Decentralised finance (DeFi) is a peer-to-peer financial system based on blockchain technology. There are many reasons why consumers prefer DeFi; the main reason is that zero fees are charged for using financial services compared to banks and other traditional financial services. The consumer will hold their funds in a digital wallet rather than the bank, and transactions are speedy.
In centralised finance, consumer funds are held in banks; therefore, fees are typically charged when transferring money or paying merchants due to the third parties involved in the process. There are other costs also associated with using banks and financial institutions. If you want to use money abroad in the local currency, you will have to pay a charge to use your bank card. There is also the time factor to consider; for example, applying for a bank loan usually takes a few business days before anything is approved.
When you compare traditional centralised financial services to decentralised finance, the obvious and most important factor is the elimination of third-party intermediaries. Instead DeFi allows individuals to manage transactions through the use of emerging technology. This is achieved through peer-to-peer financial networks that allow for much more advancements such as security and software. By surpassing the traditional centralised model for financial services, DeFi allows the user to access financial services anywhere in the world. All they will need is a WiFi connection to lend, borrow, invest and trade using a system that monitors and authorises actions via distributed financial databases.
By using the same technology that cryptocurrencies use, applications can be created that can handle transactions on the blockchain. These applications are called dApps. There is so much a user can do already using dApps. For example, using decentralised finance, you can borrow and lend your cryptocurrency to earn interest, bet on the outcome of financial and sporting events without there being a limit, and enter a no-loss lottery where you still get your money back (the winner wins the interest earned in the pot), and also buy stablecoins.
DeFi is a phenomenon because of its central premise – peer-to-peer financial transactions. This involves paying for goods and services using cryptocurrency, without the need for any intermediaries. This works with anything. If you wanted a loan instead of going to the bank you could ideally use a dApp to fill out an online form, the algorithm running behind the scenes would match your needs to the peers that could meet. Similarity to traditional financial services, you would agree to the terms and conditions of the loan. However, what would happen is once agreed the transaction would be noted on the blockchain – once verified you would receive the loan. When making your repayment, you would do so via the dApp and again it is noted on the blockchain and your repayment is sent to the lender.
Lending is also an attractive aspect of decentralised finance due to the lack of intermediaries involved. Typically when you save with a traditional bank, you earn a percentage of interest over time. The bank you are with will lend that money to another customer while charging them a higher interest rate and keeping that difference. If the user lends and borrows using a dApp, you are lending your savings to others but earning the entire interest rate back.
How does DeFi affect the crypto market?
The central premise of DeFi is to build a new financial ecosystem that is not centralised and is entirely independent of traditional financial institutions. Most dApps use Ether to run, but as decentralised finance has accumulated more and more popularity, other cryptocurrencies are also eager to host and run dApps, which has subsequently caused a lot of competition in the market.
Crypto investors benefit from decentralised finance as there is potential to generate a higher income via crypto holdings that use dApps. An example would be crypto staking, allowing owners of digital currencies to earn a passive income. The individual would lock up their crypto investments to maintain blockchain security. In doing so, they would make a return calculated in percentage yields. This is a much more attractive option for investors as the return generated through staking digital assets is generally higher than that of the interest rates offered by traditional banks. The dApps function through cryptocurrency liquidity, and because of the demand for this, the dApps offer to pay for the yield in exchange for investors locking up their digital coins for a specific period.
Price changes in the market will, in turn, affect DeFi. More recently, the collapse of the stable coin TerraUSD has significantly impacted the sector. Investors hope the decentralised finance sector will improve rapidly in the coming months due to significant boosts from Ethereum and Gnox. Ethereum is expected to have an upgrade. ‘Merge’ as it is known, will be the most anticipated technological upgrade to the Ether blockchain. According to Ethereum’s website, the upgrade is expected to occur in Q3/Q4 2022. The upgrade marks the transition to the proof-of-stake model, which will remove the high gas fees attached to the mining Ether.
Gnox is a protocol that will provide yield farming as a service to users; with the built-in treasury, everyone will be able to access yield potential through decentralised finance. The premise behind Gnox is to deliver DeFi investment globally. Over the more recent weeks, the price of Gnox has experienced a surge of over 52% – making it a hot asset in the DeFi space. The burning of tokens is set to continue, and they have already burned 2.5 billion tokens to improve its ecosystem and limit its supply. The sold number of tokens amounts to 49.4 million, and demand is rapidly increasing for this particular token.
Is DeFi safe?
Like any new investment or trade, it is essential to conduct research and create an efficient strategy that includes risk management before jumping into the crypto market. Many investors are turning to DeFi; as mentioned earlier, this demand is due to potentially higher returns via passive income. However, the investor needs to understand the risks of decentralised finance.
There are several regulations and safeguards in place when we use traditional banks, and those are there to protect our money. The same protections may not be in place if the user decides to use a dApp, so what would happen to the individual’s money if something were to go wrong? If, for example, there was a significant bank collapse, client money is protected via insurance and financial regulation. There is a real possibility that dApps could fail, and there isn’t much protection in place if it does. If individuals want to invest in DeFi, there are numerous things to consider. Before putting money into a DeFi platform, ensuring that cash is stored offline by insured cold storage is key – that is also making sure that the insurance will cover hacking too.
Individuals should always determine how their assets will be used when wanting to gain a higher form of revenue. With DeFii, individuals may get a high-interest rate once they deposit their crypto on specific platforms, but it is vital to understand how this works before doing so. Usually, investors will get a higher interest rate as the platform will lend out their crypto and pay the investor a percentage of the interest the borrower has paid the platform.
Being careful of scams is another crucial factor to consider before investing in a DeFi project or putting your money into a platform. More recently, the term ‘getting rugged’ has been coined within the crypto community and refers to exit scams. Exit scams are when liquidity pools are launched after a new token has been created and paired with a base token or a stable coin. The scam comes into fruition when the scammer receives a major portion of the total supply of tokens in the liquidity pool once their token has launched.
Is DeFi a good investment?
DeFi is a relatively new sector in the crypto world and has rapidly grown. The industry grew from $700 to $13 billion back in 2020. Many investors believe there is still growth potential, and there are different ways you can get involved with decentralised finance to get a healthy return. However, with every investment and trade, there is always an element of risk attached. Below are a few ways in which an individual can invest in DeFi.
DeFi Staking: This is one of the options that an investor will go for to receive a form of passive income. Individuals will usually lock or hold their funds in a crypto wallet and, in return, will receive a set interest rate. The locked funds will be used to maintain the operations in the proof-of-stake (PoS) model.
DeFi Yield Farming: This is another form of earning an additional passive income. This works when the user provides liquidity via their crypto assets to a decentralised exchange. The exchange will then use the liquidity given to execute orders from token swappers who pay a fee. Yield farmers, as they are known, will earn a percentage of the cost that the token swapper pays. An example of a decentralised finance project involved in yield farming is Aave, which allows the individual to lend and borrow cryptocurrencies.
DeFi Derivatives: Tokens that represent DeFi networks can be traded for the individual to use the market’s volatility. Eightcap, an award-winning CFD broker, offers a number of tokens involved in several DeFi projects for the investor to speculate on, all with ultra-low spreads. Users can get started with an Eightcap trading account with as little as $100. However, even though there is an opportunity to make the most of market movements when trading derivatives, there is also a high risk attached. Both profits and losses can be magnified when trading on margin.
DeFi lending: Investors will essentially lend their crypto to another individual to earn interest on the loan, and numerous DeFi lending platforms are specifically used for this.
Example of DeFi coins?
More coins are being introduced into the cryptocurrency market. There are now more DeFi coins as the market evolves. Here are the top four DeFi coins based on market capitalisation.
This stable coin is unique because it is soft pegged to the USD. Typically stablecoins such as USDT and BUSD are pegged by traditional assets like corporate bonds. The question then arises, how do users generate Dai? Individuals can deposit their crypto-asset into the Maker Vaults which is found on the Maker Protocol. These can be accessed via interfaces built by the community. An example is Oasis Borrow which allows the user to lock in assets such as ETH, LINK, UNI, MANA and more. Then, the user can borrow against what they have deposited as long it remains within their collateral ratio – ranging from 101% to 175%.
Wrapped Bitcoin (WBTC):
Running on the Ethereum blockchain, WBTC is a tokenised version of Bitcoin. The reason why it meets the standard of the Ether blockchain is that WBTC is compliant with ERC-20. It was founded by three organisations: Ren, Kyber Network and BitGo. Everyone knows Ethereum runs entirely different from the block’s oldest crypto: Bitcoin. The Ether ecosystem has been considered more advanced by supporting technologically revolutionary concepts such as smart contracts, hence the birth of decentralised finance. WBTC works on this Ether ecosystem by ‘wrapping’ BTC to fit into the ERC-20 mold, allowing the Bitcoin-based asset to function in the DeFi environment while also bringing forth the liquidity attached to the BTC market. Exchanges and payment services can use WBTC with just an Ethereum node making it much more seamless than having to run BTC and ETH.
Avalanche is a smart contract platform for decentralised applications that are deemed super fast, low cost and environmentally friendly. It differentiates itself from other decentralised networks because of the avalanche consensus protocol it uses, allowing it to confirm transactions in under one second. The scalability of this smart contract is impressive as it can handle 4,500 transactions per second while ensuring security.
A decentralised trading protocol that is used for automated trading of DeFi tokens has risen to popularity due to the sudden increase in token trading. The goal for Uniswap is to keep token trading automated and available to everyone that holds a token. The overall efficiency of token trading is hoped to be better than that of traditional exchanges, which is achieved by overcoming problems with liquidity using automated solutions. In 2020, Uniswap launched its governance token, UNI, available for its users. Owning UNI governance tokens allows the member to vote over the treasury, governance and roadmap of the DEX.