What is DeFi and how is it different from classical finance?

Decentralized finance, or DeFi for short, is a general term for a group of financial instruments built on blockchain. The idea is to allow anyone with access to the internet to lend, borrow and bank without intermediaries.

DeFi is an emerging field that aims to create financial systems that are open, transparent and accessible to all, without the need for banks or other financial institutions. In DeFi, financial transactions are conducted on decentralized blockchain networks, where they are protected by cryptography and executed using smart contracts.

There is no specific author of the idea or creator of DeFi. It is generally accepted that the system has existed since the advent of blockchain technology. However, DeFi really took off in 2019, when the number of decentralized financial applications began to grow rapidly. Today, most of DeFi's existing applications are built on the Ethereum blockchain, which provides a powerful platform for developing smart contracts and decentralized applications.

The first popular DeFi app was MakerDAO, launched in 2017. MakerDAO is a decentralized lending platform that allows users to borrow DAI, a stable coin pegged to the US dollar. This application is built on the Ethereum blockchain and uses a sophisticated collateralized debt position (CDP) system to maintain the value of DAI. Despite some early difficulties, MakerDAO has grown to become one of DeFi's most widely used applications.

DeFi is currently one of the fastest growing areas of blockchain and the decentralized internet.

The difference of DeFi and traditional finance

The fundamental difference between DeFi and traditional finance is that DeFi is a decentralized system, while classical finance is centralized. In traditional finance, all transactions are carried out through intermediaries such as banks. These intermediaries are responsible for managing transactions, storing assets and ensuring regulatory compliance.

DeFi, on the other hand, uses blockchain technology to eliminate intermediaries and create a fully decentralized system. In DeFi, financial transactions are conducted directly between users, with no third parties involved. Transactions are cryptographically protected and carried out using smart contracts — self-executing programs that automatically fulfill the terms of the contract if certain conditions are met.

DeFi features

DeFi has several key features.

Decentralization. DeFi operates on a decentralized network of computers, which means there is no central authority controlling it. This ensures transparency and security and eliminates the need for intermediaries.

Transparency. DeFi transactions are recorded in a public ledger (blockchain), which means they can be easily verified and traced. This ensures transparency and helps prevent fraud.

Interoperability. DeFi applications are designed to be interoperable, which means they can work seamlessly with each other. This makes it possible to create a wide range of financial applications based on the DeFi ecosystem.

Programmability. DeFi is highly programmable — it can be customized to suit a wide range of usage scenarios. This makes it a flexible and adaptable tool for innovation.

Trust-free. DeFi uses smart contracts, which are self-executing contracts that automatically enforce the rules and regulations of the application. This eliminates the need for trust between the parties and reduces the risk of scams.

DeFi has many advantages over the traditional financial system:

  • Lower costs. DeFi transactions are peer-to-peer — meaning that users can save money on fees that banks usually charge.
  • Faster transactions. Transactions in DeFi can be almost instantaneous because they do not require approval from intermediaries. Users can send and receive funds in seconds or minutes instead of waiting hours or days.
  • Enhanced security. Transactions in DeFi are secure because of cryptography and decentralization — users can be confident that their funds are safe and that transactions are being executed as intended. And because DeFi applications are open-source, they can be inspected by anyone to make sure there are no vulnerabilities or exploits.
  • Financial affordability. DeFi allows anyone with an Internet connection to access financial services. Decentralized financial applications can be accessed from anywhere in the world, without the need for a physical presence at a bank or identification documents.

Applications of DeFi

DeFi is a fast-growing ecosystem with a wide range of applications in various fields of finance. Some of DeFi's most popular applications are:

  • Lending and borrowing. DeFi's platforms, such as Aave, Compound and MakerDAO, allow users to lend and borrow cryptocurrency without having to go to a traditional bank. Borrowers can pledge their crypto-assets and receive loans in stablecoins, while lenders can earn interest on their assets.
  • Decentralized exchanges. Curve, Uniswap and SushiSwap are examples of decentralized exchanges (DEX) that allow users to trade cryptocurrencies without intermediaries. These platforms use automated market makers (AMMs) and smart contracts to facilitate transactions.
  • Prediction markets. Augur and Gnosis are examples of DeFi prediction markets that allow users to bet on the outcome of events such as elections or sporting events.
  • Insurance. DeFi platforms Nexus Mutual, Unslashed and Guard-Helmet provide insurance services to users, protecting them from hacking and other risks. These services use smart contracts to automate the insurance process, making it more transparent and efficient.
  • Yield farming. Yield farming is a DeFi concept in which users provide cryptocurrency to a platform in exchange for rewards. Platforms such as Curve and Balancer allow users to earn interest on their assets. Providing liquidity for exchange transactions and receiving rewards from trading transactions is the basic concept of earning for DSF.

Risks and disadvantages of DeFi

Despite its many advantages, DeFi is not without its risks and drawbacks. However, it is worth noting that these drawbacks are not unique to DeFi — similar problems exist in traditional banking systems as well. Nevertheless, it is important to be aware of these potential issues and take the necessary precautions.

Security issues. Like any other digital platform, DeFi is vulnerable to hacks and cyber-attacks. Because DeFi operates on a decentralized network, there is no central authority to protect against hacking attacks.

The risks of smart contracts. DeFi applications rely on smart contracts, which are programs that automatically execute transactions. If there are bugs or defects in the code, these transactions can be exploited by unscrupulous individuals.

Before using a DeFi application, it is important to check whether its smart contract has been audited. This can help mitigate some of the risks associated with using decentralized platforms.

Market volatility. The DeFi market is highly volatile — asset values can fluctuate quickly and dramatically. This can lead to significant profits but also significant losses. It is important to understand the risks and invest only funds that you can afford to lose.

To minimize the risk of market volatility, you can make deliveries of the same assets. For example, you can use DSF to deliver different stablecoins to the Curve exchange. By doing so, you can minimize the risk of volatility or sharp price movements of crypto assets.

Key indicators and market tracking in DeFi

As in any other financial market, indicator tracking and analysis is very important to understand the state and trends of the DeFi market.

DeFi indicators

One of the most commonly cited indicators for the DeFi sphere is Total Value Locked (TVL). TVL measures the total value of all assets locked into DeFi applications. This indicator is used to track the growth of the decentralized finance ecosystem over time. Another key metric is the number of unique addresses or users interacting with the DeFi applications, which provides insight into the level of user adoption and engagement in the ecosystem.

Other important indicators to track include the volume of trading on decentralized exchanges (DEX), the price of cryptocurrencies used as collateral in lending DeFi applications, and general market sentiment towards DeFi. In addition, tracking trends such as new application launches, token listings and regulatory changes can also provide valuable insight into the state and growth of the DeFi market.

Platforms for tracking DeFi market performance

There are several platforms that allow investors and analysts to track DeFi market performance. One of the most popular is DefiLlama, which provides up-to-date information on TVL of various DeFi applications, as well as ratings and information on individual DeFi projects.

Also available for DeFi market analysis are the CoinGecko platform, which tracks tokens, provides price charts and trading volume data, and Dune Analytics, which allows users to create and share custom DeFi dashboards.

07.07.2023 10:27
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