The realm of decentralized finance (DeFi) is both exciting and challenging. After holding investments for a period, many individuals ponder how to extract additional returns from their portfolios. However, the landscape of DeFi is rich and diverse, requiring careful study and exploration of its various components.
When executed correctly, the decentralized applications (DApps) and projects within DeFi can become powerful tools. Yet, rushing into the space can easily lead to confusion and irrational investment decisions. Therefore, it is essential to understand the associated risks and identify the most suitable way to participate before diving in. This article will explore the fundamental knowledge required to enter the world of DeFi.
What is Decentralized Finance (DeFi)?
Decentralized finance (DeFi) is a financial application ecosystem built on blockchain networks. Specifically, the aim of DeFi is to create an open-source, permissionless, and transparent financial services environment accessible to all, without reliance on any central authority. Users have complete control over their assets and can interact with this ecosystem through peer-to-peer (C2C) transactions and decentralized applications (DApps).
The core advantage of DeFi is its ability to democratize financial services, particularly for those who do not have access to traditional financial systems. Another notable benefit is its modular framework, which allows for the development of highly interoperable DeFi applications on public blockchains, potentially leading to the creation of entirely new financial markets, products, and services.
Main Advantages of DeFi
Traditional finance often relies on intermediaries such as banks and requires courts for arbitration. In contrast, DeFi applications can directly eliminate these intermediaries and arbitration institutions. The corresponding code provides clear solutions for potential disputes, allowing users to maintain complete control over their funds. This automated process not only reduces costs but also fosters a healthier financial ecosystem.
The blockchain-based model of financial services mitigates the risk of single points of failure. Data is recorded on the blockchain and distributed across thousands of nodes, making it more difficult to audit or shut down services, thereby lowering overall risk.
Furthermore, DeFi significantly enhances the openness of the financial ecosystem, enabling more individuals who lack access to traditional financial services to benefit. The profit model of traditional financial systems heavily relies on intermediaries, which typically do not serve low-income individuals. However, DeFi dramatically reduces costs, allowing low-income populations to utilize a variety of financial services.
Potential Use Cases for DeFi
Lending
Open lending protocols are among the most popular applications in the DeFi ecosystem. Compared to traditional credit systems, decentralized lending offers numerous advantages, such as instant transaction settlement, the absence of credit checks, and support for digital assets as collateral.
These lending services are built on public blockchains, significantly lowering the trust requirements and ensuring security through cryptographic verification schemes. Blockchain-based lending markets effectively reduce counterparty risk, saving on borrowing costs while increasing loan processing speeds, thus enabling a broader audience to enjoy these services.
Banking Services
As the name suggests, DeFi is a financial application ecosystem, with banking services representing a typical application scenario that includes the issuance of stablecoins, mortgages, and insurance.
With the ongoing development of the blockchain industry, stablecoins have gained increasing attention. The value of stablecoins is typically pegged to real-world assets, facilitating transfers within the digital environment. Despite the sometimes volatile nature of cryptocurrency prices, decentralized stablecoins can serve as digital currencies for everyday transactions, requiring no central authority for control or management.
The introduction of smart contracts has the potential to significantly lower underwriting costs and legal fees associated with mortgages. On the blockchain, insurance can operate without intermediaries, allowing numerous participants to share the risks collectively. As a result, policyholders may enjoy the same level of service at a lower premium.
Decentralized Marketplace
In the DeFi space, decentralized exchange platforms (DEXs) such as Uniswap and PancakeSwap are among the most widely used applications. Through these platforms, users can trade digital assets directly without entrusting their funds to a trusted intermediary. Using smart contracts, users can execute trades directly from their personal wallets.
Some trading platforms are known as automated market makers (AMMs), which facilitate trades through liquidity pools without the need for direct counterpart matching. Compared to centralized exchange platforms, decentralized exchanges have lower maintenance and management requirements, and trading fees are generally significantly lower than their centralized counterparts.
Additionally, blockchain technology is often employed in the issuance and authorization of various traditional financial instruments. These applications operate in a decentralized manner, eliminating the possibility of single points of failure by removing the need for custodians.
Yield Optimization
DeFi DApps can automatically optimize compound yields obtained from staking, reward pools, and other interest-bearing products, a process commonly referred to as liquidity mining.
For instance, you can earn regular rewards by mining Bitcoin, staking BNB, or providing liquidity. Smart contracts can utilize the rewards you earn to automatically purchase more related assets for reinvestment. This process allows you to earn compound interest, significantly enhancing your returns.
Smart contracts save you time and enable yield optimization. Your funds are generally pooled together with those of other users, meaning that all participants in the yield optimization smart contract will jointly share the gas costs.
The Role of Smart Contracts in DeFi
Currently, many existing and potential decentralized finance applications involve the creation and execution of smart contracts. Traditional contracts describe the relationships between different parties using legal language, whereas smart contracts employ computer code for their specifications.
The terms in a smart contract are written in computer code and activate automatically. Many business processes that traditionally required human oversight can now be executed automatically, greatly enhancing reliability.
With smart contracts, parties can reach transactions more quickly and conveniently while reducing common risks. However, smart contracts also introduce new risks, as errors or vulnerabilities in the computer code may lead to the exposure of key information within the contract.
Challenges Faced by DeFi
Poor Performance
Compared to centralized competitors, blockchain technology is inherently slower, which impacts the applications built on it. Developers of DeFi applications must be aware of these technical limitations and take measures to continuously optimize their products. For example, Layer-2 solutions like Arbitrum and Optimism aim to address this issue by providing faster transaction processing speeds and lower transaction costs.
High Risk of User Error
DeFi applications transfer the responsibilities of traditional financial intermediaries onto the users themselves, which may not be ideal for many individuals. As these products are built on immutable blockchains, it is challenging to design mechanisms that reduce the losses incurred from user errors.
Poor User Experience
Currently, using DeFi applications can still be a cumbersome experience for users. To make DeFi a core component of the global financial system, it is essential to provide clear value that encourages users to shift away from traditional financial systems. Many projects are actively working on optimizing user interfaces and enhancing the richness of educational resources to improve this situation.
Ecosystem Confusion
Users often face difficulties akin to searching for a needle in a haystack when trying to find the most suitable applications. They need to possess the ability to discern and identify the best solutions. The challenge not only lies in the process of building applications but also in how to integrate them into the expansive DeFi ecosystem.
Risks in DeFi
While DeFi can offer attractive annual yields, it also harbors various risks. As a decentralized financial option, users face some familiar risks even while enjoying these financial services.
Counterparty Risk
If you participate in staking borrowed assets or other types of lending activities, you must contend with the risk that the counterparty may fail to repay their debts on time.
Regulatory Risk
The legality of certain services and projects can be confusing. If the smart contracts you invest in are shut down due to regulatory issues, your funds could also be at risk. Recent actions and guidelines from regulatory bodies around the world are likely to affect the development and adoption of DeFi.
Token Risk
The risk level of the assets you hold varies depending on liquidity, credibility, the security of the token's smart contract, and the status of the related projects and teams. Given the presence of numerous low market cap tokens in the DeFi space, token risk can be quite high.
Software Risk
Vulnerabilities in the code can compromise the security of the smart contracts in which you invest. Additionally, connecting your wallet to a DeFi DApp and granting it certain permissions may expose you to security threats. To mitigate these risks, security measures such as multi-signature wallets and risk assurance funds have emerged.
Impermanent Loss
If the value of tokens within a liquidity pool diverges from the price ratio at which you initially invested while staking, you may incur losses when withdrawing funds.
Participating in DeFi Projects
Ethereum has long been the center of DeFi, but many other blockchains have now established relatively mature DeFi ecosystems. For instance, BNB Chain, Solana, Polkadot, Avalanche, and emerging Layer-2 solutions on Ethereum are gradually becoming popular alternatives.
Finding reliable DeFi projects and protocols requires in-depth research and analysis. Online forums, social media, and professional websites can help you discover new opportunities. However, it's essential to maintain a cautious attitude towards the information you find and thoroughly verify the security of any projects you encounter to ensure you are well-informed.
What Do You Need to Participate in DeFi Projects?
If you wish to use DeFi DApps, you will need to prepare the following:
Compatible Wallet
You can use browser extension wallets (like MetaMask) or mobile wallets (like Trust Wallet). It's important to note that custodial wallets (where users do not have access to private keys) typically do not support connections with DApps.
Cryptocurrency Assets
While this may seem obvious, you may need to prepare various digital assets. For example, if you plan to use an Ethereum-based DApp, you will need to have ETH to pay for transaction gas fees, as well as another token to cover the costs of the services you wish to use.
DeFi vs. Traditional Finance (TradFi)
DeFi represents an open financial system where anyone with internet access can participate, contrasting sharply with traditional finance, which relies on centralized institutions and regulatory bodies. However, the interactions between DeFi and traditional finance are increasingly frequent, as many banks and financial institutions explore DeFi protocols, creating new hybrid financial models by combining the strengths of both systems.
DeFi vs. Centralized Finance (CeFi)
In the cryptocurrency space, not all financial services are decentralized. For instance, if you stake through centralized exchanges like Binance, you typically must hand over your tokens to the platform for management. In such cases, you must trust these centralized entities to handle your funds.
Although both provide similar services and are often accessible through DeFi platforms, CeFi manages the complexities of DeFi investment processes on behalf of users and may offer additional protection for your deposits.
Both CeFi and DeFi have their advantages and disadvantages, and users should choose the appropriate service based on their individual needs. Using CeFi may mean relinquishing some control, but it often comes with stronger protections while also reducing the burden of managing assets and executing transactions.
How Does DeFi Differ from Open Banking?
Open banking refers to allowing third-party financial service providers secure access to banking systems through application programming interfaces (APIs), enabling them to safely retrieve financial data. This allows banking institutions and non-bank financial service providers to interconnect their accounts and data, fostering more innovative products and services within the traditional financial system.
In contrast, DeFi introduces an entirely new financial system that operates independently of existing infrastructure. DeFi is sometimes referred to as "open finance."
For example, open banking can securely fetch data from multiple banks and institutions and manage interactions with all traditional financial tools within a single application. In contrast, decentralized finance can manage entirely new financial tools, creating novel ways of interaction.
Conclusion
DeFi has rapidly constructed a self-sustaining value ecosystem, attracting funds, developers, and new products. While the potential of DeFi is immense and promises to revolutionize the finance industry, it remains in an emerging stage. Its future development will depend on continual technological advancement, evolving regulations, and widespread public adoption. To ensure sustainable growth, DeFi must continuously innovate to address its limitations and associated risks.
Risk Warning
While the cryptocurrency market offers significant growth potential and innovation opportunities, it also carries a high level of market risk and price volatility. The value of crypto assets can fluctuate dramatically in a short period, potentially leading to substantial financial losses for investors. Additionally, the cryptocurrency market faces multiple risk factors, including technical risks, legal and regulatory uncertainties, cybersecurity threats, and market manipulation. We strongly advise users to conduct thorough research and due diligence before making any investment decisions and to consult professional financial advisors. All investment decisions are made at the user’s own risk. Thank you for your trust and support of Venkate!
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