DeFi – short for decentralized finance – is a new vision of banking and financial services based on peer-to-peer payments via blockchain technology. Via blockchain, DeFi enables “trustless” banking, bypassing traditional financial intermediaries such as banks or brokers.
What’s in it for investors? DeFi promises to allow investors to “become the bank” by offering them the ability to lend money peer-to-peer and earn higher returns than those available in traditional bank accounts. Investors can also send money quickly anywhere in the world and access their funds through digital wallets without paying traditional banking fees.
Here’s how DeFi works, how it can benefit individuals, how it challenges traditional banks, and the risks it presents.
How DeFi Works
The goal of DeFi is to provide many of the financial services that customers and businesses currently benefit from – loans, interest on deposits, payments – but to use decentralized technology to do so. Indeed, DeFi is changing the industry not so much by changing the what but rather the how. That is, DeFi creates a new infrastructure to provide similar financial products and services.
To do this, it uses, among other tools, blockchain technology and smart contracts. Blockchain is a kind of ledger technology that tracks all transactions on a given financial platform. Think of it as a continuous record of all transactions on that specific blockchain, recorded chronologically. If person A pays money to person B, it will be permanently timestamped in the ledger.
“The building blocks of DeFi are smart contracts, which are executable codes that can store cryptocurrencies and interact with the blockchain according to its rules,” explains Oleksandr Lutskevych, CEO and founder of CEX.IO, a company that facilitates DeFi and cryptocurrency.
To enable DeFi, smart contracts automatically execute transactions between participants. When the conditions of the contract are met, they execute their set of instructions themselves.
“DeFi enables smart contracts on the blockchain to replace trusted intermediaries – such as banks or brokerage firms – for peer-to-peer transactions,” says David Malka, CEO and founder of Truffle.vc, which invests in disruptive technologies. like artificial intelligence and Web3. “These peer-to-peer transactions in DeFi can include everything from payments to investments to lending and much more.”
In this world, cryptocurrency becomes the de facto currency of transactions and records.
“DeFi is the natural continuation of the vision outlined in the Bitcoin whitepaper regarding the creation of electronic money, so it’s a very exciting time for the industry,” Malka said.
Main benefits of DeFi
For individuals, the benefits of DeFi include potentially greater security, potentially lower costs, broader types of services, and the ability to earn higher income from their crypto holdings. Additionally, security measures such as on-chain data allow transactions to be verified and recorded on the blockchain. These and other benefits are enabled through decentralized applications created by various groups.
“Decentralized applications, or dApps, allow people to transfer capital anywhere in the world (with fast, low-cost settlement), peer-to-peer borrowing and lending, crypto exchange services , NFTs and other services such as crypto wallet and storage. solutions,” says Lutskevych.
“DApps are pre-programmed by developers and, depending on their purpose, they can execute transactions on a specific blockchain network, enter into buyer-seller agreements, or move assets from a decentralized exchange to a decentralized lending platform” , he explains.
In short, the only limit is the possibility of coding an application that executes your instructions.
One of the benefits currently appreciated by investors in cryptocurrencies is the possibility of generating income. Crypto staking, for example, allows owners of a coin to help support that coin’s ecosystem and earn revenue by helping validate transactions. This is part of what we call yield farming.
“Anyone can provide crypto assets as cash or loans through so-called yield farming that pays the depositor with interest and fees,” explains Malka of Truffle.vc. “Yield farming is how you leverage your crypto in order to earn passive income.”
To provide their services, many dApps require liquid cryptocurrency available on the app. They therefore offer to pay an income, a yield, in exchange for investors’ participation in their coins for a certain time. In effect, they provide income to those providing liquidity – similar to the interest paid on deposits at traditional banks, but riskier (as discussed below).
Depending on the type of dApp, cryptocurrency owners can generate income through various services such as:
These methods of generating yield therefore provide another source of profit for investors, although you will have to pay taxes on crypto profits, just as you would for traditional sources of income.
“Even the least risky farms can easily earn interest rates many times those of bank savings accounts,” says Malka. “This is especially important during bear markets, where the prices of cryptocurrencies like Bitcoin or Ethereum tend to decline.”
DeFi risks for investors
Although DeFi looks like a brave new world for finance, DeFi presents various drawbacks and risks for potential participants:
- Complexity: Participating in DeFi is not as simple as going to a local bank. “DeFi can be challenging for beginners due to the massive amount of DeFi applications and investment opportunities,” says Malka. “Even the onboarding process can be confusing for some people, because you need to move money from an exchange like Coinbase to a non-custodial wallet, like through MetaMask, to start accessing the world of DeFi.”
- Pure and simple scams: Many fraudsters seek to trap new crypto investors attracted by returns that can significantly exceed those offered by traditional financial institutions. A high yield might just be too good to be true.
- Flight: Beyond outright scams, it is possible for crypto coins to be stolen via exploits, especially given the vulnerabilities in the coding of some dApps. “In these exploits, funds may be lost, and it is then up to the core team behind the DeFi project to decide how, if at all, to compensate the participants,” says CEX.IO’s Lutskevych.
- Cost: Interacting with smart contracts requires so-called gas fees, like a token to operate a machine. Multiple steps along the way could easily drive up costs, and this could prove particularly costly for those with modest funds.
- Volatility: Although yield farming can help alleviate your disadvantages in the volatile world of cryptocurrencies, you will still have to endure astonishing fluctuations to achieve what might be modest returns. In one day, the cryptocurrency could easily lose a year’s return, or even more.
- Fluctuating returns: In addition to fluctuations in cryptocurrencies, DeFi participants have to deal with fluctuating returns. Yields may fall as supply increases for a given application.
- Dying projects: A given dApp may ultimately die on the vine, while the core team developing it pursues other projects. “If, one day, they decide to shut down, the protocol logic will run as is, but no further upgrades will take place,” says Lutskevych.
These are some of the most significant risks of DeFi and ones that investors considering participating should understand before fully committing. Although potential costs must be considered, recent innovations such as Layer-2 solutions have helped reduce costs.
How is DeFi challenging traditional banking?
One of the main claims of DeFi proponents is that this new financial technology will disrupt traditional banking. In the extreme case, they argue, DeFi would totally disintermediate – eliminate middlemen – in financial transactions, to be replaced by decentralized networks of peers.
But if DeFi is so powerful, why wouldn’t banks just pick up the technology and offer it?
“We clearly see that traditional financial institutions are increasingly leveraging blockchain and distributed ledger technology,” says Malka of Truffle.vc. “You’ll see this really accelerate in the coming years as these traditional institutions all recognize the security inherent in blockchain.”
Malka expects banks to create various DeFi products “to stay competitive and relevant.”
“You can easily imagine a scenario where a traditional bank creates yield farming opportunities that its customers can participate in,” he says.
But such a change would be easier on paper than in practice due to the regulatory burden, says CEX.IO’s Lutskevych, creating complications for traditional companies that even want to do it.
“Integrating blockchain technology would require overhauling many well-established processes while exposing them to additional risks,” he says. “Moreover, subject to regulation, these institutions would need approval from regulators for these activities.”
Conclusion
Those looking to get started in DeFi, beyond the basics of cryptocurrency trading, should proceed with caution and ensure they are working with a reliable counterparty. Although the returns offered by DeFi are attractive, don’t let the potential return blind you to other risks. A decline in cryptocurrency markets could quickly wipe out small gains from yield farming, and scams or outright theft could wipe out your crypto wealth even faster.
— Bob Haegele contributed to an update of this story.
