What is DeFi and its risks?

Are there risks in DeFi investments?



Many of you may be pondering on the matter of how financial matters in the digital world are driven without a central authority. This piece will address this matter through the description of DeFi.



Decentralized finance (DeFi) takes regard to new forms of financial applications driven on the blockchain network without the need for a central authority (like financial institutions or banks). The use of blockchain technology allows it to become decentralized and open-sourced for users across the world, meaning it is not controlled by any individual or central figure. It is instead managed by smart contracts which are practically sets of codes and commands that, when met and satisfied, would yield as input.



Most DeFi projects are found on the Ethereum network as it is managed with the Solidity programming language, which facilitates ease when implementing smart contracts. Additionally, it is also the second largest blockchain system, right behind Bitcoin.



The very concept of DeFi was built from the desire to accomplish financial transactions in a faster and more efficient way with less costs. Centralized Finance (CeFi) relies on the mediation and administration of central authorities, like banks and other financial institutions, to provide trustworthiness for users and clients when processing transactions. Such functions would yield great amounts of costs for users, not to mention the long duration they’d have to wait.



With these issues being ever-present, DeFi was erected with the goal of initiating a financial system so users worldwide can manage transactions in a faster manner through the use of blockchain technology. By doing so, the costs involved have been reduced to a mere smidge, when compared to cApps, allowing DeFi to further bridge people worldwide without needing to go through diligent banking procedures and facing middlemen.



DeFi is separated into numerous subcategories to serve the ever-changing needs of users:



1. Decentralized Exchanges (DEXs) are platforms for trading digital currencies that connect users directly through Peer-to-peer technology to allow decentralized interactions.



2. Stablecoins are digital assets that peg their value to other assets, often physical, such as the U.S. dollar or Euro, to allow stable change in prices.



3. Lending platforms are platforms that allow users to lend and borrow digital currencies through staking their own firstly. It is managed by smart contracts, which facilitate automatic transactions.



4. Wrapped" Bitcoins (WBTC) are a method of transferring Bitcoin to the Ethereum network, allowing Bitcoin to be utilized on DeFi platforms. Wrapped Bitcoins peg their value to Bitcoin in a 1:1 ratio.



5. Prediction markets are platforms wherein users can predict future price movements, comparable to Futures markets.



6. Yield farming is like farming in real life, users can utilize this DeFi platform to yield rewards and profit by selecting the most profitable, trustworthy and rewarding farms. The DeFi world is comparable to farming fields as they can affect a users’ reaped rewards and transaction fee returns. Additionally, the rewards would coincide with the ratio of staked assets beforehand, along with the provided liquidity on the platform as well.



The market capitalization of the DeFi world is around 41.51 USD, increasing from its previous evaluation of 911.02 USD in March 2021, accounting for a 4,557% growth according to DeFi Pulse (Total value locked on DeFi Pulse). This indicates immense and rapid growth from the worldwide support it has received in a span of less than a year, displaying signs of financial modernization. 

Reasons behind the sudden shift of attention to DeFi

In the financial world, fast and efficient transactions are key. In the traditional model (CeFi), a middleman, financial institutions and banks, is present to help mediate and process various transactions and operations. However, in the digital world, users are not required to pay excessive fees for these services or rely on them at all as decentralization has now allowed the freedom of personal management and administration of assets for users worldwide.



Utilizing the blockchain network for sending and receiving transactions is no longer a time-consuming process. Users are able to trust the system, making reliance on third parties obsolete. DeFi has also increased the opportunities for users to conduct and enforce various forms of contracts through the creation of smart contracts.



An additional point of focus is that DeFi facilitates ease of asset and risk management for users. In the past, banks and financial institutions have been found to be at fault in such predicaments. Therefore, the rise of DeFi will provide freedom of administration and a solution to the aforementioned problem.





DeFi’s value and worth



DeFi’s value derives from a number of factors, consisting of demand, utility, trust, and popularity. DeFi’s multipurpose characteristics add value to it as it allows the creation of a range of functions and uses, making transaction processes easier, meeting users’ demands. Such demands are undeniably ever-changing, therefore, DeFi has been structured to handle changes and alterations to suit changing needs of users.



According to Coinmarketcap (on March 11, 2021), DeFi tokens’ market capitalization amounts up to around 83.89 USD (around 2,565,000 THB), with Uniswap topping all other DeFi tokens are ranked as 8th, when compared to all other digital currencies. Currently, Uniswap is valued at around 1.6 hundred million USD (around 489,161,000,000 THB). An adding factor to this sense of popularity derives from the basis of the Ethereum network, which facilitates a system for the enforcement of smart contracts that lay down rules and regulations, much like physical contracts, without the need for middlemen or various institutions involvement, accounting for a large source of trustworthiness.



Another sense of popularity comes from Governance tokens that allow its holders the opportunity to present and vote for systematic changes. Such changes can include transaction process details, fee reductions, addition of new coins and tokens. From this point onwards, other token holders are able to vote for or against such regulation changes to provide sustainable and continuous growth on the platform. Examples of platforms that include governance tokens are Uniswap with UNI and Compound with COMP. This not only enhances the platform’s functionality, but also uplifts its utility and meets its users’ demands.





Risks involved in DeFi



Nonetheless, investing in cryptocurrency can always be risky and DeFi platforms are no different either as they are built upon the Ethereum network, when its blockchain system is under maintenance or requires updating to handle scalability, users may face connectivity issues in the meantime. This can directly affect any ongoing transactions through slow processing and temporarily increased fees. Furthermore, such occurrences can inflict other damaging effects in the forms of token value depreciation and high market volatility.



With smart contracts functioning as the main driving technology, besides the blockchain network, there is a high chance that hackers will attempt to tap into the network and its accounts in the efforts of accessing personal information. During maintenance or software issue occurrences, the smart contract could be prone to sudden protocol changes.





Conclusion



The blockchain technology and its collaborative use with Ethereum’s network has birthed decentralized finance for users across the globe to utilize and benefit from, while also providing a large systematic uplift from the traditional financial system shown in banks and financial institutions’ models. Users have been provided freedom of management in both investments and risks, all under the administration and regulation of smart contracts.



However, investments are never without risks. Investors are highly advised to conduct deep research before investing, while also conducting risk management strategies to handle any probable systematic security breaches, market volatility situations or any damaging effects that can take place as a result of the Ethereum network’s malfunction.





Reference:



Coindesk, Finnomena, Defiprime, Bitcoinaddict, Radix, Medium, Trending topics