Decentralised Finance (sometimes called DeFi) is a system for financial services and products which is based on blockchain technology. In a similar way to Bitcoin, which uses a decentralised ledger for recording transactions, DeFi aims to remove third parties from financial transactions to eliminate fees, increase speed and enhance security.
Consumers are able to have greater control over their funds by using a digital wallet rather than traditional bank account and this removes the need for central banks, financial institutions and established financial products and services which can be expensive, cumbersome and complex.
The wheels of global finance move slowly too and consumers lack choice as major financial institutions tightly regulate what is and isn’t possible. DeFi aims to change all this by putting more control into consumers’ hands and reducing dependency on central banks and institutional investment businesses.
In a traditional finance model, all liquid funds are stored and protected by a bank and to provide this security and service, the bank charges fees to manage funds. This is particularly true when customers need to transfer money, pay or services or make large purchases. In addition, rates are charged when exchanging one fiat currency for another, withdrawing money in a foreign country, using a bank card for central payments or taking out a mortgage, loan or credit card. These fees can accumulate quickly and generally the burden of payment falls on consumers, in addition almost all parties are at the mercy of banks when it comes to the time it takes to complete transactions.
However with DeFi anybody who has an internet connection can make an instant payment for any goods, products or services – anywhere in the world using a peer-to-peer network that is near instantaneous. They can do so without needing approval from a central authority or big company and because there are no third parties involved in the transaction, there are zero fees. Software and security are key to unlocking the potential of DeFi and allow customers and businesses to shift away from a tightly controlled central banking model to become more flexible and user friendly. The tech behind DeFi has a number of exciting use cases too including lending, borrowing, trading and purchases – all based on a trusted, visible system of distributed financial databases.
DeFi uses the same tech as cryptocurrencies to enable developers to build applications which handle transactions across the blockchain. Similarly to cryptocurrencies, these transactions are recorded using unique identifiers on the blockchain, preventing fraud and creating a real-time record of every transaction. These apps are called dApps and already they have become flexible enough to help crypto owners leverage their own coins to earn interest. Other dApps power sports betting, decentralised lotteries, virtual property purchases and more – the limit to possibilities within a DeFi context in nearly limitless. dApps make it possible to remove third parties and bring pools of liquidity to regular users on the blockchain – for example instead of approaching a bank for a loan, users can register with a relevant dApp or platform and this would match the need or amount with peers willing to lend the required finance. Repayments can be made according to the terms and conditions of the loan and these can be significantly more flexible than traditional finance options.
One of the key advantages of DeFi is this ability to remove significant interest payments and associated fees. With dApps and a DeFi model consumers are the end beneficiaries rather than established financial institutions because they have more say in where and how their money is used while being able to set limits and interest rates when lending as part of a peer-to-peer system. This has removed the barriers of entry to a world of more flexible finance and empowered users around the world to explore new and exciting ways to make their money work for them.
How does DeFi affect the crypto market?
At its heart, DeFi is about building a more authentic, fair financial ecosystem that bypasses centuries old systems of control that consolidate power and wealth in the hands of a few large banks and financial institutions. The premise of DeFi is to create a financial system that is entirely independent, free from influence by central banks and rate decisions. This opens up the door for more cryptocurrencies to flourish, building dApps for their blockchain which can support new and exciting DeFi use cases which make our financial system fairer, more transparent and open than ever before. This surge in popularity has created a great deal of competition within the space, which in turn has created opportunities for investors as various cryptos, blockchains and dApps compete to become popular.
An additional advantage for traders and coin owners in a DeFi model is the ability to generate income from existing crypto holdings by using dApps to lend funds to start-ups and new digital finance initiatives. This is generally referred to as crypto staking and enables crypto owners to earn passive income which can build accumulative value over time. The returns are based on percentage yields and vary between different cryptos. One of the biggest drawcards here is the ability to earn higher interest by providing funds for new projects and innovation – firstly the interest is often higher than traditional interest rates available at banks or in a regular investment vehicle and secondly by staking funds, investors often get an inside track on the latest and most exciting crypto projects. While having coins staked for a project or time period, the funds are locked up and inaccessible for trading, buying or selling as with any other type of investment.
Another impact of DeFi on the market is around volatility and this is closely linked to the price movements of cryptocurrencies which are traditionally more volatile than fiat currencies. A good example of this interrelationship is the recent collapse of the stable coin TerraUSD. TerraUSD was pegged to US$ and widely viewed as a relatively low risk investment in an otherwise volatile market. Its collapse has impacted DeFi in a variety of ways from withdrawn investment to a more bearish outline so it is worth remembering that while DeFi offers exciting new opportunities and potential to do things differently, the decentralised finance landscape is not yet operating seamlessly and can still present significant risk as an investment. Investors will be keeping a close eye on the price of Ethereum and newcomer Gnox – particularly with an upcoming ETH update which could upgrade functionality across the Ether blockchain. This is likely to be released in Q3 or Q4 this year and aims to remove the high gas fees associated with ETH mining.
Is DeFi safe?
Investing in DeFi projects is the same as assessing any potential investment, investors should be aware of both the potential benefits as well as the risks. Prices can both rise and fall based on a number of macro and market factors and volatility within the crypto market can significantly impact the DeFi space. As mentioned earlier, the TerraUSD collapse is a good example of some of the inherent risk in the DeFi space, through demand remains high primarily because of the future potential uses of DeFi.
The addition of potentially passive income through staking is one key advantage in DeFi though investors must do deep dive analysis and research to understand more about both the project, dApp and rules and returns around staking before investing funds or coins. Regulation is another key concern around the DeFi space, the advantage of regulation in centralised banks is that bodies like the Treasury has strong rules in place to govern the use and safety of investments. As DeFi is still in its embryonic phase of growth there are occasionally bad actors who may look to take advantage of poor investment strategy. The phrase “getting rugged” is unfortunately part of the crypto landscape and refers to exit scams. This is when liquidity pools are created in bad faith and a scammer pulls the investment in a project before it comes to fruition.
Again, research and a deep market understanding are key before investing real money. Account hacking is another concern, even for investors who use digital wallets, and while cold storage can help prevent some of this, remembering passwords and phrases and maintaining good security practice is key.
Investors should only invest with trusted, well-established platforms and in dApps and projects that show significant potential. Understanding the process behind how funds are used, how interest is earned and where the funds will ultimately be used is critical to ensuring a safer, more reliable trading experience. Many platforms, and cryptocurrency sites, have a significant amount of information available online and this is almost always the best place to start research.
Is DeFi a good investment?
The DeFi sector has grown exponentially over the past few years and was worth up to $13 billion in 2020. According to Eightcap, while the market is currently undergoing a correction, there is still plenty of opportunity within the space for investors. Some of these opportunities include:
- DeFi Staking: A way to earn passive income by “staking” coins or funds which are locked up as investment for new projects or initiatives. Investors receive interest based on the amount of crypto staked for new protocols.
- DeFi Yield Farming: Investors can provide liquidity by using their crypto assets on a decentralised exchange to enable order execution from token swappers. These investors are known as Yield Farmers and earn a percentage of income based on volume.
- DeFi Derivatives: Investors and traders can speculate on market movement within different crypto markets with a CFD broker like Eightcap. This enables traders to profit from both rising and falling markets. Like with any investment there are risks associated with CFD trading and because positions are opened on margin profits and losses can be magnified.
- DeFi lending: Investors can also lend their coins or crypto to other users via a peer-to-peer network and earn interest on the assets loaned.
Example of DeFi coins?
The DeFi landscape has a number of well-known coins and as capabilities increase and adoption grows we can expect to see many more DeFi coins on the market., Some of the most popular coins right now include:
The unique stable coin is pegged to the USD runs on the Ethereum (ETH) network, attempting to maintain a value of $1.00 USD for increased stability.
Wrapped Bitcoin (WBTC):
A tokenised version of Bitcoin, Wrapped Bitcoin runs on the ETH blockchain and is ERC-20 compliant. The coin’s value lies in its ability to “wrap” BTC to fit ERC-20 functions and enable more advanced, use cases.
A smart contract platform for dApps, AVAX enabled fast, cheap and environmentally friendly applications to flourish. With its Avalanche consensus protocol it allows transactions to be confirmed in less than a second and can handle over 4,500 transactions every second.
UNI is a decentralised trading protocol for automated DeFi token trading designed to make it simple to exchange Ethereum ERC-20 tokens. Tokens are traded, swapped or exchanged via liquidity pools defined by smart contracts.