What is DeFi in Crypto, and Why Do We Need It?

Decentralized Finance (DeFi) has been among the main buzzwords recently. You can easily find plenty of contradicting information on the Web, from overenthusiastic praises to horror stories. Thus, it is worth looking deeper to understand the subject better. We’ve prepared a series of articles on DeFi, platforms, and products available in this market. This article is just a brief introduction to the industry. We will go much deeper and get into specifics further down the line.

DeFi — The Definition

DeFi tackles the same issues as centralized finance (investments, loans, trading, etc.), but there are no authorities, regulators, or powerful institutions to rule over the industry. It functions based on blockchain-based smart contracts. Thus, financial services are provided via dApps - decentralized applications and their tokens.

Most of these dApps are deployed on the Ethereum blockchain. However, networks like Tron and BNB also have rapidly growing DeFi clusters.

The name “decentralized finance” explains the concept pretty well — it is an alternative to the centralized system (CeFi or TradFi) that emerged as a response to the latter's limitations.

It is permissionless, decentralized, and more flexible. Moreover, it allows anyone to participate and often offers more favorable terms than CeFi. However, lack of centralization creates a lot of regulatory uncertainty. For example, there are a lot of difficulties in enforcing AML/KYC standards, and risk mitigation regulations are virtually nonexistent in the industry. We will talk about DeFi advantages and risks below.

What Products DeFi Has to Offer

Currently, a wide variety of financial products are available via dApps. DEXes (decentralized exchanges), liquidity farming protocols, lending platforms, and aggregators are the most common types of platforms. They are supplemented by cross-chain swap platforms and bridges that ensure interoperability between different networks.

Decentralized exchanges (DEXes), such as UniSwap or PancakeSwap, are similar to their centralized counterparts (CEXes) in functionality but are very different “under the hood.”

Most well-known exchanges, including Binance, Huobi, Kraken, and hundreds more, are centralized. They are run by a company that governs the exchange, can change the rules at their discretion, and provides a set of software — the engine — to match buyers and sellers. Most importantly, to trade on a CEX, you have to trust it with your money — it is transferred to the exchange’s account, and the platform handles it during trading.

DEXes, on the other hand, operate via sets of public smart contracts that can’t be changed on a whim. All transactions happen between users’ wallets directly, the platform connects them but never has access to their funds.

DEXes also often offer copy-trading services — users can follow an experienced trader and automatically copy their trades while paying a small share of the profit to said trader.

DEX aggregators (1inch and OpenOcean are great examples of typical aggregators) collect data from an array of DEXes to find the best offers at a given time.

Lending protocols allow users to get loans while their digital assets serve as collateral. Unlike CeFi, nothing is required besides the collateral: no bureaucracy is involved, so it takes only a few moments to get a loan. Users can deposit funds to such platforms and earn interest payments. These funds are used to provide the loans mentioned above.

Liquidity or yield farming, also known as staking, usually comes up when people talk about DeFi. The basic concept is as follows: DEXes need liquidity to operate effectively. They enable users to provide liquidity by locking their crypto assets in liquidity pools. In return, liquidity providers earn a share of the DEXes' trading fees as rewards and receive liquidity providers' tokens, which can also be used in other pools or on other platforms. Virtually every DEX has such protocols enabled.

Yield aggregators help users gain as much as possible from providing liquidity. Investors can lock their assets in an aggregator’s pool. The platform will then find the most profitable liquidity pools available and, most importantly, constantly switch to more profitable options, transferring tokens and coins automatically. Harvest Finance and Beefy Finance are among the most popular aggregators.

There are also a variety of niche protocols. For instance, Nexus Mutual is an interesting peer-to-peer insurance platform, and Synthetix is a dApp used to create derivatives of commodities, fiat money, or digital assets.

Why is DeFi Important?

Decentralized finance protocols offer many advantages over TradFi and address some of its key issues:

• Accessibility. There are no bureaucratic barriers so common in CeFi. Anyone with Internet access can take advantage of financial services regardless of location or background.
• Empowerment. Users of financial dApps are in control of their funds at all times. There is no need to trust anyone else with your assets.
• Immutability. Traditional financial services can be disrupted in various ways, from software glitches to government actions. Unfortunately, we’ve seen enough examples recently. DeFi is built to be resilient — it is very difficult to stop a decentralized system from working since it doesn’t have a single critical point.
• Lack of intermediaries. Due to removing intermediaries, decentralized protocols can reduce fees and offer better interest rates than their centralized counterparts - fewer participants are involved in every operation.
• Security. The reliance on smart contracts and public ledgers increases transparency and helps prevent fraud, manipulation, and human error, making DeFi more secure and reliable than CeFi.
• Flexibility. You can get financing faster via DeFi than via CeFi; thus, DeFi users can take advantage of fleeting business opportunities much more easily.
• Innovations. Decentralized platforms can introduce innovations and react to the ever-changing market situation much faster than banks and other traditional financial institutions since they don’t have to deal with extensive bureaucracy.

How Does DeFi Solve Some of the Main Problems of Centralized Finance?

Using blockchain technologies as the basis of protocols and platforms eliminates the risk of data manipulation. Every transaction is public and stored on multiple nodes, making it virtually impossible to fudge all copies of the data.

Thus, blockchain ensures decentralized protocols' decentralization, immutability, resilience, and security.

Another important aspect is the reliance on smart contracts — self-executing programs recorded in the blockchain. Such programs can’t be edited after deployment; their code is public. Thus, no one can “change the rules of the game.” All DeFi protocols, without exception, use smart contracts to operate. This way, human factor risks are also reduced since the user interacts only with the code — no human employees are involved.

What Are the Dangers Associated with DeFi?

It is worth remembering that despite all the great things DeFi offers, there are still significant risks. The most common dangers are:

• Scam platforms. Any lucrative sphere attracts scammers, so it is necessary to carefully study and double-check any platform and its background before committing any funds.
• Novelty factor. With the proliferation of DeFi products, it has become apparent that it can be challenging for newcomers to adapt. People used to CeFi have to de-facto learn an entirely new financial system. As a result, newcomers are easy prey for scammers and often commit expensive mistakes. Thus, it would be wise to stay careful and conservative during your first months in DeFi.
• Market manipulations by major players. Such manipulation can significantly influence the price of the underlying token of a liquidity pool, so the return on investment in a particular pool can be reduced significantly.
• Bugs and errors. There can be flaws and errors in the smart contract code, and the platform’s website can have issues. As a result, serious issues with receiving rewards, withdrawing funds, and other operations are certainly possible. New and small protocols are especially risky in this regard.

In other words, DeFi is still a high-risk environment, just like any other segment of the crypto industry and should be treated as such.