Decentralized Finance, also known as DeFi, is a form of finance based on the technology of the blockchain. What makes it different from the traditional finance is the absence of central financial intermediaries such as brokerages, exchanges and banks and the adoption of smart contracts to regulate the transactions between subjects.
A smart contract is a computer program or a transaction protocol which is intended to automatically execute, control or document legally relevant events and actions according to the terms of a contract or an agreement, which are decided by the users. This leads to a reduction of costs, to faster and more secure transactions and to an easier access for individuals who otherwise wouldn’t have access to any financial services.
Most of the applications called DeFi are built on top of Ethereum, because its blockchain is flexible, and because it adapts better to the smart contracts’ requirements.
The most common use cases for DeFi include the following:
- Open Leading Platforms: These are decentralized applications also known as DApps. These apps allow users to either lend digital assets out to other users to earn interest or borrow digital assets from them — paying interest on top.
- Stablecoins: These are cryptocurrencies that have their value pegged to another asset in order to reduce volatility and keep the price as stable as possible. Normally, stablecoins are tied to an asset outside of cryptocurrency, for example to fiat like dollar or euro.
- Decentralized Exchanges: These are online exchanges, also known as DEXs. Through the decentralized exchanges users connect to each other directly and they can trade cryptocurrencies without the need of intermediaries.
- Yield Farming: It is also known as liquidity mining and it is considered high risk/high reward. Yield Farming projects require that users stake liquidity provider (LP) tokens that are received after providing liquidity at certain decentralized exchanges, like Uniswap. These tokens are then used to mint a new type of token that can either be sold or used. It is considered risky because locked assets can be lost if there is a backdoor or loophole in the farm smart contract, while the assets generated may be worthless.
What are the main opportunities and risks?
On the one hand, decentralized finance increases the efficiency, transparency, and accessibility of the financial infrastructure.
- Efficiency: While much of the traditional financial system bases and depend on centralized institutions, DeFi replaces them with smart contracts. If two users want to exchange digital assets they can do it through them. This makes the transactions faster and more efficient.
- Transparency: DeFi applications are transparent. All transactions are publicly observable, and the smart contract code can be analyzed on-chain.
- Accessibility: DeFi protocols can be used by anyone. DeFi may create an open and accessible financial system. In particular, the infrastructure requirements are relatively low, and the risk of discrimination is almost inexistent due to the lack of identities.
On the other hands, there are also risks that come with Defi, those include:
- Smart Contract Execution: While the deterministic and decentralized execution of smart contracts does have its advantages, there is risk that something may go wrong. If there are errors in the code, these errors may create vulnerabilities that allow an attacker to drain the smart contract’s funds, cause chaos, or render the protocol unusable.
- Operation Security: Many DeFi protocols and applications use admin keys. These keys allow a group of individuals (usually the project’s core team) to upgrade the contracts and to perform emergency shutdowns. While it is understandable that some projects want to implement these precautionary measures and remain somewhat flexible, the existence of these keys can be a potential problem. If the keyholders do not create or store their keys securely, malicious third parties could get their hands on these keys and compromise the smart contract.
