Monday, February 27th, 2023, 12:55:58 PM
It is essential to understand what is Decentralized Finance, a.k.a. DeFi, to take full advantage of this revolutionary approach to finance. Whether you want to diversify your investment portfolio, pay for goods and services, try your luck in an online casino or bet on a virtual pony race, DeFi essentially makes it possible to do so fast, securely and anonymously. You don't even have to get off the couch to use it.
In this post, we look at what DeFi really is, what benefits it provides, what to look out for, and whether it is right for you.
DeFi offers many mainstream financial services which we are already familiar with, however, it is not controlled by a central entity. DeFi's objective is to eliminate hidden fees and discriminatory practices to make financial services transparent and available to all.
DeFi is managed by peers and is designed to benefit its entire community, not just the chosen few on top. It eliminates the "big guy" and the "small print" to make the financial system transparent, and hopefully truly democratic. DeFi in an internet-native system that was created by utilizing the new blockchain and smart contracts technology and it is here to change the way we deal with money.
CeFi refers to traditional financial systems that are centralized and controlled by a single entity or a small group which includes banks, stock exchanges, and insurance companies. These organizations rely on centralized intermediaries to facilitate transactions and enforce regulations.
Generally, CeFi keeps the public in the dark about how it really works by creating loads of complexities around its functionality and the products it offers. Legal jargon and tangled policies act as a smoke screen for centralized financial institutions and obscure any transparency into their operations.
More often than not, CeFi policies are too difficult for the average Joe to understand and to deal with. As a result, these institutions provide inferior services yet still come out on top.
Besides, top-tier CeFi services are just simply unattainable for the public due to the high barrier of entry. Superior products with the greatest benefit potential are often reserved for the wealthiest. In addition, the most vulnerable who might benefit from these services the most in times of need, are often completely shut out from using the centralized banking system.
Ever heard of "the devil is in the details" idiom? "The devil is in the small print" fits even better when it comes to navigating complex policies, legal twists and turns that are so common in traditional finance. Have you ever subscribed to an exciting offer from your bank and found out just shortly after it costs an arm and a leg in hidden fees? Yet you stick with it because there is no real alternative… CeFi has been profiting from its status quo for a long time. However, DeFi is here to reinvent how we do finance and challenge those in control.
In 2009, Satoshi Nakamoto (group's or individual's real name or pseudonym), frustrated by the current state of the central financial system and the 2008 financial crisis, in particular, introduced Bitcoin to the world. The core purpose of this new digital currency was to provide access to financial instruments to ordinary people and make it a more democratic ecosystem. The Bitcoin Protocol allowed peer-to-peer financial transactions, without a need for third-party services.
The creation of Bitcoin sparked massive innovations based on the new blockchain technology it introduced. These advancements gave rise to a whole new movement of Decentralized Finance.
In 2014, Ethereum, the first Smart Contracts-powered blockchain was released. These smart contracts automatically trigger transactions and other actions when certain conditions are met by both parties. This allowed for the development of more complex functionalities and opportunities in blockchain technology.
In 2017, DAO, Decentralized Autonomous Organization was launched, which marked the beginning of DeFi. It allowed landing and borrowing without third-party involvement. Also, Single-Collateral Dai (SCD), was created and provided proof of concept for the idea of the first decentralized stablecoin.
In 2018, the most popular decentralized exchange (DEX), Uniswap, was launched. Since then, DeFi services have evolved a great deal. Following Ethereum, many more blockchains that utilize smart contracts were launched, such as Solana, Binance Smart Chain and Polkadot.
Traditional finance is based on fiat currencies like USD or Euro, which are banknotes that represent a certain value. These paper notes issued by a bank used to represent a specific amount of gold that was redeemable for these notes at the bank. However, in 1971, the U.S. dollar was untied from the gold standard. Dollar value since then is determined by the market, the federal reserve and the government which has a monopoly on currency production: meaning it could print as many notes as it sees appropriate. For example, the Fed made 1.2 billion new notes or $107 billion between June 2021 and June 2022 according to The Federal Reserve's official page.
Actually, most of this fiat money was not even printed. The majority of it was created out of thin air by simply adding a few zeros or moving a few decimal points on a computer screen.
This system raises many serious questions and concerns. Who is really in control of the money? Who has the option to make more of it? Where does the new money go? Is inflation really unavoidable? Why is the purchasing power of the dollar continuously going down and never up? Can your financial assets in the bank be frozen or confiscated by the feds?
Fundamentally, Decentralized Finance is a movement that challenges the traditional central banking system and offers instruments that aim to democratize current financial services. Its main objective is to provide an alternative to the highly regulated, legally elusive, rigidly managed institutions that are designed to benefit a small group of elites.
More accurately, DeFi is an umbrella term used to describe financial services that operate on a peer-to-peer basis rather than relying on a third party, like a bank for example. Decentralized Finance at this point, features traditional financial services like lending and borrowing, allows asset trading, utilization of interest-earning products and so on. But with the constantly evolving ecosystem, DeFi offers a much wider range of services to its users than CeFi.
DeFi runs on Decentralized Apps or dApps that are open-source software applications that are mediators between peers and are built on the blockchain. DeFi protocols are essentially a set of codes that govern how digital assets are used. Because dApps are built on the public blockchain, no one person or entity can manipulate the system for self-benefit.
DApps used to be built on the Ethereum blockchain only, but recently other blockchains have been utilized by developers as cheaper and faster options. Popular ETH alternatives include TRON, EOS, NEO and Ontology.
DApps utilize smart contracts to connect to the blockchain, which are digital self-executing contracts. Once the terms of the agreement which are written directly into the code are fulfilled, transaction is automatically triggered. These self-enforcing contracts can be applied to virtually any transaction and can have an infinite set of conditions eliminating the need for third-party members that charge service fees.
Smart contracts are immutable, meaning they cannot be modified by anyone or anything in any way, thanks to the blockchain technology. Smart contracts make it possible to lend, trade, and borrow using software that records and verifies financial actions in distributed databases.
Decentralized exchanges allow the trading of cryptos and stablecoins without involving CeFi services that require third-party intermediaries like a bank or a broker. Read our post explaining DEX in greater detail and see how it benefits online gamers specifically.
DeFi operates using its own currencies known as stablecoins. They are cryptocurrencies that have a consistent price in fiat and are an important facilitator of DeFi.
For example, Tether, USD Coin, Binance USD, and Dai stablecoins peg their value to the US dollar, in a 1-to-1 ratio. They are mostly used in DeFi for lending, borrowing, trading, etc., due to their stable price and the ability to be converted to fiat.
Typically, cryptocurrencies are extremely volatile which makes investing and trading much riskier compared to traditional stocks and commodities. Also, switching from crypto to fiat can require paying high fees and can take quite some time. That's where stablecoins come in to save the day!
Stablecoins function as governance currencies in DeFi and allow fast & smooth transactions without the use of third-party services. They provide a relatively stable asset that allows access into a volatile crypto ecosystem.
An average Joe, who does not want to waste time learning about multiple tokens, studying the fundamentals, and maybe even attempting to get a glimpse of the situation through technical analysis, instead can just purchase stablecoins and collect interest for holding them. It's that easy!
You are basically digitizing your dollars, euros or whatever, and using it to access state-of-the-art financial opportunities. For example, you can take advantage of the very profitable, high-interest-earning instruments that DeFi offers.
Do not confuse stablecoins with digital currencies issued by the banks though, those are different and are part of the centralized financial system.
To access the world of DeFi, you need a DeFi wallet. Think of it as a regular wallet for your paper money, but for digital assets. A proper DeFi wallet will keep your investments safe and organized in one place. It could be a physical hardware wallet or a software-based one, like Argent or MetaMask, that could be accessed through a mobile device or your PC.
Typically, DeFi wallets can hold assets from multiple blockchains, but one wallet does not support all available blockchains. One might need a combination of wallets to access all available instruments and get the most out of DeFi. That's why we did the research and reviewed the top DeFi wallets on the market for you. Check out our DeFi Wallet Reviews here.
Are DeFi wallets safe? The short answer is yes. However, certain measures have to be taken to keep the scammers at bay. In the post mentioned above, we explain how to use DeFi wallets and which type might be the best choice for you.
Bitcoin is the largest and most popular cryptocurrency, yet it is not really part of DeFi. Its ecosystem is based on blockchain technology and is designed to include cryptocurrencies. However, the vast majority of DeFi projects so far have been built on the Ethereum blockchain, as it was the first one that utilized smart contracts. That's why you will encounter lots of cryptos and tokens which are Eth-based.
Bitcoin could be used successfully in DeFi but it is a bit more complicated, takes a few extra steps and requires "wrapping" it first.
DeFi has a huge number of functionalities that will only grow and improve over time as the ecosystem evolves. Earning interest, getting a loan and investing in digital assets are the most popular ways DeFi is used today. Let's take a better look at these key features.
DeFi lets you transfer funds in seconds, worldwide without using the banks or other international money transfer companies. You can use it to pay for goods and services online and offline. And that's just some of the most basic DeFi features.
Some DeFi protocols allow users to earn interest and rewards to generate passive income from their crypto holdings. DeFi can offer much higher APY through staking and yield generation compared to banks or bonds. DeFi protocols just basically reward you for providing liquidity for the DeFi pools. Utilizing these protocols could potentially be an alternative to a traditional savings account but with much higher yields and much higher risks.
DeFi with the highest APY? These metrics are constantly changing but we recommend looking into DeFiSwap, Nexo, Crypto.com or Binance to find what works best specifically for you. Some of the most common staking coins include Ethereum, CAKE, DOT, BNB and SOL.
DeFi lets you take out loans without going through the official banking approval process. DeFi loans, just like CeFi loans require collateral but in a form of digital assets, which is typically somewhere between 1.5-3 times the amount of the requested amount. DeFi however, approves you instantly, without a need to wait days for a bank clerk to decide if you qualify.
DeFi microloans allow the underbanked and unbanked to get very small loans. These tiny loans are usually too insignificant for the central banking system to be bothered with, but for people who need them, having these funds could make all the difference in the world.
DeFi allows anyone to participate in small or large-scale global projects, like financing of real estate, infrastructure and tech projects by using tokens. These tokens allow practically anyone to take part in these investment opportunities, due to very low barriers to entry. It is possible to invest as little as $10 in a chosen project, thanks to DeFi.
Worldwide accessibility to certain products and the ability to transact without borders might vary from geolocation to geolocation as each government has its own rules and regulations for DeFi services. This can potentially compromise the borderless essence of DeFi.
For example, some DeFi wallets are not available in certain locations and others provide only very limited services in highly regulated territories. Not just your country, but even your region could be excluded from participating in a certain DeFi protocol for one reason or another.
US residents, for instance, do not have the option to earn high interest on owned digital assets through DeFi Yield offered by Crypto.com DeFi Wallet. It is one of the most popular Defi wallets, yet many of its features and functions are not supported in the U.S. due to strict regulations that Crypto.com had to comply with to legally function in the US.
KYC stands for Know Your Customer. Some DeFi services require you to disclose your identity and provide details like your name, address and so on. This happens as some companies that provide DeFi services are starting to comply with federal regulations to be able to legally deliver specific financial solutions to their citizens.
Governments around the world, including the U.S. government, have already started to require compliance from DeFi companies. These regulations originally were created to protect the public from scams and fraud that are common in the crypto world (well, that’s what they say). Generally, crypto assets lost due to these shady activities are not recoverable.
So what happens if you do get scammed? How do you get the assets back? Who will enforce laws and of which side (country and/or entity) if a scam has occurred? More questions than answers out here, but it is exciting to see how these issues will be resolved as the DeFi ecosystem evolves, and new services and functionalities are introduced.
According to the official UNICEF statistics, 1.7 billion people are still unbanked, meaning they do not have a bank account and have no way to access traditional financial services. DeFi can facilitate the use of various financial instruments by people who are ignored or rejected by the centralized financial system. There are so many reasons why one might not have access to CeFi services, but thankfully DeFi is here to help.
No more waiting for days to receive funds from overseas or spending days worrying if you are approved for a loan by your local bank. DeFi services are much faster, and more convenient, are open 24 a day, 7 days a week without lunch breaks.
Because there are no intermediate third parties that charge fees, DeFi services are typically more affordable. There are network servicing fees to look out for, but they vary depending on which network is being used. DeFi protocols are constantly looking to lower transaction costs though, as high fees are seen as a barrier to the wide adoption of DeFi.
If proper measures are taken, DeFi can be extremely secure and safe. As it is a new technology, there are many edges to smooth over but with time, DeFi security will get only more robust and its users will learn to always implement the necessary safety measures.
In CeFi governments, banks or other entities can freeze or even confiscate your assets for one reason or another. DeFi however, provides secure methods to keep assets safe and unattainable to others. To be fully in control of your digital assets, especially if they are substantial, we recommend using a cold storage DeFi wallet.
Fiat currencies have a value that can be manipulated by central institutions by raising interest rates and so on. DeFi uses stablecoins that are pegged to fiat value. However, the price of other tokens and cryptos is determined by the market and by the demand in the community which utilizes them. This gives incredible power to individuals, businesses and organizations to invest in projects of their choice using tokens. Theoretically, as that project grows, the token value will grow as well, benefiting its original investors and its community.
Online gaming and casinos are sometimes looked down upon by traditional payment providers and transaction regulators. This could be an obstacle for some depending on the rules imposed on your geolocation. DeFi can provide a way to bypass these institutions and make your life so much easier and so much more fun!
DeFi does not limit its services based on gender, age, skin color, political views or religious beliefs, social status, or other factors that are sometimes an obstacle to gaining access to CeFi services. It seeks to provide access to financial services for all, no matter who you are or where you are from. DeFi uses the blockchain instead of third-party intermediaries, which in the past might have limited access to products and services for certain individuals and organizations.
Smart contracts are immutable, meaning they cannot be edited or manipulated in any way once activated. This means that no one can tweak the original policy or the agreement for self-benefit.
Technology that allows accessing the best of DeFi services is still generally too complicated to be widely adopted. However, there is an incredible amount of effort being made to make DeFi services very simple to access and easy to use, so that even your grandma can pay for biscuits with Satoshi.
Some DeFi protocols are already so easy to use that they do not require a smartphone. Kotani Pay, for example, lets users convert cryptocurrencies to fiat and vice versa using basic feature phones.
Liquidity is important when one wants to trade assets. Low liquidity could be an issue for many less popular tokens. There simply might not be enough demand for that specific token, so you could be stuck with it for some time. This is particularly a big issue for large-scale orders and less-known tokens.
DeFi is based on anonymity and transparency, yet it is still a very profitable playground for all sorts of fraudulent activities. More than 15 billion dollars was already lost to DeFi scams and thefts. These assets are generally not recoverable, so DeFi safety practices should be always a priority for its users.
Some top DeFi services have insurance to cover any losses their customers might experience if the company itself is hacked. However, if the funds are lost due to phishing and other scamming activities, it is considered to be the fault of the user, so no refunds are issued.
Even so, DeFi offers all sorts of insurance, including protection from scams and fraud that could be useful for those concerned about the safety of their assets.
The recent bankruptcy by FTX, which was a crypto exchange focused on trading derivatives and leveraged products, has given us a glimpse of what could potentially happen in the future if a big crypto company goes kaboom. In FTX case, many customers that lost funds are now actually selling their credit claims at discount prices to other companies that buy bankruptcy claims like Cherokee Acquisition and others.
Using DeFi services requires an internet connection. Now, this is pretty negligible for most, yet it could be an issue for some. In the modern world, we are totally dependent on the world wide web so if there is ever a global issue with an internet connection, it will be a huge problem not just for DeFi users but for the whole world, DeFi and CeFi alike.
Unstable market prices of digital assets can be a challenge for some DeFi users. It could be quite uncomfortable to see your holdings fluctuate dramatically in value. Due to this extreme volatility, conventional investment experts generally recommend not putting all your eggs in one basket and investing only a percentage of your funds in digital assets. Stablecoins provide only a partial solution to this issue.
Traders, however, considerably benefit from these price fluctuations and do not see it as a problem.
Paying taxes on financial gains can be complicated, but with DeFi it could be even more difficult. You might have to maintain your own records and files for tax purposes as governments are currently not completely clear about how to tax various digital assets. However, this will be sorted out with time.
In this case, day traders might have the toughest time with taxes as things can get tricky. Lots of trades, lots of taxes to pay. As new DeFi tax regulations roll out all around the world, we have yet to see how things will play out.
Some DeFi protocols already provide organized tax records and make it easier for you to report passive income, capital gains and losses. Even so, currently, most DeFi protocols do not report to the IRS in the United States or other tax-collecting organizations in other countries. However, this could change shortly as governments are eager to profit from this new technology as well.
One of the biggest concerns DeFi critics have is that any mass withdrawal of tokens and stablecoins can cause a whole system to crash. If a mass withdrawal of funds from DeFi protocols is triggered for one reason or another, there won't be enough funds to fulfill everyone's order. This scenario can happen because even though stablecoins are pegged to fiat money, there might not be enough actual funds backing those coins.
However, this large-scale redemption scenario is an issue not only for DeFi services but for centralized finance as well, because of the fractional reserve banking system it employs.
Smart contracts are incredibly versatile and can be applied to virtually any transaction. They can also include as many conditions as necessary for the particular action to be triggered. However, its immutability means that these contracts cannot be edited, changed or modified. If new terms and conditions need to be added a fresh new contract must be made.
DeFi is an internet-native system that can replace traditional finance or at least challenge its status quo. As more and more people figure out how to use DeFi to improve their lives, fewer people will be willing to engage with CeFi. So, whether traditional financial services will continue to exist or not, they will have to evolve for the better to keep up with DeFi.
We do not yet fully understand the full capabilities of DeFi and how exactly it will change the way we think about finance. Some see it as the beginning of a truly democratic monetary system that will transform humanity for the better. Others might view it as a fad or another conspiracy created to separate the 99% from the resources.
Even the biggest DeFi fans acknowledge that there are still lots of issues to iron out before mass adoption can be possible. The DeFi ecosystem is in its early development stage and is still evolving technologically, but there are already amazing opportunities available for those willing to explore its intricate terrain.
Innovators and early adopters have benefited from DeFi the most so far. Clever investors and traders have been using DeFi to produce returns unheard of in traditional finance. Due to very high volatility in the DeFi world, someone who likes a challenge and can handle high risks can make huge profits that CeFi simply can't offer.
Less aggressive, long-term investors looking to diversify their asset portfolio might benefit from exploring many opportunities DeFi provides.
Online gamers have already been using DeFi very successfully to transfer funds securely, instantaneously and anonymously for quite some time. It allows for bypassing the central banking system which sometimes creates too many restrictions and regulations around these areas.
Businesses and individuals interested in low-cost, fast and secure transaction methods are starting to include DeFi payments as checkout options.
Individuals rejected by the centralized financial system, the unbanked, are potentially the biggest beneficiaries of DeFi, as it allows access to financial services previously unavailable. Low-income populations, unqualified for traditional financial services like loans due to low credit scores or other reasons, can use DeFi to take control of their financial future.
no bank account is required
can be accessed by anyone, anywhere
secure transactions
transaction speed
low fees
allows total control of your digital assets
no third-party intermediaries
immutable smart contracts
technical skills required
high level of scams and fraud
requires an internet connection
high volatility
complicated tax regulations
large-scale redemption concern
immutable contracts
DeFi is here to liberate people from banks and other financial institutions that "keep the men down". Anonymity and transparency make DeFi a great alternative to a current centralized financial system which is full of mysterious fees, regulations and other underwater stones that tend to pop out when you least expect it.
DeFi is a new and rapidly growing field that is having a significant impact on the way we interact with and think about money. By creating a more open, transparent, and accessible financial system, DeFi has the potential to truly empower individuals and communities around the world.
Nevertheless, it is important to remember that DeFi is a relatively new technology and is in its early stages of development. Some of the tokens and protocols that exist today may not be around in the future, so invest wisely and diversify.
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