What Is DeFi?
Centralized finance is what you see every day when you conduct bank transactions. From getting loans and paying mortgages to trading stocks and buying bonds, all these activities are regulated and monitored by centralized financial institutions.
This existing system is being challenged by a new technology called DeFi. Its goal is to put control over money into the hands of regular people.
What is DeFi?
DeFi stands for decentralized finance. It refers to a system wherein financial products are made available to the public using a decentralized blockchain network instead of the traditional banks and brokerages.
The scope of DeFi is wider than what cryptocurrencies cover. The aim of a DeFi is to recreate traditional financial systems by replacing them with a decentralized one similar to how digital currencies operate. However, it does more by acting as the financial institution itself, allowing you to lend, borrow, and earn interest on your digital tokens.
Cryptocurrency and blockchain are the core technologies that enable DeFi apps to operate. It utilizes similar concepts, making use of decentralized and distributed ledgers to maintain the integrity of the system.
Currently, the majority of the DeFi apps use BTC and ETH as their main digital currencies for transactions. The apps are used in a variety of functions including traditional financial transactions, e-wallets, decentralized exchanges, non-fungible tokens (NFTs), and flash loans.
The DeFi ecosystem is still young and riddled with bugs, mishaps, errors, and hacks. Scams like ‘rug pull’ are quite common, so be sure to do your research thoroughly before putting in a big amount of money into any of the DeFi apps.
Advantages of DeFi
- Easy account opening
Unlike with banks and brokerage firms, there is no need to present government-issued IDs as proof of identification and address that is tied to your account.
- Better rates
It has more attractive rates compared to traditional banks. The barrier to entry is also lower compared to traditional systems, enabling you to use digital assets like crypto coins and NFTs as collateral.
Disadvantages of DeFi
- Technology pitfalls
Smart contracts and blockchain networks have proven their efficiency, but there is always a risk that the code can be exploited or manipulated by hackers. It is only as good as how it was coded.
- Collateral issues
Borrowing through a DeFi network will require you to present another digital asset as collateral. In some protocols, the loan may be required to collateralize at 150% of its value. And with how volatile the crypto market is, the risk of being in a losing position is higher.
- Premature protocols
DeFi is still in its early stages, so they are generally riskier even when compared to other cryptocurrencies in the market.
When putting your money in a DeFi application, make sure you understand what it is about. Study the underlying network and make sure it is not controlled by a small group of people who can manipulate the system to their advantage. Also consider the capacity of the system to handle heavy demand, as well as present affordable transaction rates.
When the founders of the application seem to be hiding something, consider this a big red flag. Transparency in decentralized systems is necessary for it to maintain integrity. When in doubt, look for other opportunities where you can put your money.