this is not entirely accurate. These peer-to-peer payments still rely on centralized financial intermediaries, as you need a linked debit card or bank account to execute transactions.

How is DeFi currently being utilized?

DeFi, short for Decentralized Finance, is increasingly utilized in a range of financial activities, facilitated by decentralized applications (dapps) and protocols operating mainly on Ethereum. Here's how they're being utilized:

1. Traditional finance tasks : DeFi handles various financial operations like payments, trading securities, insurance, and lending/borrowing.
2. Decentralized exchanges (DEXs) : Unlike centralized exchanges such as Coinbase, DEXs enable peer-to-peer transactions, granting users more control over their funds.
3. E-wallets : Developers are creating digital wallets independent of major exchanges, providing access to cryptocurrencies and blockchain-based applications.
4. Stablecoins : These aim to stabilize value by pegging to non-cryptocurrencies like the US dollar, countering the volatility of typical cryptocurrencies.
5. Yield farming : DeFi allows speculative investors to lend crypto for potential high returns through platforms that issue proprietary coins as rewards.
6. Non-fungible tokens (NFTs) : These transform non-tradable assets like videos or tweets into digital assets, making them tradable.
7. Flash loans : These instant cryptocurrency loans operate within a single transaction, enabling profit opportunities without traditional legal processes, leveraging Ethereum blockchain's smart contracts.

DeFi adoption is measured by the total locked value, currently at around $43 billion, reflecting the amount of capital invested in DeFi protocols. Blockchain's global accessibility allows dapps to be instantly available worldwide. Unlike centralized systems, dapps operate outside traditional regulations, offering potential rewards along with increased risks.

Challenges and drawbacks of Decentralized Finance (DeFi)

Challenges and Hazards in DeFi

DeFi represents a nascent trend accompanied by numerous risks. As a relatively new concept, decentralized finance lacks extensive stress-testing through widespread or prolonged use. Moreover, regulatory bodies are scrutinizing its systems more closely, contemplating potential regulations. Some of the key risks associated with DeFi include:

Absence of consumer protections

DeFi has prospered in the absence of regulatory frameworks, implying that users may have limited recourse in case of transactional disputes. Unlike centralized finance, where institutions like the FDIC offer deposit insurance and banks adhere to capital reserve requirements, DeFi lacks similar safeguards.

Vulnerability to hackers

While the blockchain itself is highly secure, other components of DeFi are susceptible to hacking, posing threats of fund theft or loss. Given that various DeFi applications rely on software systems, they are inherently vulnerable to cyberattacks.

Collateralization requirements

DeFi lending typically necessitates collateral, which serves as security for loans. Comparable to traditional lending practices like mortgages, DeFi loans usually mandate collateral equal to or exceeding the loan value, limiting accessibility to such financial instruments.

Private key management

Secure management of wallets, which store cryptocurrency assets in DeFi, is crucial. Wallets are protected by private keys, unique codes known solely to their owners. Losing a private key results in irreversible loss of access to funds, as there's no mechanism for key recovery.

Getting started with DeFi

To delve into DeFi through practical experience, consider the following steps:

Obtain a Cryptocurrency Wallet

Begin by setting up an Ethereum wallet like Metamask and funding it with Ethereum. Self-custody wallets are essential for navigating DeFi, but it's crucial to securely store your public and private keys to avoid losing access to your wallet.

Engage in Digital Asset Trading

Trade a small amount of two assets on a decentralized exchange such as Uniswap. This hands-on experience allows enthusiasts to grasp the current landscape of DeFi. However, be prepared to encounter potential losses while learning about different assets, platforms, and risk management strategies.

Explore Stablecoins

Experimenting with stablecoins like TrueFi offers a way to experience DeFi without being exposed to the price volatility of underlying assets. TrueFi provides competitive returns on stablecoins, which are tokens backed by fiat currency and remain unaffected by price fluctuations.

When venturing into new financial realms like DeFi, it's important to proceed cautiously, remain humble, and avoid rushing into complex endeavors. Remember that digital assets in the cryptocurrency and DeFi spheres are highly dynamic, and there's a considerable risk of financial loss.

What does the future hold for DeFi?

The potential of DeFi appears promising, from eliminating intermediaries to transforming various assets, such as basketball clips, into valuable digital assets. Dan Simerman, the head of financial relations at IOTA Foundation, an organization dedicated to DeFi research and development, acknowledges the extensive promise and potential of DeFi, despite its current stage of nascent capabilities.

According to Simerman, investors will soon enjoy greater autonomy, enabling them to utilize assets in innovative ways that may seem unattainable today. Additionally, as DeFi matures, it holds significant implications for the big data sector, potentially revolutionizing how data is commodified.

However, despite its potential, DeFi faces significant hurdles, particularly in terms of widespread adoption among the general populace.

Simerman underscores that while the promise of DeFi is evident, concerted efforts are required to educate individuals about its potential. Furthermore, continuous efforts are necessary to develop the necessary tools that enable people to witness the benefits of DeFi firsthand.