What is Decentralized Finance (DeFi)?
DeFi, or decentralized finance, is rapidly disrupting traditional finance (TradFi) and introducing users to a new way to approach finance… on the blockchain!
DeFi offers users financial instruments through the use of smart contracts on a blockchain without relying on intermediaries such as brokerages, exchanges, or banks. But why would users choose DeFi over TradFi, what are some common applications, and potential risks?
What Are Some Common DeFi Applications?
There are hundreds of DeFi protocols in the space serving a number of different use cases. Protocols like Compound and AAVE are centered around lending and borrowing. This means you could lend wrapped Bitcoin or Ether on the protocol for return and borrow another asset like the DAI stablecoin against it. You could even use the borrowed asset to stake in another protocol or liquidity pool to compound your yield.
Some protocols like Uniswap facilitate swaps between different crypto assets. Standard users are granted the near-instant ability to swap nearly any chain-based asset with ease for a small fee. Meanwhile, investors may choose to become liquidity providers for different pools in the Uniswap ecosystem to generate a yield and provide the infrastructure needed for swapping assets.
Other protocols are dedicated to generating yield with liquidity pools established for different DeFi strategies. Protocols that seek out the best return strategy are known as yield aggregators. A popular pool for many protocols facilitates swaps between wrapped Ether and BTC. Liquidity Providers (LPs) who stake those assets in the pool receive a share of fees from users trading between those assets.
Is DeFi Easy to Use?
Much like riding a bike, the world of decentralized finance gets easier to use over time. However, just like riding a bike, you’re probably going to fall on your face and scrape your knees a few times in the process. And sometimes, no matter how good you are at riding your bike, the handlebars might bust off at any moment.
My point here is not to scare anyone off but to plainly illustrate that using decentralized finance apps is not without risk and not without consequence.
Once you get more familiar with the process of copying and sending wallet addresses and swiping from different blockchains, most of the other aspects of DeFi translate well from one chain to another. However, for those used to operating exclusively on a chain like Ethereum, you may be used to a single chain that is much more expensive to use due to user congestion. On the other hand, you may end up using a newer blockchain like Avalanche which has 3 different blockchains built into it to handle the processing load and allocate resources in a more streamlined fashion. This can be more confusing but also much less expensive.
Another issue is that things are literally changing all the time. As we speak, this space is evolving. New and innovative solutions are being created to solve many issues like blockchain scaling, changes from consensus mechanisms, translation of real-world TradFi (traditional finance) products to decentralized apps, projects that make staking and securing the network much easier to do on a large scale, and of course, projects and software that make everything easier to use and encourage a more welcoming environment to those new to the world of DeFi.
For now, DeFi is not easy to use unless you take the time to understand the traditional world of finance or take the time to understand blockchain technology. However, the best part is there are so many articles and videos, and walkthroughs available that anyone can learn and use DeFi if they really want to do it.
Why Use DeFi Applications?
Having no intermediary as a central authority over transactions in DeFi offers users many benefits. Participating in DeFi is permissionless, meaning anyone can participate. Your credit score may limit you in applying for a TradFi loan, but in DeFi you simply need the collateral and you can take out a loan with no KYC (know your customer) information given.
No intermediary also means a more efficient financial system, so rates for staking crypto assets for return are much higher than what you would find in TradFi. To compare, the national average interest rate for a savings account at a traditional bank is .06% APY. In DeFi, you could stake to validate the network on many Proof of Stake (PoS) chains for a conservative return between 7-10% APY. With more risky strategies that may be subject to impermanent loss, you can earn 100+% APY. It’s just far more profitable to participate in DeFi.
The Risks of DeFi Investing
Offering much higher rates of return than what you would find at a bank, you would think DeFi would be the clear choice when compared to TradFi. However, DeFi does come with many risks that would make some risk-averse types avoid DeFi and prefer the comforts of a bank.
For example, smart contract risk always exists. Smart contract risk is the possibility that a smart contract will fail or be exploited in some way that results in the loss of funds. Bugs in smart contracts have led to exploits that resulted in the loss of hundreds of millions of dollars in user assets. It’s happened too many times to count and it keeps happening every day. Scammers and hackers are always improving their skillsets and finding new and innovative ways to take advantage of this newly-emerging technology.
Additionally, when connecting your wallet to a protocol in DeFi, you also must be careful as you are giving a protocol permission to undertake certain actions on your behalf. This includes the possibility of draining your wallet for all your assets. Users must always be careful about where they connect their wallets in DeFi.
When considering connecting to a new protocol to generate a return, take advantage of some benefits in the DeFi ecosystem, or mint an NFT, always do your own research and investigate new projects thoroughly! Also, keep an eye on URLs, as scammers can lone sites and swap letters in their own URL in order to trick users. It’s the wild west out here and you always need to be on guard. However, with the right moves and the right skill set, you just might strike gold too!
Disrupting Traditional Finance (TradFi)
Offering such a higher return than what one would find at a bank, DeFi is sure to disrupt the world of TradFi. However, there are some obstacles DeFi will face when converting mainstream users of TradFi.
There is still a huge learning curve when it comes to engaging with DeFi protocols for the first time. There have been many improvements in the user experience, but much still needs to be done to make DeFi as easy to use as TradFi. Improved user interfaces that are more visually intuitive will help greatly in making DeFi more accessible to users, especially those familiar with traditional online banking. Users are also very susceptible to scams perpetrated against DeFi communities, in part due to needing more education about how DeFi works.
Most importantly, DeFi can disrupt TradFi by focusing on educating users! Educating users on managing their finances effectively is not something that comes naturally to even developed countries like America. By educating users on how to interact safely in DeFi, we can make them more productive members of DeFi communities and stay engaged in DeFi products. They will also be less likely to fall victim to scams, a reality that scares many users right out of DeFi.
These are just some of the reasons DeFi is likely to disrupt TradFi. Offering users a permissionless ecosystem of access to yield generation and potential financial freedom, DeFi is likely to transform our perception of finance for years to come.