Decentralized finance is an alternative financial structure that is built on top of the public, permissionless, and programmable blockchain.
By being public, a participant can verify correct execution. Permissionless means that transactions validated by miners on network. Programmable means that a set of rules in encoded into the the algorithm, known as a smart contract.
DeFI aims to remove traditional intermediaries like banks from financial services processes by using blockchain technology.
Who Runs It?
Voluntary groups of people often with no connection to one another power DeFi services across thousands of computers. These volunteers are rewarded with Ether for providing the processing power.
How Do You Use It?
On the user side, one needs a crypto wallet to interact with DeFi. The wallet is protected by a private key—a random string of numbers and letters, much like a strong password—and is used to access and move crypto funds to pay for these services.
There are two types of wallets: custodial and non custodial. Users of custodial wallets outsource the handling of private keys to third parties, like crypto exchanges. Users of non custodial wallets retain ownership of private keys. We've previously discussed the risks and benefits of each type.
Features of DeFI
- Non custodial: There is no central authority. Particpants manage digital assets directly.
- Self-goverrned and community driven: Most DeFi protocols are open-source and allow community to review and further deveop the code
- Composalbe: This provides the potential to further amplify network effects
Growth Drivers of DeFi
- Digitalization has meant economic activity is moving online
- Growth in blockchain market
Key Sectors
- Decentralized Lending Platfroms, for example Aave
- Decentralized crytpo-exchanges, like Uniswap
- Decentralized Derivatives, which derive value from underlying assets performance, Synthetix Dapp
- Decentralized Asset Management
- Decentrlized Stable Coins – DAI, which is pegged to USG
- Decentrliazed Insurance – Nexus Mtual
Benefits of DeFI
- Faster, cheaper and frictionless transactions of value
- Transparency – publicly available
- Reduced cyber risk – no single point of failure
- Custodial Risk is Eliminated
- Countter-party settlement ris is eliminated
- Innovative flexibility – composiblity allow creation of new products and services
- Democraization of finance
Risks of Defi
- Regulatory and Compliance – gaps exist
- KYC/AML – gives rise to money laundering
- Market Manipulation
- Theft
- Investors have no recourse
- Lack of audit and due diligence
- Investor Financial Capability
- System risks – overall market confidence
- Protocol Flaws – errors in code
- Network Risk – Scalability, congestion
Policy Solutions
- Regulatory / supervisory access
- Mandatory audit of codes of smart contracts
- Legal clarity in laws for liability of holders
- Regulatory global cooperation
- https://www.2tokens.org/blog/how-blockchain-is-disrupting-financial-markets
DeFi Use Cases
Decentralized exchanges. Trades on these are executed by smart contracts and don't rely on the intermediaries usually required to update records, ensure compliance, and manage counterparty risk. This removes transaction friction, enhances asset liquidity, and removes the risk of human error. UniSwap is one of the largest decentralized exchanges and processes $1.5 billion trades on average a day. And Square recently announced it would develop a decentralized exchange.
Stablecoins. Tether, the largest stablecoin globally, and its parent company, Bitfinex, were fined $42.5 million this month for lack of transparency regarding the composition of its reserves. Rather than being fully backed by US dollars, Tether is partially backed by assets like debt securities and bonds. As a centralized company, Bitfinex can be opaque about its books. DeFi platforms, by contrast, can create a more transparent stablecoin with reserves that can be checked by anyone on a blockchain. Dai is a decentralized stablecoin—anyone can create new Dai tokens if they offer enough other cryptos as collateral.
Lending protocols. Some DeFi protocols let users earn interest on crypto deposits or borrow more cryptos without having to go through a financial intermediary or pass long credit checks. The Compound protocol has processed more than $12 billion in loans as of October.
The challenges ahead:
High barrier to entry for everyday users. By now, you may have noticed it can be hard to wrap one's head around the DeFi sector. It's easy for users to make mistakes and suffer financial losses. That can put off further adoption: Mainstream users are often reluctant to trust a technology they don't understand with their money.
Lack of regulatory protection. Financial firms that act as intermediaries in the legacy financial system are heavily regulated, and consumers can rely on bodies like the SEC to police the sector and remedy any faults. But there are no legally recognized, centralized entities that can be held responsible for smart contract problems like a mistake in the code.
Prone to crime. DeFi losses from fraud and theft reached $10.5 billion this year, up from $1.5 billion in 2020. The confusion around how to use DeFi services and the lack of regulatory protection, combined with the significant money moving through these protocols, make it a fertile ground for illicit activity.
Crypto adoption. 2021 was the year of crypto adoption, with the global market hitting the $3 trillion mark for the first time earlier this month. And now that everyday people are accustomed to trading cryptos on the likes of Coinbase and Robinhood, many will be open to experimenting with more complex use cases. And consumer-facing fintechs like eToro are also adding DeFi services and removing the barriers to entry.
Significant capital pouring in. Global blockchain funding reached $8.7 billion in H1 2021, up from $4.3 billion for all of 2020, and 12 new crypto unicorns were born in Q3. Venture firm Paradigm's recently closed $2.5 billion crypto fund underscores that investments will keep flowing into blockchain startups with the potential to innovate financial services, like DeFi firms.
Promise of the metaverse. Recent moves by crypto firms show that they expect DeFi services will play a key role in facilitating transactions within the metaverse. Consensys just raised $200 million thanks to its crypto wallet, MetaMask, which now has more than 21 million monthly active users—a 38-fold increase from 2020—to access such services. And crypto exchanges Coinbase and Gemini are planning to expand their crypto wallets' compatibility with the DeFi sector in a nod to the metaverse.
https://www.businessinsider.com/the-definitive-guide-to-decentralized-finance-defi-2021-11