How DeFi Works and What Models Exist
If you have been engaged or at least interested in the world of finances, you have definitely heard the buzzword “DeFi,” which stands for decentralized finance. Originally, this concept was conceived in 2018. The idea behind DeFi is to challenge the current global financial system, which is based on public blockchains. The DeFi concept has grown tremendously in the past several years and brought new innovative ideas and models to the crypto industry.
In this article, we will take a look at what decentralized finance is, how it works, its advantages, risks, and the most used DeFi models as of today. In the end, we will try to give a modest prediction for the upcoming years.
First of all, let’s find out what CeFi is about so that we can thoroughly compare these two models.
Centralized Finance (CeFi)
Banks, big businesses, and other centralized institutions share one goal — to make as much capital as possible. That being said, these entities enable cash flow between all involved participants in the financial system, charging a fee for their services. For instance, assume you use your credit card to get groceries. The cost is transferred from the shop owner to an issuing bank, which then forwards the card information to the credit card network and so on. Because the various vendors, processors, and banks want to earn money from their services, every stage of transaction processing includes some sort of fee.
Lending, borrowing, sending, and other financial operations are being monitored and approved by centralized entities.
Now, let’s compare that to DeFi.
Through decentralized finance, individuals, merchants, and certain companies can process payments without the need for middlemen. Payments based on decentralization are completed via peer-to-peer financial networks that employ security procedures, interconnection, and highly effective modern software.
This distributed database collects data from all participants and verifies it using a consensus mechanism. By utilizing tools that archive and confirm financial transactions in a decentralized database, this concept allows you to lend, trade, and borrow funds.
Furthermore, decentralized finance is based on technology, which allows anyone with access to the internet to utilize financial services abroad, regardless of where they are located. If you want to be involved in DeFi, you need to obtain a personal crypto wallet, which is easier than acquiring a bank account. Therefore, DeFi technology gives people more control over their finances.
How Does DeFi Work?
DeFi, coins, tokens, and NFTs all use blockchain technology, which is a public, secure ledger. dApps are applications that are built on the blockchain (for example, Ethereum) and handle transactions.
Every single transaction is archived in the block on the chain and then validated by other participants. When these validators agree on a transfer of funds, the block is sealed and encrypted. After that, the new block with data about the preceding block is generated.
Due to the fact that not a single bit of information in the preceding block can be modified without impacting subsequent blocks, it is impossible to change blockchain data. This idea, including other security measures, contributes to the blockchain’s reliability and trustworthiness by the community.
You might wonder how payments are processed in the DeFi ecosystem.
One of the main principles of DeFi is peer-to-peer (P2P) financial transactions. A P2P transaction occurs when two unknown parties agree to transfer crypto assets without relying on a third party.
Suggest you get a loan in CeFi. You would need to apply for one using your bank or some other responsible subject. If you were approved, you would pay interest and service charges to use that specific lender’s services.
In DeFi, you might well access your loan requirements into your decentralized finance application (dApp), and an algorithm would compare you with peers who met your requirements. You would then have to cooperate with one of the lender’s terms in order to get your loan.
When you make a payment through your dApp, the money can be transferred to the lender via the same blockchain procedure. The transfer is recorded in the blockchain, and you will obtain your loan once the consensus protocol has verified it. The creditor will then be able to start accumulating payments from you at the required intervals.
With a better understanding of the concept, let’s take a closer look at the advantages of DeFi.
Minimized Human Flaws
In the financial system, many irreversible mistakes can occur due to central banks and intermediaries mishandling the job. With smart contracts, the human factor is practically excluded from the blockchain system. However, to achieve that, smart contracts must be programmed flawlessly to avoid trouble.
Before DeFi, whenever you needed a loan, you had to physically visit a bank, stand in the queue, do lots of paperwork, and so on. It takes a lot of free time. With DeFi, however, people have a chance to receive a loan with just a few clicks, anytime, anywhere on the planet. The only thing you need is to have a stable internet connection.
More Withstanding System
Take the ongoing pandemic as an example. COVID-19 has demonstrated the vulnerability of CeFi to global chaos, which happened due to the fact that centralized financial institutions rely on physically interacting with people.
The levels of physical contact required to sustain DeFi are minimal; therefore, the system significantly increases the chance of working effectively round the clock.
Almost every financial operation in the traditional financial system requires a permit from an intermediary.
Individuals must wait for bank permission to withdraw funds from their accounts, whereas DeFi users can interact with financial services without authorization from a third party.
Obviously, DeFi is not risk-free, like anything else. DeFi products offer a new way of handling finances, yet they have their issues, which are described below.
What challenges are facing DeFi projects?
Most of the issues and risks a DeFi project faces are related to blockchain technology. Since over 90% of DeFi projects are running on the Ethereum blockchain, it would be relevant to describe Ethereum blockchain challenges particularly.
Lack of Certainty
Suppose the blockchain that supports a DeFi initiative is inconsistent and problematic. The project will naturally obtain the host blockchain’s turmoil, leading to harmful consequences. When we talk about the Ethereum blockchain, it is still evolving, and errors caused when transitioning from PoW to the new ETH 2.0 PoS system may add additional threats to DeFi initiatives.
A further significant issue with DeFi projects is the blockchain’s scalability.
The scalability issue causes two main challenges:– A single transfer might take a long time to be successfully verified.
– A single transfer might take a long time to be successfully verified.Transactions, especially on Ethereum, could be extremely expensive during periods of delays.
At the highest output, Ethereum can process approximately 13-15 transactions per second, which, compared to centralized entities, can handle thousands of operations.
Smart Contract Problems
The weakness of smart contracts can be a significant cause of problems for many DeFi projects. The smallest defect in a smart contract’s script can result in the loss of assets due to the high probability of cyber criminals getting easy access to the code.
There are various blockchains, including Bitcoin, Ethereum, and Binance Smart Chain. Every single one of them has its DeFi ecosystem and community. As these networks are separate, the interaction between participants from different systems can be complex and difficult. Due to this, a large number of projects are limited in scope.
Users Hold All The Responsibility
DeFi shifts liability away from middlemen and moves towards users. If you lose your finances for whatever reason, there is nobody to help you. Moreover, once you lose your funds using decentralized exchange, they are gone forever. Thus, developing means to prevent human missteps is critical in the DeFi space. With flexibility comes a high level of responsibility. As life shows, many participants are just not used to looking after themselves in this way, which can result in them losing money or being scammed.
Let’s proceed and take a look at what DeFi models are mostly used and available as of today.
One of the most used DeFi models is lending, which is comparable to traditional bank lending. The difference is that it is provided by decentralized peer-to-peer applications (dApps).
In traditional finance, you open a saving account and deposit fiat to earn specific interest. However, in the case of DeFi, crypto investors can either secure their finances or use them to offer liquidity to liquidity pools and make returns.
Moreover, there is no central entity in crypto trading to maintain optimal liquidity of both traded pairs. Decentralized platforms rely on and help encourage cryptocurrency investors to provide liquidity.
DeFi lending works by the borrower depositing on a DeFi lending platform through the use of a smart contract related to a specific currency that should meet the amount of the loan. This deposit is known as “collateral.”
Anyone can become a lender in DeFi. There are numerous ways to lend crypto funds, and it is helpful to examine all of them because one might produce more income than others.
Borrowers should also explore the available lending pools and pick the best one for their specific requirements.
Assume a borrower requests a DeFi loan of one BTC. The borrower must deposit an amount equal to one bitcoin in another crypto asset.
There might be an issue if the crypto prices fluctuate and the collateral’s value falls below the loan’s value. That’s why some DeFi lending platforms, such as MarketDAO, require a collateral deposit of at least 150% to 200% for the DeFi loan.
The collateral becomes subject to liquidation penalties when it drops below the loan price.
Another DeFi model worth noticing is crypto arbitrage. In general, it is an investment strategy associated with price variations between platforms. Say you notice that Bitcoin’s price differs on multiple crypto exchanges. You can purchase it on one and sell it on the other.
The situation is similar in the case of DeFi. To gain additional profit, traders seek liquidity pools for investment opportunities that vary in value from the market average. They purchase these assets at reduced costs, drive up demand, and thus bring them in line with the market.
To find arbitrage opportunities on DeFi, closely watch the prices of certain assets and compare them to the rest. One of the best moments appears during a ‘pump and dump’ scheme. During massive price swings, different markets cannot remain stable.
Such activity is certainly not an easy task. Some traders depend on their own experience when developing strategies. Some even developed so-called “automated bots,” who can perform these activities without significant manual work.
The prominent example of DeFi derivatives is synthetic assets, also known as tokenized derivatives. They utilize blockchain tokens to reflect on-chain and off-chain assets represented by smart contracts. Synthetic assets can be bought and sold on the blockchain. A blockchain transfer of funds encourages asset-to-token correlation, where tokenization reflects this transaction. Tokenization can apply to any asset, including stocks, fiat currencies, cryptos, and other traditional assets.
Using oracles to serve smart contracts with asset price volatility is essential. Participants frequently overcollateralize synthetic assets by locking in collateral worth more than the asset’s value. In the crypto world, there are subjects such as wrapped Bitcoin (wBTC), wrapped ETH (wETH), and so on. A wrapped cryptocurrency is a new cryptocurrency that reflects the valuation of an underlying asset. For instance, 1 ETH equals 1 wETH. The smart contract keeps the initial asset and mints an equal amount of the wrapped asset to return to the user. Clients can receive the original asset in the future by burning the wrapped asset.
Derivatives are important to the future stability and prosperity of the digital asset ecosystem as a whole. With systems in place to go long or short on various assets, these tools provide a good base for traditional traders to gain access to cryptocurrencies.
Decentralized finance is still in its early development. Remember that DeFi is unregulated, meaning that the ecosystem is full of infrastructure hiccups, security breaches, and scammers.
The ability of DeFi to freely conduct international money transfers raises critical issues about regulations in this sphere. It is necessary to have some subject that would investigate a financial crime that takes place in the ecosystem, especially when it comes to international transactions.
The easy and access-free format of the decentralized finance ecosystem may also pose challenges to the traditional financial system.
The DeFi sector also has some problems with system stability, energy consumption, environmental impact, software upgrades, operation and maintenance, and system errors.
This leads us to the conclusion that numerous issues need to be resolved and measures taken before DeFi can be used confidently. Centralized financial institutions will never give up one of their predominant sources of revenue. If DeFi proves successful, it is almost certain that central banks and giant corporations will figure out how to get into the system and make their presence known. Thus, the future of DeFi remains unknown.