Decentralized Finance (DeFi) – A Guide To Understanding Benefits, Applications, And Risks

The traditional architecture of financial systems (e.g., banks, brokers, Exchanges) relies heavily on intermediaries. These intermediaries serve centralized nodes that govern access to the financial system and provide customers with a broad range of services, such as record keeping, verification of transactions, settlement, liquidity, and security. Therefore, they signify a galvanic force empowering most of the core functions of the centralized institutions, helping them with the implementation of regulatory compliances, like tax reporting, anti-money-laundering laws, or consumer financial protection.

However, these centralized financial systems are not without some considerable inefficiencies. They give birth to certain concerns, like inherent fragility and systematic risks, especially as a fallout of core intermediaries becoming insolvent, or as a result of dwindling trust of investors in the system. These concerns reflect the experience of the 2008 financial crisis that exposed the corruption or fragility of intermediaries. It also spearheaded a new ‘revolution’ of blockchain technology, especially its ability to build decentralized platforms to democratize finance, in an open, decentralized, permissionless, and autonomous way.

Explaining Decentralized Finance (DeFi) In Layman’s Terms, And Its Motive

Decentralized Finance (DeFi) stands for a financial system that allows users to conduct financial transactions without relying on intermediaries. It may sound like you are using a digital banking system in which you send money to a recipient without paying fees that would otherwise be chargeable via traditional banks or other financial companies for using their service.

If you take a close look at the term ‘decentralized’ in DeFi, you will get the idea of why it is called a “decentralized finance”. The platform allows users the leeway of conducting their financial transactions without depending on legacy, centralized finance systems. There is a dedicated digital wallet for users to keep their money in DeFi, and they can transfer funds in minutes. And interestingly, anyone with an internet connection can use Decentralized Finance.

From the above explanation, it may appear that Defi is bent on completely removing the intermediaries, but that’s not the real picture here. In fact, Decentralized Finance aims at removing unwanted intermediaries with more technological innovations to improve the efficiency of the financial system, and strengthen the competition.

Key Takeaways:

• The DeFi came into existence as an alternative to legacy, traditional financial services
• It is based on emerging technology to rule out third parties and centralized institutions
• Users can keep their money in a secure digital wallet, and transfer money in minutes
• Anyone with an internet connection can use DeFi
• Regulations are the infrastructure of DeFi are already constantly evolving

How Does Decentralized Finance (DeFi) Differ From Centralized Finance (CeFi)??

Centralized Finance (CeFi)

Centralized finance is overseen and regulated by banks, regulatory authorities, and governments. Under this system, centralized authorities and regulatory bodies oversee everything, from providing funding to facilitating transactions.?

Don’t think that centralized finance acts like traditional banking systems handling fiat currency equity trading. In fact, it is an approach within the cryptocurrency market to buy, sell and trade cryptocurrency tokens under the supervision of centralized authorities and regulatory bodies.

CeFi, however, is not strictly regulated all over the world, unlike fiat currency equity trading. Moreover, it mandates KYC (Know Your Customer) compliance from users to confirm their identity before being allowed to use a centralized exchange. To say the least, every activity, including financial transactions, is monitored in centralized finance, from loan applications to services via a local bank. In this context, software development companies for financial software development is another concept catching up fast among companies to maximize DeFi for their profitable growth.

Binance, Coinbase, Gemini, Kraken, and Nexo are some popular examples of the CeFi model.

Benefits of CeFi:

• Better user experience due to fast transactions, simpler interfaces, and ease to handle without much technical expertise
• Facilitates fiat-to-crypto conversions for cryptocurrencies, enabling individuals and investors to inject capital considerably into the market, leading to crypto’s growth.
• It functions like a regular bank, offering round-the-clock customers.
• It supports cross-chain exchange across diverse crypto tokens.

Downsides of CeFi:

As far as the downsides of CeFi are concerned, this centralized system poses an inviting chance for cyber criminals. To say otherwise, hackers are typically drawn to the centralized system and could hack sensitive data to steal customers’ money. Another downside is related to expensive transaction fees due to several intermediaries in centralized finance. Also, lack of transparency constitutes another major issue with the system, augmenting a chance for distrust in it.

Decentralized Finance

It is an emerging financial landscape that uses breakthrough blockchain technology to facilitate financial transactions by ruling out intermediaries, such as central regulators, like financial institutions, governments, and exchanges. With this model, transacting cryptocurrencies, including purchasing, selling, loans, and payments can be facilitated through the Peer-to-peer (P2P) approach.

In fact, Peer-to-peer (P2P) financial transactions underpin the core premises behind DeFi, in which two parties agree to exchange cryptocurrency for goods or services without involving intermediaries.

So, basically, DeFi is a concept of transaction model in contrast to CeFi that mandates the involvement of intermediaries to oversee every financial activity on the platform. DeFi doesn’t permit the involvement of centralized exchange to regulate or govern assets.

On the contrary, the system allows individual traders to take control over the assets, using decentralized exchanges (DEXs) to help facilitate cryptocurrency operations. However, the role of DEXs in DeFi doesn’t mean as an authority to execute transactions, but rather to help enable the flow of transactions.

1inch Network, MakerDAO, PancakeSwap, Stargate Finance, and Uniswap are some examples of DeFi companies.

Understanding Smart Contracts In DeFi

With decentralized blockchain technology and smart contracts, DeFi unleashes transformative impacts on financial space with new infrastructure capable of rendering financial products and services.

While blockchain refers to a specific type of ledger storing public records of every transaction facilitated via the Defi platform, smart contracts refer to instructions as a computer code, or self-executing agreement that doesn’t require a central authority or rent-seeking third party to operate.?

Note that the functions of many cryptocurrencies and decentralized applications depend on smart contact codes. It facilitates a variety of activities, such as the exchange of goods, services, data, funds, and so on.

The importance of smart contracts can be understood with the fact that it is extremely necessary for decentralized applications (DApps) to use smart contracts to validate each transaction, in a trustless manner (i.e. without intermediaries or trusting a third party).

Moreover, smart contracts also ensure that two parties fulfill their end of the agreement.

One of the most important things about smart contracts is that they are the core premises governing DeFi protocols, just as a centralized system is regulated by banks, custodians, escrow agents, etc.

Key Benefits Of DeFi -

• Facilitates monetary transactions, from payments, trading securities, and insurance to lending and borrowing.
• Allows decentralized exchanges (DEXs) for peer-to-peer financial transactions to help users take control of their money.
• DeFi developers would build e-wallets allowing investors to access anything from cryptocurrency to games based on blockchain.
• It helps speculative investors to lend crypto and potentially reap a big reward
• Allows users with real-time transaction updates, market value, interest rates, etc.
• Allows users to take control of their money via smart contract-powered escrow accounts.
• Lower fees on transactions compared to CeFi-based transactions.
• Enables anonymous use of services and financial transactions.

Downsides of DeFi -

• Users relying on the simplicity of traditional banking systems won’t find it useful, given DeFi relies on complex smart contracts and sophisticated algorithms. Not suitable for new participants to innovate themselves to DeFi platforms.
• Since DeFi protocols are not regulated, they are considered safe against hackers. In fact, they have become a high-priority target for cybercriminals
• It lacks customer service, as the technology is run by algorithms, not humans.

Where Do Both CeFi And DeFi Stand Similar To Each Other?

Well, for starters, both DeFi and CeFi platforms use blockchain technologies as the main foundation for their operations. That’s why they use the same approach of delivering a wide array of financial services related to cryptocurrency. In addition, both the systems enable their users to perform a set of common operations, like helping users buy, sell, and trade cryptocurrencies. For their services, they also use digital assets as collateral, allowing individuals and businesses worldwide to access DeFi and CeFi products from anywhere. Another similarity between both platforms is that they rely on digital and internet-based technologies to automate financial services. Moreover, these technologies permit the use of automated processes and algorithms to enable more efficient financial transactions for users.??

Understanding The Key Components Of Decentralized Finance

To get to the bottom of decentralized finance, how it works, and its characteristics, it is essential to understand its components. DeFi components could be stablecoins, liquidity mining, stableswap, aggregators, or services, such as crypto exchange and lending services.?

Stablecoins

It is a type of cryptocurrency where the prices remain steady. Stablecoins are supposed to be backed by tangible assets. Value, as said before, of the stablecoins remains stable over time, according to whichever tangible asset backs them.?

Though used as a store of value or a unit of account, stablecoins are also used in situations where volatile cryptocurrencies are not in high demand. To maintain price stability, different stablecoins follow different strategies, like centralized and decentralized.?

Tether is one of the first and most famous stablecoins regulated by a centralized third party.?

Decentralized Exchanges (DEXs)

It allows peer-to-peer transactions in which crypto-traders can make transactions without being regularized or going through an intermediary or custodian. The transactions using this mechanism occur due to self-executing agreements or pieces of code on a blockchain known as smart contracts.?

The uniqueness of smart contracts is it allows fewer transaction costs or slippage (i.e. a price difference between submitting a transaction and confirming the transaction on the blockchain) compared to a centralized cryptocurrency exchange.?

Examples of this mechanism include Uniswap, PancakeSwap, dYdX, and Kyber. The main goal of DEXs is to save users from the hassle of going through third parties, like banks while executing transactions.?

Stableswap

It serves as a key foundation for the DeFi ecosystem, whether it is related to borrowing, lending, or yielding farming. It is an implementation of an automated market maker (AMM) of Curve Finance intended to swap specific assets (i.e. USD stablecoins) with minimal slippage.?

Stableswap also allows more efficient trading for liquidity providers but is considered not ideal for swapping pegged assets (such as stablecoins) for the fear of intensifying the price volatility of the assets with a high slippage fee.

Liquidity Mining

The concept of liquidity mining refers to the process of lending assets by crypto lenders to a decentralized exchange (like Uniswap) in return for rewards. Liquidity mining drove itself to popularity as crypto investors found it useful to participate in DeFi. Revenue generated by miners is based on the share of commissions paid by investors or traders and the lifetime of the orders.?

Decentralized Lending & Borrowing

Decentralized lending and borrowing conducted on DeFi platforms facilitate issuing and taking out loans using DeFi protocols without going through intermediaries. Borrowers can be loaned through P2P decentralized platforms, while DeFi lending protocols ensure profitable gains for lenders from their supply of crypto. The goal is to simplify the critical banking function in terms of transparency and accessibility to crypto users without requiring intermediaries.?

Aggregator

A DeFi aggregator came into existence to help users save time and increase efficiency for crypto traders, as it enables them to bring together trades across different DeFi platforms. It is touted as an intelligent way of diversifying investments for DeFi protocols and getting the best yield rates out of crypto lending.?

DeFi aggregators siphon optimal prices from decentralized exchanges and liquidity pools into one place, allowing participants to optimize their trades. Obviously, if there is no aggregator, an individual trader will have to try each platform to make a comparative analysis of prices to generate the best deal for it.?

Risks Or Challenges In Decentralized Finance

In spite of the growing popularity of DeFi, issues, such as the 3Commas hack and the FTX debacle warrant the significance of understating its risks. Here is a quick rundown of some of the potential risks associated with DeFi.

• Faulty smart contracts pose risks to DeFi, as smart contracts with weak coding could fall prey to hacking into users’ funds.
• Unsecured flash loans are one of the challenges in DeFi lending posing risk, considering large disbursal of large sums of crypto to users without collateral. While it seems beneficial for serving the legitimate purposes of users regarding the funds, it may also encourage scammers or malicious actors considering the large sums of capital involved.?
• Reentrancy attacks pose another challenge in the DeFi market in which malicious actors create a loop that triggers the withdrawal function numerous times.
• A type of crypto scam, rug pulls also pose one of the challenges in the DeFi space, allowing malicious actors to pull it off easily.
• One of the most misunderstood DeFi market risks is impermanent loss. It occurs when the price of the deposited assets changes from the price when you deposited them. The bigger the change, the closer you get to impermanent loss.

Key Features & Benefits Of Decentralized Finance

While the value and importance of decentralized finance or DeFi keep increasing worldwide, here is insights into some of the most prominent features of the platform. These features or benefits reflect the core competencies of DeFi, something that you can leverage to include in your DeFi solutions. Companies looking for intuitive fintech software solutions can also leverage the benefits of DeFi by understanding its core features.

• No Intermediaries

That’s perhaps the most noticeable feature of DeFi platforms, ruling out the involvement of intermediaries, or third-parties, or regulatory bodies. As a result of such freedom, users in DeFi platforms can transact funds faster and without having to go through any official protocols typical in traditional banking systems. This results in faster and more transparent financial transactions for the users.?

The permissionless nature of Defi applications is one of the reasons behind the growing reputation of DeFi. Unlike traditional finance, it follows a permissionless access model, allowing users with an internet connection to access their digital wallet without problems and conduct financial transactions easily, from anywhere in the world.?

• No Manipulation

Ever thought of DeFi being prone to manipulation? Well, that’s hardly the case with the platform. That’s because it is structured and integrated, in conformity with the blockchain system, allowing participants to conduct businesses through smart contracts, a cryptographic technology.?

• Transparency

Transactions conducted on DeFi platforms are verified and secure. For instance, broadcasted transactions to specific users require their permission or verification to validate the same. To say otherwise, transactions are confirmed through consensus methods over a network of nodes, a typicality of blockchain on DeFi platforms. In other words, every user can review the data regarding transactions and is allowed to make decisions in a transparent and fair manner.

• It's Decentralized

The popularity of DeFi is attributed to many factors, including the fact that the platform is itself a decentralized system. That said, it provides convenience and greater efficiency when it comes to keeping your crypto assets safe and transferring funds without having to follow regulatory compliances of profit-seeking third parties or intermediaries.?

To say otherwise, users have complete and absolute control over their assets and personal data. They are under no obligation to follow intermediaries and so their financial activities conducted on the DeFi platforms are quicker and highly encrypted to be called unbreachable from unauthorized access.?

• Interoperability

The notable features of DeFi also narrow down our discussion to interoperability as one of the most commendable features of the platform. To understand DeFi’s interoperability, we must understand that the platform’s ecosystem is a constituent of various protocols and blockchains which individually feature a set of rules and regulations.?

While such types of diversity could be good, they also pose problems in terms of interoperability. For example, lack of interoperability results in problems, such as restricted liquidity, reduced efficiency, and creativity.?

As a matter of fact, interoperability is just the ability of numerous DeFi protocols and blockchains to effectively interact and function. Lack of interoperability causes compartmentalization of Defi protocols and blockchains.

The Future Of Decentralized Finance

Agreed that decentralized finance has some risks or challenges, yet the significance of it; from ruling out intermediaries to ensuring safe and transparent monetary transactions, makes its future look bright. Experts are confident about the far-reaching effects of DeFi it would deliver in the future, even though it is still in the nascent stage of development of its capabilities.??

The experts believe that DeFi, in due course of time, will become capable of enough to allow investors to deploy their assets in creative ways, something that appears difficult today. In addition, it signifies a great opportunity for the big data sector over time its maturity, enabling innovative ways to commodify data.?

Concluding Statement

Decentralized finance, based on cryptocurrency and blockchain technology, enables financial transactions in a secure and transparent manner. The very concept of DeFi is tied to the goal of democratizing finance in replacement for legacy, centralized institutions through peer-to-peer transactions and by removing intermediaries or third parties from financial transactions.

Still in its evolution mode, DeFi is considered one of the most sought-after innovations in the future. It enables people, merchants, and businesses to conduct financial transactions by using security protocols, and hardware advancement.

Our detailed discussion about the DeFi leaves no doubt about the capability of the platform in reshaping the whole financial system, in the context of decentralizing the core traditional financial services, like payments, lending, borrowing, etc.

Considering the potential of decentralized finance in delivering profitable growth for businesses, companies are already considering innovative DeFi applications. It has catalyzed a sharp increase in the demand for app development companies, particularly for their abilities to help businesses build an application helping them grow their businesses on DeFi. Binmile is one such company that can help you create a DeFi platform.