Decentralized Finance. Financial products and exchanges on the blockchain.

In this article, I will discuss ''decentralized finance'', also called ''DeFi''. What is DeFi and why is DeFi potentially changing the financial sector? What kind of DeFi applications are there and is it risky to invest in DeFi? I will also discuss pros and cons of DeFi. 

DeFi is becoming increasingly known to the general public. DeFi is also on the radar of many investors. Besides, the developments in DeFi are moving fast and it has the potential to disrupt the traditional system.

Decentralized Finance (DeFi) is the trend that focuses on the decentralization of financial products. Whether it's loans, savings, insurance, commerce or payments. The idea behind DeFi is very simple: cut out the 'middle man' from the transaction and everything becomes safer, faster and cheaper. The middle man is generally the traditional bank and/or insurer.

The essence of DeFi is not to change the content of products or services. Lending is still lending. Saving is still saving. And investing is still investing. But the biggest difference is in both the platforms and the vision. In DeFi, it's not about the middle man, but about the transaction. Because it is about the transaction, blockchain technology plays an utmost important role in the DeFi sphere. On DeFi, users are not dependent on a bank or BKR (Credits registration office).

The interesting aspect of DeFi is that DeFi works with cryptocurrency, blockchain technology and smart contracts. Because smart contracts are at the core of DeFi, DeFi applications are mostly run on the Ethereum blockchain.

DeFi embraces more than the development of P2P credit marketplaces on blockchain technology and crypto-currencies. It also embraces the development of lending platforms, investment platforms, token sales platforms, decentralized exchanges, stablecoins, open marketplaces, crypto asset management platforms and prediction markets. There is a trend that the old financial order is being disintermediated.

With fiat currency, people can invest their money, save, lend and/or pay for goods and services. That doesn't change on DeFi. You can still do the same thing with it. In DeFi, you do that with cryptocurrencies, rather than with fiat money (without a bank or insurer). So what kind of applications of DeFi applications exist?

Staking

If a person has cryptocurrency that runs on the Proof-of-Stake consensus protocol, that users can ''stake'' its cryptocurrency in a wallet. With staking cryptocurrency, that person receives cryptocurrency (a reward) in return. The reward you earn from staking cryptocurrencies depends on the length of time you stake it. The longer the staking period, the higher the reward. It is similar to a (fixed) deposit in the traditional banking system that is rewarded with a defined interest rate at the end of the period. The concept is the same as saving and receiving interest, but with DeFi, you do not receive interest, but a reward (cryptocurrency).

Lending

Cryptocurrency can also be lended to a platform. This platform then lends money to individuals and businesses, without the interference of intermediaries.

Stablecoins

These are tokens designed to hold a specific value, such as the value of 1 US dollar. The value of a stablecoin is backed by fiat money or (for example a) commodity, like the price of silver. Stablecoins are intended to reduce the volatility that exists with cryptocurrency.

Decentralized exchanges (DEX)

On decentralized exchanges, cryptocurrency holders can exchange their cryptocurrency to another currency, whether USD/EUR for bitcoin or ether for bitcoin. DEX is really popular, because DEX connects users directly through a DEX so they can trade cryptocurrencies with one another without trusting an intermediary.

Is investing in DeFi risky?

In general - investing in DeFi is risky. A DeFi platform is as strong as the underlying smart contracts. If these are not written fool proof, then they can be abused. This has already happened several times. Spartan protocol, a DeFi project, was hacked. Around USD 39 million was stolen.
For beginners, it is also really hard to distinguish the good projects from the bad. So doing research is step 1. If you do not know what you are investing in or if you do not know how a DeFi application operates, I would strongly advise to do your own research first before investing your hard earned money.

Pros and cons of DeFi

Pros:

- Accessibility: to participate in the traditional financial system (centralized system), every person must open a bank account. This excludes people who do not have the capabilities to open a bank account. A decentralized financial system can be accessed by anyone with an internet connection.

- Availability: In the decentralized financial system, people do not have to rely on opening hours, as is the case with financial institutions, for example. There are no opening hours in the decentralized financial system. This makes it possible to conduct transactions and trade around the clock.

- Privacy: The processes in the decentralized financial system are anonymized (due to hashing technique etc.). Information cannot be read and recorded by third parties.

- Transparency: The contract details are agreed between the parties in a smart contract. This ensures transparency and all relevant information can be viewed by both parties at any time (on the blockchain).

- Cost Efficiency & Speed: Because in the decentralized system no broker is needed, the cost of financial services can be reduced. In addition, blockchain technology and the degree of automation make it possible to handle processes even faster and more efficiently.

Cons:

- Uncertainty: The development of DeFi is still early. It is not yet possible to truly assess the direction in which DeFi will develop.

- Risk assessment: It is still difficult to assess how risky trading is for investors. In some cases, markets are subject to high volatility and the risk of speculation and bubbles is greater. 

- Security gaps: Problems related to smart contracts have been reported several times in the past. Some of the criticisms have included vulnerabilities to technical errors. There have also been reports of hacker attacks on platforms that managed to hack cryptocurrencies and tokens worth millions. 

- Legal and tax issues: Tax conditions are still unclear and there is a risk that transactions will not be taxed correctly. In addition, decentralized platforms are subject to a lack of regulation, leading to potential problems from a consumer law perspective.

- Accessibility: Not everywhere is the internet working properly. In addition, the elderly often cannot work well with the Internet. This also applies to the low-literate people. If DeFi (and blockchain in general) wants to reach everyone, these groups must also be reached.

These disadvantages are not insurmountable. DeFi is new and has yet to develop. In addition, the market has yet to grow. So these are points that can be solved just fine in the future.

To conclude

DeFi is a very young concept and technology with its limitations (a few major hacks) and no regulations yet. I think that if the technology becomes more mature and the framework becomes more clear, DeFi has the potential to compete with the traditional financial system. And I hope that regulators keep room for innovation (not only in DeFi, but in cryptocurrency and blockchain in general).
Nobody thought that bitcoin would become mainstream and that also big corporation would invest in bitcoin. But in 2021, big players like Tesla and PayPal have invested in bitcoin (El Salvador adopted bitcoin as a legal tender). This could also happen with DeFi applications. Time will tell if DeFi applications will become (more) mainstream. 

I published this article previously on my LinkedIn page. This article was written on May 8 2021. This article was updated on October 3, 2021.