DeFi – short for decentralized finance – is a new vision of banking and financial services based on peer-to-peer payments through blockchain technology. DeFi enables “trustless” banking via the blockchain, bypassing traditional financial intermediaries such as banks or brokers.
What do investors get out of it? DeFi promises to enable investors to “bank” by giving them the ability to lend money peer-to-peer and earn higher returns than available on traditional bank accounts. Investors can also quickly send money anywhere in the world and access their funds via digital wallets without paying traditional banking fees.
Here’s how DeFi works, how it can benefit individuals, how it challenges traditional banking, and the risks it poses.
How DeFi works
The goal of DeFi is to offer many of the financial services that customers and businesses currently enjoy — lending, deposit rates, payments — but using decentralized technology. In fact, DeFi isn’t changing the industry so much by changing the what as it is changing the how. That is, DeFi creates a new infrastructure to provide similar financial products and services.
To do this, it uses blockchain technology and smart contracts, among other things. Blockchain is a type of ledger technology that tracks all transactions on a specific financial platform. Think of it as a running record of all transactions on that particular blockchain, recorded chronologically. When Person A pays money to Person B, it is permanently timestamped in the ledger.
“The building blocks of DeFi are smart contracts, which are executable codes that store cryptocurrencies and can interact with the blockchain according to their rules,” says Alexander Lutskevych, CEO and founder of CEX.IO, a company that DeFi and cryptocurrency facilitated.
To enable DeFi, smart contracts automatically execute transactions between participants. When the terms of the contract are met, they carry out their instructions themselves.
“DeFi enables smart contracts on the blockchain to replace trusted intermediaries — like banks or brokerages — for peer-to-peer transactions,” says David Malka, CEO of YieldFarming.com, which helps investors generate revenue from cryptocurrency. “These peer-to-peer transactions in DeFi can include anything from payments, investments, lending, and more.”
In this world, cryptocurrency is becoming the de facto currency for transactions and records.
“DeFi is the natural continuation of the vision of creating electronic money outlined in the Bitcoin whitepaper, so it’s a very exciting time in the industry,” says Malka.
Main advantages of DeFi
For individuals, the benefits of DeFi include potentially greater security, potentially lower costs, larger types of services, and the ability to earn more income from their crypto holdings. These and other benefits are made possible by decentralized apps created by various groups.
“Decentralized applications or dApps enable people to transfer funds anywhere in the world (with fast processing and at low cost), peer-to-peer lending and lending, crypto exchange services, NFTs and more services like crypto wallet and -Storage solutions,” says Lutskevych.
“DApps are pre-programmed by developers and depending on their purpose, they can perform transactions on a specific blockchain network, set up buyer-seller agreements, or move assets from a decentralized exchange to a decentralized lending platform,” he says.
In short, the only limit is the ability to code an app that will carry out your instructions.
A currently popular benefit for cryptocurrency investors is the opportunity to generate income. Crypto staking, for example, allows owners of a coin to support that coin’s ecosystem and generate revenue by helping to validate transactions. It is part of the so-called yield farming. This is proving to be attractive when bank interest rates have been at their lowest point for years.
“Anyone can provide crypto assets as liquidity or loans through what is known as yield farming, which pays interest and fees to the depositor,” says Malka of YieldFarming.com. “Yield farming is how you use your cryptocurrency to generate passive income.”
In order to provide their services, many dApps require liquid cryptocurrency available within the app. So they offer to pay income, a return, in exchange for investors investing their coins for some time. In fact, they offer an income to those providing liquidity – similar to the interest paid on deposits in traditional banks, but more risky (as discussed below).
Depending on the type of dApp, cryptocurrency owners can manage earnings through different services such as:
So, these methods of generating income present another source of income for investors, even though you owe taxes on crypto profits just like you would with traditional sources of income.
“Even the lowest-risk income operations can easily return interest that is many times higher than the savings accounts at banks,” says Malka. “This is especially important during bear markets – where the price of cryptocurrencies like Bitcoin or Ethereum is trending down.”
Risks of DeFi for Investors
Although DeFi sounds like a brave new world for finance, DeFi comes with several downsides and risks for potential participants:
- Complexity: Participating in DeFi is not as easy as going to a local bank. “DeFi can be challenging for beginners as there is a huge amount of DeFi applications and investment opportunities,” says Malka. “Even the onboarding process can be confusing for some people because you need to move funds from an exchange like Coinbase to a non-custodial wallet like through MetaMask to gain access to the world of DeFi.”
- Obvious Fraud: Many scammers try to attract new crypto investors who are lured by yields that can drastically exceed the offerings of traditional financial institutions. A high return can be too good to be true.
- Theft: Aside from the outright scams, it is possible for crypto coins to be stolen through exploits, especially given the coding vulnerabilities in some dApps. “Funds can be lost in these exploits, and then it comes down to the core team behind the DeFi project to decide how, if at all, participants will be compensated,” says CEX.IO’s Lutskevych.
- Costs: Interacting with smart contracts requires something called a gas fee, like a token, to get a machine running. Multiple steps along the way could easily incur costs, and that could prove particularly costly for those with modest bankrolls. “It’s not uncommon that a round trip can cost well over $200 in gas fees,” says Lutskevych.
- Volatility: While yield farming can help mitigate your downside in the volatile world of cryptocurrency, you still have to endure amazing swings to potentially reap modest returns. In one day, the cryptocurrency could easily lose a year’s return and more.
- Fluctuating returns: In addition to volatile cryptocurrencies, DeFi participants have to deal with volatile returns. Yields may decrease as more offerings support a particular app.
- Dying Projects: A particular dApp can ultimately be left to decay while the core team developing it pursues other projects. “If one day they decide to quit, the logic of the protocol will run unchanged, but no further upgrades will happen,” says Lutskevych.
These are some of the biggest risks with DeFi and ones that investors thinking of participating need to understand before fully committing.
How is DeFi challenging traditional banking?
One of the biggest claims made by DeFi proponents is that this new financial technology will disrupt traditional banking. At the extreme, they say, DeFi would completely disintermediate – wipe out the middleman – in financial transactions and be replaced by decentralized networks of peers.
But if DeFi is so powerful, why shouldn’t banks just co-opt and offer the technology?
“We definitely see traditional financial institutions increasingly adopting blockchain and distributed ledger technology,” says Malka of YieldFarming.com. “You will see this really accelerate in the coming years as these traditional institutions all recognize the inherent security of being on the blockchain.”
Malka expects banks to develop different DeFi products “to stay competitive and relevant”.
“It’s easy to imagine a scenario where a traditional bank creates yield opportunities for their customers to 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 who want it in the first place.
“Integrating blockchain technology would require an overhaul of many established processes while also exposing them to additional risks,” he says. “More than that, subject to regulation, these institutions would require approvals for these activities from regulators.”
bottom line
Those looking to get into DeFi beyond the basics of cryptocurrency trading should proceed carefully and be sure they are working with a reliable counterparty. While the returns offered by DeFi are enticing, don’t let the potential return blind you to the other risks. A downturn in cryptocurrency markets could quickly wipe out any small gains from yield farming, and outright fraud or theft could wipe out your crypto assets even faster.
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