The Basics of Decentralized Finance (Defi) - Explained

A few years ago, back in 2017-2019, most people in the crypto space already saw the possibilities of smart contract platforms. Projects like Ethereum, EOS, NEO, Cardano, and Tron were all doing well because everybody saw that smart contract platforms would eventually evolve and help the crypto industry to grow. 

However, 2020 was the game-changing year for the smart contracts space because it was the time when Decentralized Finance (DeFi) finally became mainstream. After the rise of Compound and Aave, many other projects started to pop up and took over the crypto industry. Even right now, in the midst of a bear market, DeFi remains very popular.

Blockchain technology can help achieve financial freedom for everyone. But before you start investing your money into DeFi projects, there are several factors you should consider first. Below is everything you need to know about decentralized finance (DeFi) and its potential impact on society moving forward.

Decentralized finance is defined as any financial service offered by smart contracts without relying on third-party centralized institutions. It means users do not have to trust anyone when doing financial activities using DeFi services. Instead, these platforms allow individuals to access their funds directly from where those funds were originally held.

There are many different ways to interact with DeFi apps. In fact, there are a lot of various DeFi applications and their level of decentralization. Some DeFi apps might not fully utilize smart contracts for everything, while others are more “pure” in this regard. 

With DeFi, you can do what traditionally you can do on CeFi (centralized finance), such as earn interest or borrow assets. The difference here is that everything is automated via smart contracts within the DeFi space, while with CeFi there is always at least one centralized authority that oversees everything.

When you interact with a DeFi app, you may notice that each app differs depending on which project you’re interacting with. For example, MakerDAO generates an algorithmic stablecoin called DAI, while Compound relies on lending pools.

Decentralized finance loans always require collateral (as of now). That way, lenders ensure borrowers won’t be able to get away with their money since they’d lose ownership of the asset if they defaulted on payments. The entire loan process and collateral mechanism are always coded from the beginning.

However, decentralized finance isn’t perfect yet. Since no single institution controls the entire system, there’s always room for fraud and scams. As more people join the industry, however, security measures get better with time.

Another common issue in DeFi is smart contract exploitation. Since DeFi developers typically rush to deploy their code to the blockchain, these practices leave a lot of potential attacks if their smart contracts are monitored by cybercriminals. Ideally, the codes should be audited before they are deployed.

In many cases, smart contract exploits in DeFi almost always happen due to a lack of security audits. The thing is, complicated smart contract audits are expensive and take a lot of time. In the meantime, many of the newer projects always want to put their codes out there as fast as possible.

Another challenge facing DeFi operators is scalability. While alternative blockchain tech allows for faster transactions and executions, current DeFi projects are usually built on Ethereum, which is a bit too slow for high-traffic activities. By the way, for those who are still new to crypto, you should know that there are big differences between Ethereum vs Ethereum Classic. When people build dapps, majority of them were deployed on Ethereum, and not Ethereum Classic.

The good thing is that there are many developers who are trying to build on alternative smart contract platforms such as BSC, Polygon, or Avalanche. The activities on these alternative chains are usually much faster and the gas fees are cheaper.

Although both types of finance share similar goals and basic activities (earn interest and get loans), the execution methods vary significantly. Here are some key differences between DeFi and regular CeFi.

People with regular bank accounts deposit their hard-earned money in national currencies such as US Dollars or Euros. Banks then lend out that money to businesses based on commercial terms. If customers fail to pay back their debts, banks take full control of repossessing clients’ property and assets. Every single step of this process is highly regulated.

On average, major bankers earn higher salaries compared to private entrepreneurs. Besides, they also enjoy perks such as free health insurance and retirement benefits. Furthermore, major banks rarely go bankrupt either. Central governments would bail them out in case things go wrong. All of these things make banks very safe bets for investors despite lower potential gains.

Compared to central banks, DeFi platforms lack any formal power structures and regulations. DeFi (for now) is self-regulated through the automatons via smart contract usage. It’s basically a wild wild west world in the DeFi industry.

Users own their funds in their non-custodial crypto wallets rather than placing themselves under the authority’s umbrella. Unlike fiat currencies, cryptocurrencies aren’t backed by anything other than the crypto community’s faith. Thus, when you lose access to your cryptocurrencies, most likely, nobody will be able to help you.

This is not the case when you lose your internet banking password or debit card. You can just report your losses to your bank and they will replace them with a new one.

Also, unlike central banks, companies and foundations behind the DeFi projects cannot print new money to meet unexpected expenses. Therefore, they must rely on capital injections from external sources when their projects are not making revenues (such as in the current bear market).

Despite these limitations, decentralized finance offers numerous advantages over centralized alternatives. Most importantly, DeFi doesn’t involve intermediaries taking large cuts of profits. Cryptocurrencies transparency helps reduce riskiness and uncertainties in the process.

In established DeFi smart contracts, users usually have certain functions that they can publicly call whenever they wish. For example, when a user stakes his stablecoins to a DeFi protocol, he might be able to call an “emergency withdraw” function if he decides to change his mind and pull out his funds from that same protocol.

Not all DeFi apps have this “emergency withdraw” function, of course. That’s why I said it’s like a wild wild west world. You must be able to do your own due diligence before you decide to trust a DeFi app or protocol.

Always remember that DeFi developers can go rogue and put in some “hidden” functions to disallow withdrawals or other tricks to manipulate their own investors. You should only trust popular DeFi protocols with multiple smart contract audit reports.

Besides all of the things mentioned above, one more advantage of DeFi compared to regular banks is that they typically provide faster or nearly instant settlement periods.

While centralized finance dominates today’s world economy, DeFi represents an alternative to future generations. Blockchain technology enables low operational costs while allowing consumers to have complete control over their finances.

Withdrawing funds from traditional banks requires filling out multiple forms and submitting documents. The banks can also reject your request for multiple reasons. In the meantime, withdrawing your crypto assets from DeFi protocols takes less than 30 seconds.

Also, sending funds to friends and family members becomes seamless thanks to fast and nearly instant transfer speeds.

Furthermore, DeFi eliminates bureaucratic barriers that slow down processes in mainstream finance. You’ll find DeFi providers offering convenient mobile apps and web3 portals. By having these advantages, clients never need to visit physical branches or wait days for paperwork approvals.

Lastly, given the fact that blockchain records remain public, user privacy is honored in DeFi apps. Many DeFi projects only use standard web3.js connections to their front end and require zero user registration. As a result, DeFi facilitates greater privacy for its participants.

Overall, the growth rate of DeFi surpasses that of traditional finance by over 3x every year. It is projected that total worldwide spending on DeFi products will exceed $7 trillion.

Since DeFi lacks formal governance bodies, regulators struggle to define rules and guidelines. Unfortunately, fraudulent activities happen quite frequently. As mentioned above, some DeFi developers might go rogue and put in some “hidden” functions that may be able to manipulate naive investors.

Before you decide to trust a DeFi application, you must check everything very thoroughly, including smart contract audits that are usually done by third-party companies.

Keep in mind that even though smart contracts are immutable after they are deployed, some of the “settings” can be changed via function calls. And unfortunately, some of these functions might be only available for whitelisted wallet addresses (usually the deployer’s wallet address).

That’s why you must always check the smart contract audit results to make sure the admins don’t have certain privileges that can disallow withdrawals or other malicious intent. Admittedly, all these hassles would become one of the biggest obstacles for DeFi future adoption.

Unlike banks where they will help you with everything, activities and analysis related to DeFi must be taken more thoroughly and carefully.