10. DeFi: opportunities, advantages and disadvantages of decentralized finance
From previous lessons, you already know that DeFi stands for “decentralized finance”. In translation – decentralized finance, i.e., systems and various types of applications (mainly financial) built based on blockchain technology. They operate without the supervision of external bodies or third parties. The opposite of DeFi is CeFi, or centralized finance – traditional finance that has institutions “above it” that fully control it. Perfect examples of this are banks, or centralized cryptocurrency exchanges.
Decentralized finance is their complete opposite. They operate quickly and simply, without the oversight of institutions or third parties. DeFi uses cryptocurrencies, blockchain and smart contracts to provide and deliver financial services. What can you do with them? Everything that you would do with centralized finance: borrow, put your funds in deposits, or even take out loans. The difference is that everything is anonymous, transparent, simpler, and cheaper.
Building a DeFi
Decentralized finance consists of four, main layers:
- Settlement – the so-called zero layer. It is the basic layer of the ecosystem on which other transactions are built. It includes Blockchain and cryptocurrencies.
- Protocols – which include standards and rules for managing tasks and other activities. Its purpose is to provide liquidity to the entire ecosystem of decentralized finance.
- Applications – as the name suggests, this layer contains all the applications that users can use. It is where you will find DEXes and lending platforms.
- Aggregation – these are built by aggregators; their job is to connect applications from layer three. It is this layer that allows us to transfer money and maximize profit. This is where the borrowing of funds and exchanges take place.
Decentralized finance services:
The possibilities for decentralized finance are endless. It is speculated that they have ushered in a new era in the financial market by introducing new and unknown solutions. We will now describe the services that this new economic sector offers us.
As we have already said – loans and credits, which are possible through platforms designed for this purpose. The ecosystem of these applications is entirely based on blockchain technology. It works without third-party intervention or administration. Users connect to the network and manage their resources, regardless of location. Such platforms are entirely self-sufficient. Leaders among lending and credit platforms are: Maker, Compound, and Aave.
When talking about decentralized finance, we must also mention decentralized exchanges (DEX). These exchanges allow the exchange of digital assets, without the involvement of a central authority. For this reason, they are becoming increasingly popular among the crypto community. What does it look like? Everything works based on a peer – to – peer algorithm, that is, directly between buyer and seller. Investors do not move their assets to the exchange, thus minimizing potential theft or hacking attacks. The decentralization of trading that takes place on such exchanges prevents price manipulation.
The simplicity of exchanging services and goods. All thanks to the decentralized markets and their architecture. Buy-sell transactions take place through smart contracts, mainly based on Ethereum. No one regulates the entire market, such as in the case of Allegro, as there is no central authority to set top-down rules.
Decentralized finance – advantages and disadvantages
It’s not all gold that glitters. Like any financial system, DeFi also has its pros and cons. Although we mostly see this innovative service in all superlatives, this does not mean that it is so flawless. Let’s focus on the benefits first:
- Decentralized finance gives you 100% control over your finances.
- Keeping the number of transaction intermediaries to a minimum, thanks to the peer – to – peer algorithm.
- Low buy – sell transaction costs.
- DeFi’s platforms are mostly built on existing blockchains and are therefore resilient to failures.
- The user of the ecosystem can track the transactions and changes that take place in it. All thanks to ‘open source’ technology.
- Decentralized finance is available 24 / 7. All you need is access to the Internet.
- No censorship. In a centralized system, it is often institutions that decide what you spend your money on. Here it is you who have full decision-making power.
- They ensure anonymity.
- They provide smart contract verification by allowing you to see the code.
- Furthermore, they are resistant to fraud and hacking attacks.
We have discussed the advantages of the system. As you can see, there are quite a few. Now let’s look at the disadvantages of DeFi:
- Low optimization and many bugs. All because of the early stage of system development.
- Most DeFi applications are slow because blockchains don’t run as fast as their centralized equivalents. All due to their complex nature. However, new developments are constantly being worked on to improve the scalability of the system.
- Hacking attacks. Although the blockchain codes are visible to all users, you still need to keep an eye out for a vigilant hacker who will take advantage of the slightest stumble.
- Changes made to the blockchain are irreversible.
- Network users are responsible for any mistake they make.
- Complicated terminology and concepts that need to be understood before investing in DeFi, but what do you have us for? 🙂
Let’s remember that what DeFi is proposing to us, an entirely new financial system. This is why it is called “open finance” in the crypto world. It’s a solution to build services completely different from the traditional banking model, so finance would become more open. The system would eliminate the censorship and discrimination that can be encountered in the classical financial model.
DeFi technology, for now, is in the development stage. However, we should expect its rapid popularization. If only from the economic point of view – income from DeFi is often higher compared to the traditional financial sector. Let us also mention that decentralized finance has unlimited potential for services that have only been exploited to a small extent.