Defi

What Is Decentralized Finance (DeFi)?

Decentralized finance, abbreviated as DeFi, is a generic term phrase for the segment of the crypto world that's focused on creating a new, internet-based financial system by replacing existing intermediaries and trust systems with blockchain technology.

In banking, intermediaries, including banks or stock exchanges, are required to transmit or accept funds. And, to be at ease with the transactions, all parties must trust the intermediaries' fairness and honesty.

Coded programs in decentralized finance are replacing these financial intermediaries. Rather than making dealings via banks or stock exchanges, people transact directly with one another with blockchain-based "smart contracts," creating marketplaces, settling transactions, and guaranteeing that the whole system is fair and trusted.

the development of DeFi

Decentralized finance incorporates lending platforms, futures markets, options, and derivatives.

Crypto enthusiasts are essentially building their own Wall Street — primarily decentralized and exclusive. It initially offers products from conventional financial institutions without much red tape and regulations that currently govern the financial system.

How Big Is The Decentralized Finance Market?

As stated by DeFi Pulse, Web3 finance's total value locked, aka T.V.L. — a typical way of calculating the monetary value of crypto retained among all the decentralized finance projects — is now over $77 billion. If these projects combined are considered a bank, it will be the 38th biggest bank in the U.S. in terms of deposits.

To track blockchain finance's development, other than T.V.L., you may look into decentralized exchange trading volumes, which increased by triple-digit percentages last year.

In the future decades, the market is likely to expand further.

When Was Decentralized Finance Invented?

In an August 2018 Telegram chat between Ethereum blockchain engineers and entrepreneurs, including Inje Yeo of Set Protocol, Blake Henderson of 0x, and Brendan Forster of Dharma, the name DeFi (short for decentralized finance) was created.

Is DeFi safe?

Decentralized finance is still mostly unsupervised and lacks many legal protections and safeguards in traditional financial systems.

Stablecoins are arguably the finest example. Stablecoins are cryptocurrencies whose worth is tied to a government-backed currency, such as the U.S. dollar. 

And stablecoins are a crucial part of Web3 finance markets, which act like blood in a body. It provides liquidity to ensure investors can easily convert crypto and dollars in a snap without exposure to the intense volatility of cryptocurrencies.

Nevertheless, to date, they remain largely unregulated.

Let us look at the example of Tether to understand the concept of stablecoins.

Tether (USDT)

For instance, Tether (USDT), one of the most valuable stablecoins, with a market valuation of $69 billion, nearly twice as high as the second-largest coin, USD Coin (USDC), has been questioned regarding its ability to peg stablecoins to the U.S. dollars.

Tether stated it had cash reserves equivalent to the value of the stablecoins it created to reassure buyers that it was trustworthy. 

The Commodity Futures Trading Commission (CFTC) claims that the U.S. authorities determined this was not the case. As a result, between 2016 and 2018, Tether held 27.6% of the value of issued stablecoins in fiat currency reserves. 

Tether was charged with providing "false or misleading statements and omissions of material information," which the Commission settled.

Hacking And Phishing Scams

According to bug bounty platform Immunefi, the Web3 finance market was hacked for around $1.22 billion in the first quarter of 2022.

Hacking is a significant issue that has hampered blockchain development in finance. Decentralized finance is a code set that helps you track your legitimate transactions. 

If the new project codes aren't thoroughly scrutinized, the protocol could be hacked, and the money locked in the project could be at risk.

As the market grows, experts believe that hacking will continue. In addition, the general public is at risk of being scammed due to a lack of information about decentralized finance. 

Given decentralization, blockchain finance users are responsible for their transactions; no intermediaries, such as banks, may halt a transaction after it has been confirmed.

As a result, novice users may fall prey to scammers if they lack the awareness to conduct a proper transaction in the ecosystem.

Prospect: More Regulations Will Be On A Slight

In October 2021, the Biden administration reportedly worked on new stablecoin regulations. More inspections on stablecoins are undergoing.

The U.S. Securities and Exchange Commission (S.E.C.) subpoenaed Circle, a prominent backer of the USDC stablecoin, for information on its activities and products earlier this month.

The regulations are expected to be more established in the next five to ten years.

Why are people interested in DeFi?

Despite all the flaws or potential losses that decentralized finance might come with, why would people still want to get involved in decentralized finance?

Here are some of the reasons why people want to be a part of this money revolution:

• A sandbox for experiment
• A substitute for the existing banking system
• Decentralization is everything
• Financial Utopia

A Sandbox For Experiment

Web3 finance is a new and unregulated technology. It is a playground for people to experiment with novel financial system concepts. It enables astute traders or skilled financial engineers to design new things impossible to do in the conventional financial system.

UniSwap and Sushi Swap, for example, are decentralized protocols that allow users to swap tokens without a middleman.

A Substitute To The Existing Banking System

Most decentralized finance supporters believe that Web3 finance will be a superior substitute to the existing banking system, many of which operate outdated databases and rely on intermediaries to settle transactions.

For instance, most bank transactions still rely on programs like COBOL, invented in the 1960s.

It is claimed to be the first form of internet money designed, and as it grows, it will need a novel, internet-based financial system to keep up with it.

Decentralization Is Everything

Decentralized finance is where you can participate in anything you are passionate about without much approval from concerned authorities.

Take Decentralized Autonomous Organization (D.A.O) as an example; a D.A.O can raise millions of dollars by creating a membership out of thin air, like the MakerDAO, which built and manages the stablecoin Dai, and the FlamingoDAO which focuses on buying rare and expensive NFTs. 

There is no possible way a traditional financial organization can accomplish that without finding itself in an array of problems. Yet, in the Web3 finance world, people can trade whatever they are willing to exchange without centralized approval.

Financial Utopia

Most decentralized finance fans have faith in decentralized finance, seeing it as the ideal system that can help fix the flaws of the existing financial system by taking back the power from Wall Street and giving it back to the general public.

What are the DeFi use cases?

Here is a list of the essential use cases:

• Asset management
• Privacy control
• Decentralized Autonomous Organizations
• P2P lending
• A betting market
• Data Analytics
• Derivatives
• The concept of digital identity
• As a building block for infrastructure
• Insurance protocol

Asset Management

Individuals have far greater control over their assets, which is one of the most significant implications of Web3 finance. 

Nevertheless, many popular decentralized finance efforts give consumers tools to manage their digital assets, such as buying, selling, and relocating them. 

As a result, consumers can profit from their digital assets by earning interest, which is often known as staking in cryptocurrency. Furthermore, unlike traditional banking, Web3 finance allows customers to keep their personal information private. 

Unlike traditional finance, users can keep their accounts private, as private keys (passwords) to their accounts should not be disclosed to anyone except the users.  

Due to this technological invention, asset management is seen as one of the most valuable applications for decentralized finance.

Privacy Control

Conventional financial institutions place a strong emphasis on Know-Your-Customer (KYC) protocols. KYC standards, nevertheless, are the company's most essential compliance tool for enforcing anti-money laundering (A.M.L.) and counter-terrorist financing (C.F.T.) policies. 

On the other hand, KYC regulations typically clash with Web3 finance's privacy initiatives. As a result, decentralized finance also uses a more contemporary concept known as the Know-Your-Transaction (K.Y.T.) technique to address this issue. 

As a result of this strategy, the decentralized infrastructure is more engaged in transaction behaviors and digital addresses than users' identities.

Decentralized Autonomous Organizations (D.A.Os)

D.A.O.s are the decentralized finance equivalents of centralized financial institutions, making them one of the cores of decentralized finance use cases. 

However, centralized financial bodies played a considerable role in the old system. These groups serve as the administrative bodies in charge of basic financial operations such as fundraising, wealth management, and governance implementation. 

D.A.O.s, on the other hand, are decentralized and do not adhere to the limitations established by national authorities or entities.

Peer-to-peer (P2P) Lending And Borrowing

Conventional banking institutions have become less competitive due to decentralized finance, and the advent of a borrowing and lending use case has become increasingly important. 

The decentralized finance ecosystem is well-suited to P2P borrowing and lending. As a result, several Web3 finance projects focusing on this application have been launched. 

The compound is one example of interest-based projects for lending and borrowing assets.

A Betting Market

In blockchain-based betting markets, which harness the knowledge of the community, users can bet money on the outcome of events. 

On the other hand, market prices function as consensus signals of the possibility of an event. For example, augur, a popular decentralized finance betting platform, provides prediction markets for election results, athletic events, economic events, etc.

Data Analytics

Because of transparency and decentralization, users can locate and assess previously unseen data. As a result, users may make well-informed business decisions with insight into this data, discover new financing options, and enhance risk management techniques. 

A new type of data analytics has emerged due to this industrial movement, complete with blockchain tools and dashboards.

On the other hand, decentralized finance projects such as DeFi Pulse and Co Decentralized finance Data bring significant value to the analytics and risk management space.

As a result of these comparative edges, organizations have grown more agile. It is indeed, without a doubt, one of the essential uses of decentralized finance.

Derivatives

Smart contracts can be used to build tokenized derivatives, which is now one of the most intriguing use cases of Web3 finance. 

On the other hand, tokenizing a derivative establishes the value of a contract depending on an underlying financial asset or basket of assets. 

Furthermore, derivatives tokenization is now regarded as secondary security and their value changes in line with the value of primary assets (bonds or fiat currencies). Derivatives, as a result, indeed derive synthetic assets.

The Concept Of Digital Identity

Blockchain-based digital identities have recently gained popularity. Meanwhile, combining them with decentralized finance protocols would offer them simple access to the international economic system. 

Furthermore, the new sort of digitized identity would allow the poor to use Web3 finance apps anywhere as long as the internet is available. So it might be the most widely-used application.

Building Block For Infrastructure

One of the main design ideas of decentralized finance protocols is composability, which means that various parts of a system can easily join and interact. 

Many people equate Web3 finance development to Lego construction, garnering the nickname "money legos" in the meantime. 

Also, owing to Truffle's innovative contract libraries, Infura's API suite, and Diligence's security tools, Ethereum programmers and product teams can now develop and deploy blockchain finance protocols with the full-stack toolsets and security components they need.

Insurance Protocol

Insurance is a significant financial business and is already one of the best-known DeFi applications. Customers can now choose from new insurance options to help them get coverage and preserve their investments. Furthermore, all of the difficulties with the existing system can be resolved with the proper adoption of smart contracts.

What is the difference between Web3 finance and cryptocurrency?

To answer this question, we need to go back to the decentralized finance definitions of these two terms to answer this question. Cryptocurrency is an umbrella term for digital or virtual currencies protected by encryption, making counterfeiting and double-spending practically impossible.

It includes the most well-known assets like Bitcoin, Ethereum, Tether, etc., decentralized digital assets with their blockchain.

Decentralized finance is a term that refers to a wide range of financial services operating in the same manner that conventional financial institutions like banks do, allowing you to lend, borrow, and swap cryptocurrencies via the coded protocol.

Users may earn interest, take out loans, and even put their NFTs as collateral in blockchain finance ventures built on the Ethereum network. Web3 finance apps can potentially be used to become liquidity providers for decentralized exchanges.

Users may save money and have more control over their "bank account," which is in the form of a digital wallet, with their virtual avatar. Web3 finance-related apps allow users to utilize the financial protocol "without a central service exercising control over the whole system."

Both of these inventions aim to eliminate intermediaries when it comes to transferring money or taking out loans. Typically, intermediaries would enable these actions and charge fees for these financial activities. 

What is the difference between CeFi and decentralized finance?

CeFi, Centralized Finance, means that users have confidence in centralized institutions and organizations that safeguard their assets and provide various services. 

Financial Services Provided By CeFi

Crypto exchanges are the most popular services provided by CeFi, to name a few, Coinbase, Binance, and Bybit. 

These are platforms controlled by centralized businesses in charge of pairing sellers and buyers, providing the necessary services, and ensuring everyone follows the regulations. 

The revenues from fees are distributed among its stakeholders, just as in any other corporation.

As for decentralized finance, several significant elements, including automated market-making (A.M.M.), liquidity pools and yield farming, and non-custodial swaps, have enabled crypto exchange with the advent of intermediaries, known as Decentralized exchanges (DEX), like Uniswap, Sushiswap, etc.

Companies that operate under the CeFi umbrella offer borrowing, lending, margin trading, and other financial services in addition to trading services. Cred, BitGo, Crypto.com, and Nexo are other CeFi crypto businesses that offer non-trading services.

Know Your Customer (KYC) Procedure

Most CeFi service providers use Know Your Customer (KYC) and Anti Money Laundering (A.M.L.) measures to comply with their jurisdictions' requirements. 

As a result, users must provide personal information and ensure that the money is not obtained via illicit activity.

Comparatively, Web3 finance does not require any KYC procedure at the moment.

Custodial Wallets Vs. Own Wallet

Custodial wallets, which hold users' private keys, are used by several CeFi services. Custodians would go to great lengths to keep and handle their clients' crypto money as simple as feasible. 

Nonetheless, because the institutions in CeFi have acquired ownership of their wallets, users have no direct authority over them, which means the wallets are at great risk when the CeFi institutions are prone to cyber risk.

Web3 finance, on the contrary, can only be utilized when users access the protocol through their wallets, implying that users must have complete control over their wallets, and the funds are always stored in their wallets.

Centralized Governance Vs. Decentralized Governance

CeFi is managed by a centralized group of stockholders, as previously stated. In CeFi, a director applies for a position in management.

Nonetheless, some decentralized finance initiatives include governance tokens, which allow holders to vote in decision-making processes. Compound, for example, has a governance token.

Customer Service

As a centralized organization, CeFi has the advantage of providing customer services, while most Web3 finance projects do not have a dedicated customer service team.

Distribution Of Transaction Fees 

Typically, centralized exchanges demand more significant fees to cover the costs of maintaining the platform, paying wages to employees, improving their goods, etc. On the other hand, DEX platforms are less expensive to trade on since they do not provide custodial services or have a staff active in the governance process.

The fee money is often split between liquidity providers and token holders who opt to stake their tokens. Uniswap, a crypto swap platform that distributes funds from fees across liquidity providers, is an example.

Researched and authored by Ka Chun Chiu | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Debt
• Debt Restructuring
• Leverage
• Principal Payment
• Revolver Debt