Understanding Decentralized Finance and Its Impact on the Financial World

Decentralization has proven to be the most alluring feature of cryptocurrencies and their key selling point. With the advent of Ethereum, whose market cap surpassed $521 billion as of December 8, we’ve seen ever more sophisticated applications of decentralization that have paved the way for the revolutionary system we know as decentralized finance, or simply DeFi.

Decentralized finance has been widely regarded as a more transparent, efficient, and, chiefly, secure alternative to traditional financial services. It eliminates the involvement of intermediaries, thereby creating an inclusive and reliable financial system.

DeFi manages to perfectly combine the technologies of the internet, cryptography, and blockchain with the efforts and zeal of global communities of users and developers, making it possible to push beyond the limits of traditional finance.

Read on to learn more about decentralized finance, its prospects, the best projects, and most notable use cases, and find out about the key differences between DeFi vs CeFi.

What is DeFi really and how does it work?

Decentralized finance has become a real game-changer in the financial sector. Essentially, between 2020 and 2021 the popularity of DeFi took off. According to an extensive report provided by DAppRadar, DeFi transaction volume (TVL) has grown by a staggering 1178%: from $21 billion in 2019 to almost $270 billion in 2020.

DeFi encompasses financial services provided via blockchains, the most popular being Ethereum. DeFi makes it possible for users globally to conduct multiple financial operations, including lending, borrowing, buying insurance, trading derivatives and assets, sending and streaming money around the world without having to resort to a third party or governing body for help. Instead, DeFi makes use of smart contracts that help connect network users with each other directly, allowing for smooth and global P2P communication.

Smart contracts are the core constituent of DeFi. They are responsible for powering programmable digital assets as well as decentralized applications. Smart contracts can, for example, automate pre-defined agreement terms between buyers and sellers, removing any intermediaries from the process. The terms provided in the contract can never be altered, deleted, or added. Yet, they are available for anyone to inspect and audit, which means that the community is always able to spot malicious activity taking place on the network.

In brief, it’s safe to say that the future of DeFi looks bright, and given that it’s set to continue developing further, we are yet to discover its entire gamut of functionalities.

Want to learn more about DeFi and its benefits? Then take a look at the explanatory video prepared by our tech specialists. In it, we discussed the advantages and disadvantages of DeFi, key differences between DeFi and CeFi, as well as DeFi transformative use cases.

Looking into the benefits of DeFi

Right from its inception, DeFi has demonstrated to the world that it does have substantial benefits to offer. Because it relies on blockchain technology, decentralized finance reduces the risk of fraudulent activity, corruption, and even inefficient management of users’ assets. It also has the capacity to contribute to more sophisticated handling of finances, eradicating costs for wire transfers and overdraft fees, so we can forget about waiting hours for a transaction to be verified.

DeFi is transparent

The decentralized nature of DeFi guarantees better transparency of all transactions, and indeed any activity taking place on the blockchain network. The data recorded on blockchain can be accessed by everyone 24/7/365. Such an exacting level of transparency establishes trust among all users and leads to better communication. In addition, DeFi apps can help people spot and avoid financial scams and negative business practices. It’s always possible to see who has made changes to a transaction and when, which results in a financial system with greater integrity.

DeFi is immutable

Decentralized finance helps promote immutability which is one of the biggest advantages of blockchain technology. By leveraging cryptography techniques and consensus algorithms such as proof-of-stake and proof-of-work, blockchain manages to achieve a high level of immutability, which allows for top protection of user data. DeFi helps create an amazingly high standard of security for users which is unattainable by traditional means.

DeFi is accessible to everyone

With a stable internet connection, anyone can easily access a DeFi platform. This means that even those who were previously unable to enter the financial sector (the so-called unbanked) can now become players in the game. These high levels of accessibility also mean that DeFi transactions can be carried out regardless of geographical location.

DeFi is permissionless

Normally, in the traditional financial system, users have to receive permission from a verified intermediary to execute the necessary transactional operations. With DeFi, though, users don’t need to wait for bank approval and can access a wide variety of financial services directly.

DeFi is interoperable

Thanks to DeFi, developers and product teams can acquire the ability to build high-performing dApps on top of existing protocols, customize interfaces, and even integrate third-party applications. This is exactly why DeFi protocols are often referred to as advanced “money lego”.

Considering the disadvantages of DeFi

Alongside its multiple benefits, DeFi does have some drawbacks which are chiefly related to the underlying blockchain technology. Given that the majority of existing DeFi projects are based on the Ethereum blockchain, it makes sense that DeFi shares many of the same challenges as Ethereum, including poor scalability and sluggish transaction speed.

The good news is that improvements are being made every day. Experts in the domain are tackling these problems and working out effective strategies and solutions to ensure smooth and frictionless functioning within the entire DeFi space.

Ethereum 2.0 is poised to bring about positive changes to the entire DeFi ecosystem and tackle its major challenges. On top of this, other protocols such as Raiden and TrueBit are designed to tackle Ethereum’s scalability issues.

Now let’s consider some of the drawbacks inherent to decentralized finance.

Programming design errors

According to a report by the Elliptic, DeFi fraud and theft losses were estimated at about $10.5 billion in 2021. The majority of DeFi crimes were due to bugs and mistakes in the design of dApps and smart contracts which were elaborately exploited by hackers. To prevent this from happening, it’s highly advisable to hire a team of professional dApp developers who will deliver highly secure and reliable applications and ensure that smart contracts are written with impeccable code.

Insufficient liquidity

Liquidity is by rights regarded as one of the most essential factors for all DeFi token-based projects and protocols. Although DeFi’s total value locked (TVL) as of December 8, 2021 was estimated at $105.26 billion, it’s still a drop in the ocean in comparison to the TVL of traditional financial systems.

Shared responsibility

Absolute freedom in DeFi may also bring a lot of responsibility. DeFi places the control of funds in the hands of users, removing any intermediaries from the process. The problem is that not all users will take sufficient care over all processes. If a user loses their funds somehow or is the victim of a scam, they will be the only one who can take the blame for this mishap. DeFi is yet to introduce special tools that will assist in preventing human errors and mistakes.

DeFi vs CeFi: what is the difference?

Before DeFi, it was CeFi that was used to trade cryptocurrencies.

CeFi stands for centralized finance. Both DeFi and CeFi aim to provide their users with a range of financial services without compromising on security and convenience.

In CeFi, users trust people (banks) to manage funds and conduct the various financial operations, while in DeFi users trust the technology to perform the services being offered.

For sure there are other differences between DeFi and CeFi. The major ones are the presence or absence of intermediaries, custodial status, access and permission.

Presence/absence of intermediaries

While CeFi heavily relies on trusted middlemen to regulate transactions, DeFi is based on autonomous and self-executing smart contracts that can easily secure an agreement. They make sure that all the pre-set conditions are met and then proceed with executing the transaction.

Custodial status

Custodial status determines whether a user has partial or full control over their assets. In CeFi, a third party is in charge of looking after money on behalf of the user, while in DeFi only the user has total control over their funds.

Access and permission

With CeFi, users are frequently required to undergo a Know Your Customer (KYC) procedure to access services. This means that they have to provide their personal data before they can use the desired services.

The majority of DeFi tools, on the other hand, allow users to connect directly to services using just a wallet. They are not obliged to reveal personal information or deposit funds.

Still, many experts in the domain believe that weak KYC processes are a setback for DeFi. They also think that the introduction of KYC and AML regulations will not result in DeFi losing its inherent value. Instead, tighter regulation will help bring in new customers and provide much greater security for personal data. It’s likely, therefore, that in the future KYC in DeFi will become the norm.

As for accessibility, DeFi can be accessed at any time and from any location provided that you have a stable internet connection.

What are the most notable DeFi use cases?

It’s getting extremely hard to resist the power of DeFi. New types of DeFi use cases are rolled out on a regular basis. Let’s look at the most profitable segments so far.

Decentralized lending and borrowing platforms

Decentralized lending and borrowing platforms are regarded as the most remarkable developments in the DeFi landscape. The most outstanding examples include yearn.finance, Compound, Aave, and MakerDAO. These platforms let users supply and securely lock their funds into smart contracts from which other users can borrow and pay interest without any intermediaries involved.

DeFi lending and borrowing solutions normally come with cryptographic verification mechanisms which ensure a high level of security. Notably, this DeFi use case enables users to secure their loans in just a few minutes without undergoing a complex application process.

Decentralized exchanges (DEX)

Decentralized exchanges such as Uniswap, 0x, and Kyber enable trustless P2P trading. They connect cryptocurrency or token buyers and sellers directly across a global liquidity pool.

DEXs execute trades via smart contracts that ensure predetermined trade terms and conditions are met. With decentralized exchanges, users can do without an exchange operator or ID verification, and unlike centralized exchanges, they don’t ask for an initial deposit.

Check out the video below to learn more about decentralized exchanges and how to use them effectively. You’ll also find out what are the most popular DEXs and what to look for when choosing one.

Decentralized autonomous organizations (DAO)

DAOs – Decentralized Autonomous Organizations – are companies governed in a decentralized manner via smart contracts. A number of popular protocols such as Maker and Compound have launched DAOs to fundraise, manage financial operations, and decentralize governance in the community. The main idea behind DAOs is to provide a large community of contributors with the ability to participate in their organization’s governance and future development.

DeFi margin trading

In traditional finance, traders usually borrow funds from brokers to leverage their trades. In DeFi, margin trading is normally based on decentralized, non-custodial lending protocols, such as Compound and dYdX. This has led to an increase in the number of “autonomous money markets” in the entire DeFi ecosystem, as smart contracts can fully automate and consequently replace traditional brokerage activity.

Saving apps

Many DeFi apps provide interest-bearing accounts. These allow users to earn more than they would with traditional savings accounts by means of a dynamic interest rate tied to supply and demand. Popular savings apps include Argent, Dharma, and PoolTogether. The latter, for example, is a no-loss savings game in which participants get all their money back, regardless of whether they win or not.

As you can see, DeFi can exert a powerful impact on various facets of the financial world, and we should expect decentralized finance to gradually make its mark on many more segments.

Overview of the best DeFi projects

DeFi looks certain to continue growing in popularity. So far, hundreds of trailblazing projects have been successfully delivered, each of them carving a niche for itself in a vast DeFi space. Let’s check out some of the top DeFi projects in 2021 to see what DeFi is capable of.

Aave

Aave, previously known as ETHLend, is an open-source DeFi lending protocol providing users with both lending and borrowing services. The protocol boasts a variety of features, including uncollateralized loans, rate switching, Flash Loans as well as unique collateral types.

Aave possesses its own native token called AAVE – an ERC-20 token that has about 13 million tokens in circulation. AAVE grants its holders governing rights which implies that they can use the token to propose and vote on Aave’s protocol management.

Compound

Being one of the leading lending protocols, Compound enables its users to effortlessly execute lending and borrowing operations with different cryptos such as Ether and Dai.

The Compound protocol makes use of smart contracts that control the storage and management of pooled capital. It is governed by a decentralized community of COMP token-holders as well as their delegates who have the right to propose and vote on changes and upgrades to the protocol, including new and advanced collateral types, borrowing power, and interest rate models.

Curve Finance

To facilitate frictionless stablecoin trading alongside risk-free returns for liquidity providers, the Ethereum-based Curve Finance makes use of liquidity pools and special bonding curves. This DeFi protocol also manages to achieve efficient stablecoin trades with the StableSwap invariant, which considerably reduces slippage compared to other invariants.

As well as this, Curve serves as a decentralized exchange for trading cryptocurrency assets. It provides support to numerous stablecoins, including DAI, USDT, USDC, BUSD, UST, EURS, PAX, USDN, RSV, etc.

Dharma

The Dharma app has been specifically designed to help people effortlessly get on board the DeFi bandwagon by connecting wallets directly to fiat bank accounts. Thanks to Dharma, even those who have not been engaged in the crypto sphere before can easily learn how to earn interest on different stablecoins.

Dharma doesn’t possess its own protocol. Instead, it operates as a bridge to other prominent DeFi protocols, including Uniswap, Yearn, and Compound. Currently, the Dharma app provides support to ETH and ERC-20 tokens. At the moment you can only buy USDC tokens when you use your linked bank account. This may come across as a huge limitation at first sight, but you can easily swap your USDC for other Ethereum-powered tokens via Uniswap or other DEX.

Synthetix

Synthetix serves as a decentralized synthetic asset issuance protocol. It empowers users to create, hold, and execute trades with a wide variety of derivatives such as fiat currencies, commodities, stocks, and cryptocurrencies. Notably, thanks to Synthetix, users have the ability to enjoy both long and short exposure to all assets that are represented on the platform.

What’s more, Synths – the protocol’s synthetic assets – are collateralized by the Synthetix Network Tokens known as SNX. This helps drive value as well as liquidity to the underlying assets. All in all, Synthetix plays a tremendous role in the entire DeFi space since it grants better accessibility to traditional financial assets and a variety of advanced trading strategies.

Balancer

The world of DeFi has a myriad of astonishing use cases and projects, with Balancer being one of the most illustrative examples. This is a high-performing asset management platform capable of carrying out several functions, for example, managing automated portfolios and providing high liquidity.

Balancer represents a novel approach to liquidity. The platform enables its users to adjust allocations according to their needs. This helps to add liquidity while retaining exposure to the underlying asset. In addition, arbitrage opportunities enable users to achieve a high return on assets that normally suffer from low demand. Balancer also has its own native token called BAL which can be earned by providing liquidity to Balancer Pools. BAL empowers its holders to cast votes on the protocol’s upgrades such as fees, supported collateral, and incentives.

1inch

1inch is a well-known decentralized exchange aggregator. It has been designed with the purpose of gathering liquidity and pricing information from all key DEXs into a single, unified platform. This key functionality makes it easy to achieve the best price for the desired trade. It is worth mentioning that trades conducted via 1inch are normally split across different exchanges in order to minimize slippage and offer the best prices. With 1inch, users can also buy smart contract covers directly from the exchange via Nexus Mutual.

Currently, the 1inch protocol has been integrated with the majority of the most popular DEXs. The list includes names such as Oasis, Kyber Network, Uniswap, and 0x Relays. In addition to this, 1inch reduces liquidity issues by dividing orders among exchanges while keeping a trade within one transaction.

What does the future of DeFi look like?

While DeFi is still in its early days, it has proven to be a powerful tool capable of bringing about numerous positive changes. DeFi continues to be a lucrative venture and its enormous benefits – transparency, interoperability, immutability, accessibility, and sovereignty – translate to multiple, powerful use cases.

However, just like any other innovation, decentralized finance faces some challenges too, such as insufficient liquidity, scalability, and programming design errors. This means that DeFi still has a long way to go before it can ensure frictionless functioning and wider adoption.

In spite of all its imperfections, it’s clear that DeFi is here, and here to stay. The entire DeFi movement is bringing us closer to an open-source and decentralized world where we will no longer need intermediaries and can enjoy greater transparency of processes and data.

If you have made up your mind to join DeFi too, make sure that you have a reliable and professional partner by your side. We at PixelPlex have been operating in the blockchain space since 2013 and have learned all the ins and outs of this complicated, yet extraordinarily smart technology. We will gladly assist you in discovering the potential of blockchain and DeFi and delivering a state-of-the-art decentralized application.

Drop us a line and let’s start working today on your tremendous, new project!