In this article, I will explain what DeFi is, what sets it apart from traditional finance, what components it has, and what experts believe about investing in it.
What Is DeFi?
DeFi stands for Decentralized Finance, and it represents an umbrella term for financial services on public blockchains, especially Ethereum. DeFi allows you to do pretty much everything that a bank would, such as earn interest, buy insurance, lend or borrow, trade assets or derivatives, and so on.
But unlike traditional finance, DeFi works faster, it doesn’t ask you to deal with paperwork, nor does it rely on a third party to control everything. As is the case with crypto, DeFi is global, peer-to-peer, pseudonymous(like sudan but with a p), and open to everybody.
What Differentiates DeFi From Traditional Finance?
There are several things that stand in direct opposition when we compare DeFi with traditional finance, with the most important one being the fact that DeFi allows you to hold your own money, while in traditional finance, your money is always held by a company.
In DeFi, a transfer of funds happens almost instantly, lasting only a couple of minutes, while in traditional finance, a payment can take several days to be processed, as it is processed manually. Not to mention that DeFi markets are always open, while traditional finance means that the markets get closed since employees need their break too.
Furthermore, in DeFi, transaction activity is pseudonymous, while in traditional finance, your financial activity is tightly connected with your identity.
Additionally, DeFi is open to literally everybody, while you must fill out an application in order to use conventional financial services.
Also worth mentioning is the fact that DeFi is built on transparency, which means that everybody can check the history of a product and its data, how it works, etc. Traditional financial institutions are closed to the public, as you are not allowed to see loan history, their management assets, etc.
What Are the Components of DeFi?
In a broad sense, DeFi has the same components as the already existing financial ecosystem, meaning it needs stable currencies and a large variety of use cases.
DeFi uses stablecoins and services such as crypto exchanges and lending services. Smart contracts are responsible for the framework needed for DeFi apps to function, as they encode the terms and activities needed for these services to work.
As an example, we can say that a smart contract code has a specific code that creates the exact terms and conditions of a loan between two individuals or entities. In the case that some terms or conditions aren’t met, collateral can be liquidated. This happens completely automatically, with the help of a specific code, unlike a bank, which does it manually.
Is It Safe to Invest in DeFi?
Anybody who plans to invest in DeFi should know that it is a pretty risky endeavour. DeFi could represent the future of finance, and investing in it can offer huge gains. But, for those lacking experience, differentiating between a good project and a bad one can be quite difficult.
As DeFi became more popular than ever in 2020, several DeFi applications, like the meme coin YAM, have crashed and burned, with their market cap going from $60 million to $0 in just 35 minutes. Other DeFi projects, like Hotdog or Pizza, had a similar fate.
Also, DeFi bugs are still pretty common, and while smart contracts are powerful, they can’t be changed once the rules are set into the protocol, which means that some bugs can be permanent, and that would increase the risk of investing.
Conclusions
DeFi is seen by many as the future of finance, as it offers the individual more freedom than the traditional financial system could. But while its technology can be impressive, there is still a long way to go before investing in DeFi could be seen as having a small risk level.