What is DeFi?
Discover what DeFi is and how it applies to blockchain and cryptocurrency in the 21st century.
Short for “Decentralized Finance”, DeFi has proven to be one of the most exciting, important, and revolutionary innovations in cryptocurrency since Bitcoin was created. DeFi is a very broad term, and there are many things that fall under the category of DeFi.
The easiest way to think about DeFi is to think about the traditional finance (TradeFi) world we’ve lived in and known our entire lives. This encompasses even the highly complex transactions done by wall street banks, home mortgages, interest on your savings account, and trading assets and securities.
In the world we have grown up in, these things are second nature. If you want to trade a stock, you use a broker such as E*TRADE or Robinhood. If you want to purchase a house, you get a mortgage from a bank and, depending on your financial situation, a good payment plan with a low interest rate.
If you are a startup company looking to raise money from investors, you traditionally must pitch your dream to VC’s and big investors. None of this is inherently bad if you live in the west. For the billions without access to a bank account or the western financial system, the option for economic mobility is severely limited.
Decentralized Finance is very similar to Traditional Finance, except it is done on the blockchain. Ethereum currently has the largest DeFi ecosystem, but other popular chains are trying to build out their DeFi offerings quickly. To better understand DeFi, it’s good to look at examples of DeFi compared to their TradFi counterparts.
Savings Accounts
Saving money has become something very difficult to do for many Americans and people around the world alike. Most of the world is experiencing record inflation, and banks are giving a very generous .01% interest rate on your savings account. Who else loves seeing the bank deposit a few pennies into their account a few times a year? It’s almost comical. DeFi offers an alternative to relying on a bank for your savings account.
Now before you say “woah, that sounds insanely risky, I would never do that”, it’s important to understand that those well versed in crypto don’t disagree. It might be reckless to put your entire savings account into DeFi, but I also think it’s a lost opportunity to keep your entire savings in a single or a few bank accounts. For example, across the DeFi ecosystem, people are earning strong levels of APY on their deposits.
This is in traditional cryptocurrencies like Bitcoin and Ethereum, but also stablecoins such as USDC or USDT. USDC is simply a cryptocurrency pegged 1:1 with the dollar. Inflation has been a burden to all except the uber wealthy, but DeFi provides the ability to protect yourself from inflation. DeFi uses open source algorithms to maximize interest rates for depositors, which allows significantly higher interest rates than banks offer.
Loans
Similarly to interest, DeFi has paved the way for users to take out loans quickly. There’s no need to fill out arduous paperwork or hope for approval from a bank. With DeFi, you can get a loan with no questions asked. I know that sounds a bit crazy, and in fairness it is a bit crazy.
Generally, the way DeFi loans work is by requiring a certain amount of collateral (in cryptocurrency) in exchange for a cash loan. If you fail to pay it back, the collateral is automatically kept, covering the loan.
Trading and Lending
If you remember how decentralized exchanges work, it doesn’t only apply to cryptocurrencies. Many assets have been “tokenized” which means you can buy a token that represents 1 share of a stock, or a token for a derivative. When you choose to buy these assets through DeFi, you don’t have to deal with a broker. This is especially exciting for those in the developing world who otherwise have no access to the US stock market.
You can lend out cryptocurrency through a DeFi protocol and earn rewards for lending every minute in some cases. Yes, every minute. If you’re familiar with compound interest, DeFi takes it to a level the world has never seen before.
Placing money into DeFi
While the cryptocurrency world is quite intimidating on the surface, even the more complex DeFi applications are not very difficult to get involved in. There are no “sign up” or approval requirements. You simply need a self-custody wallet, and you can put your money into DeFi. There’s also the added benefit of complete autonomy over your assets.
If you own $1000 of Apple stock on Robinhood and sell it, you then must withdraw and wait several days for the money to deposit into your bank. If you owned $1,000 worth of tokenized Apple stock, it takes just minutes to exchange that for the cryptocurrency of your choosing.
Risks
DeFi sounds great so far. 9% APY on your savings account, you’re unaffected by inflation, etc. However, DeFi can be risky. It cannot be stated strongly enough that you must proceed cautiously when using DeFi. Ultimately, it’s still a new technology, and with new technology comes security risks. While blockchain is on pace to be the most secure network in history, DeFi is not blockchain as it relies on smart contracts built on top of blockchains.
Smart contracts will likely become incredibly powerful and common in our lives as they evolve, but just as a regular contract, loopholes can exist. Sometimes these loopholes lead to the loss of millions of dollars.
If anyone reading heard about the Luna collapse in May, it’s a case study on when clear red flags are ignored. Luna offered 18-20% APY on their stablecoin. When the crypto market crashed alongside every other global market in the spring, Luna was exposed as essentially a ponzi scheme, and in just hours, 40 billion dollars disappeared along with countless people’s life savings.
Closing notes
There is no doubt that in a few years, DeFi is going to be magnitudes larger, safer, and better than it is today. To those considering DeFi, spread your risk. There are many options, including traditional finance options, to get loans, save money, trade assets, etc.
There’s no government regulations or safeguards currently in place to protect your money. If you get involved you must understand you’re entering the wild west, and if you get into trouble you have little to no recourse. Spreading your money across TradeFi, DeFi, and others opens the door to multiple opportunities.
Related articles
What are Futures?
Stablecoins: How Do They Work?
Altcoin Types and Real-World Use Cases
Special Announcement: Our Proudest Achievement to Date – META Strategy Soft Launch!
Author:
✍️ Head of Content @ Cindicator
📊 Certified Bitcoin Professional
🔐 Blockchain Chamber - Chapter President
Who is Cindicator?
Cindicator is a world-wide team of individuals with expertise in math, data science, quant trading, and finances, working together with one collective mind. Founded in 2015, Cindicator builds predictive analytics by merging collective intelligence and machine learning models. Stoic AI is the company’s flagship product that offers automated trading strategies for cryptocurrency investors. Join us on Telegram or Twitter to stay in touch.
Disclaimer
Information in the article does not, nor does it purport to, constitute any form of professional investment advice, recommendation, or independent analysis.