Recently, decentralized finance has provided a different perspective on the financial industry.
What is DeFi?
DeFi is short for Decentralized Finance. It is a form of financing based on blockchain, without the involvement of centralized financial intermediaries (such as exchanges or brokerage firms). Funds are transferred directly through smart contracts.
In essence, DeFi is a system aimed at getting rid of the established centralized banking system. Instead, it gives absolutely everyone access to financial services anytime, anywhere.
Advantages of decentralized finance
- DeFi offers easy access to financial markets
Decentralized finance (DeFi) offers investors and traders a better, simpler, and more productive method of making financial transfers.
For example, banks require customers to verify their identity before making any transfer. Similarly, the bank assesses any potential borrower to ensure their ability to repay the loan before the transaction takes place.
With decentralized finance, this is not necessary. Smart contracts simplify the process and the agreement takes place automatically.
- DeFi has a positive impact on prices
Since the emergence of DeFi, the market capitalization of major projects in the segment has grown significantly. In less than a year, the prices of some cryptocurrencies have at least doubled.
- DeFi promotes transparency
Thanks to its blockchain-based operation, the DeFi protocol offers greater transparency than traditional financial institutions can provide.
DeFi challenges and risks
The DeFi ecosystem also has a number of drawbacks that are worth mentioning.
- Third-party auditing is required
DeFi is based on smart contracts, which can be susceptible to manipulation and exploitation. Therefore, all DeFi protocols require independent auditing.
- Centralized data submission
Blockchain cannot access off-chain information. Thus, there is a need for a third party to supply real data to the blockchain, which makes the data centralized and vulnerable to problems associated with centralization.
- Hacks and other attacks using exploits
DeFi projects are vulnerable to hacks and other types of attacks due to misuse of third-party protocols and business logic errors, coding errors, flash loans, and price manipulation.
DeFi issues and risks.
Types of DeFi
- Borrowing and lending
Users can borrow crypto assets by providing another as collateral, and DeFi protocols help make the lending/borrowing process transparent and simple.
- Derivatives
Derivatives can range from asset-backed tokens to decentralized oracles or p2p protocols for prediction markets.
- Insurance
Founded on Ethereum, Nexus Mutual offers its customers the opportunity to pool and share risks through an alternative form of insurance owned by the community and known as discretionary mutual insurance.
Nexus Mutual emphasizes that it is an alternative to insurance companies and is entirely managed by its members, who decide which claims are valid. All decisions made by the members of the community are recorded and executed using smart contracts on the Ethereum blockchain.
- Decentralized exchanges
Decentralized exchanges (DEX) are cryptocurrency exchanges that conduct direct peer-to-peer transactions in a secure manner and without the involvement of an intermediary.
Uniswap is an example of a DEX that allows anyone to create a market or liquidity pool by providing equal value of ETH and an ERC20 token. The exchange rate is initially set by the market creator, but it changes as trading occurs and the liquidity of one asset decreases relative to another. The arbitrage opportunities that arise from these changes contribute to increased trading volumes.
- Payment solutions
DeFi platforms are trying to make payments less problematic by offering users lower fees than those charged by traditional financial institutions.
For example, the Lightning Network solution is a product focused on the Bitcoin blockchain that improves the efficiency of small transfers by taking them outside the network. In the Lightning Network, two or more network participants who plan to make a transfer can open a channel by depositing money. They can make as many transfers as they want, without exceeding the total amount of funds deposited. All transfers will be stored off-chain, and when the channel is closed, the final state will be recorded on the blockchain.
