What is Defi? Decentralized Finance explained

What is Defi? Decentralized Finance explained

Decentralized finance is one of the most significant technological developments in recent years. It has become so popular that there is even competition between different blockchain technologies, each trying to capture as much market share as possible. The most promising platforms are Ethereum, Binance Smart Chain, Cardano and Solana. Of course, more blockchain technologies are trying to build their ecosystem, but this article will focus on the most successful cryptocurrencies in this space. And I want to answer the question of what Defi is.

What is Defi?

Defi stands for Decentralized Finance, an umbrella term for various technologies that share a characteristic. Namely, they all offer a specific financial service, not as a central institution, but as a decentralized service. Therefore, Defi applications are considered DApps, which generally run on a blockchain that provides innovative contact features.

These Defi services can include peer-to-peer lending, options trading, prediction markets, liquidity farming, insurance, and more. Each service is a protocol that runs on the respective blockchain. Therefore, decentralized finance is considered a game-changing technology, as each protocol could offer millions of people financial services globally and without restrictions.

What are Defi services available?

The main protocols provide the ability to exchange tokens and serve as a decentralized exchange. Most use an automated market maker (AMM) to provide a job market. But the AMM needs liquidity to function, which leads to the second most crucial service: Liquidity Providers (LP).

In principle, anyone can become an LP and provide liquidity to the protocol. The incentive for LPs is a revenue sharing through royalty payments. When someone performs a transaction, that person must pay a fee to the protocol. LPs pool their liquidity into a pool, and when that pool is used to place a trade, a portion of the price is allocated to the collection, and each LP is rewarded accordingly. The advantage of this system is that liquidity is always available on demand.

Another essential service in the Defi space is lending. In this case, the protocols created a decentralized market for borrowers and lenders. The borrower usually rewards lending cryptocurrencies or stablecoins with an interest rate payable. To lend money, the borrower needs collateral, which he offers as collateral. If the borrower does not repay the money, he loses his collateral.

Trading, liquidity extraction and lending are the three primary services currently available and easily accessible to anyone interested in Defi.

What risks are involved in Defi?

Cryptocurrencies are usually hazardous investments, but on the other hand, they offer excellent upside potential. Defi protocols face many additional risks, not only due to market volatility but also because they are part of a complex system. Each service is a DApp and embedded and dependent on other protocols. Therefore, a single vulnerability in these interacting protocols can lead to catastrophic results if exploited. Since last year, millions of euros have been lost through exploits. 

Most of them focused on liquidity pools that used flash loans to siphon off liquidity and leave investors nothing behind.

But there are more than just the risks of intelligent contracts, e.LPs bear financial risks from the potential rebalancing of their deployed assets. Another factor is fees. When transaction demand is high, a single interaction with a Defi protocol on Ethereum can easily cost as much as €200. This is particularly annoying for private investors who want to invest a smaller amount of money.

How to mitigate Defi risks?

One possible way to participate in the market is not to join Defi but trade the related assets. The largest Defi platform is Ethereum, and the price of Ether has increased tremendously over the past few months. Competitors like Binance Coin (BNB) or Cardano (ADA) have also seen their prices rise.

Demand is often driven by the people using the Defi applications on the respective platforms. LiteBit offers to buy, sell and hold the most related tokens and cryptocurrencies in the Defi space. Clients can trade them without the risks that come with using Defi. Platforms and, above all, on fafavorableerms. This allows our clients to engage and participate themselves with a modest investment that decentralized exchange fees would otherwise consume.

What to expect in the coming years?

The Defi market was the driving force for altcoins in 2021. Only together with the growing demand for markets offering non-fungible tokens is Defi expected to become something more significant. Currently, most use cases focus on the needs of the crypto industry and are usually related to speculation and trading. But there are other options, such as identity management or insurance. These use cases could attract large companies and bring them to market as they can offer their proven services. On the blockchain and develop their business models.

But there are also many risks. Namely, these companies could adopt blockchain technology but use their technology instead of open and public blockchains.

These private blockchains already exist, and companies could build their services on top of white-label or on-premises solutions. Decentralized finance must prove that it is truly superior to these private applications controlled only by individual entities. They confirm that the market and technology are mature enough to attract big names, and big money remains a challenge in the years to come.

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