DeFi is a new and rapidly evolving field in the world of finance. The abbreviation stands for decentralised finance’ and refers to the new way of executing financial transactions using applications. The process used in decentralised finance eliminates the intermediaries and conducts transactions directly over the blockchain. This method is currently gaining traction for erasing banks, brokerages, and other intermediaries out of the picture.
Advocates of DeFi claim that it must not have any centralised control and should run by itself on a blockchain. Within that blockchain are smart contracts, code that is programmed to self-execute when specific conditions have been met. You can set up smart contracts to do things like having someone pay you one Bitcoin for every win that your favourite basketball team gets in one season. Smart contracts can be used for all sorts of unique conditions.
One of the sources we used for this article is Crypto Engine. It’s a trusted and beginner-friendly website that you can visit if you want to get started investing in cryptocurrencies.
The key benefits of DeFi lie in its ability to cut out the middleman for transactions, thus eliminating the cost of transaction fees, saving time, and avoiding the risk of bankruptcy or fraud. There is also no need to look for a trusted third party.
But how is DeFi related to Ethereum?
Ethereum was designed as a platform that allows its users to create decentralised applications on top of it. These applications make use of the smart contracts programmed to work on the Ethereum network. It was also designed to work with smart contracts.
Bitcoin, on the other hand, was not made to facilitate smart contracts but can be coded to direct transactions using smart contracts. This difference has led Ethereum to be the most used blockchain in the world.
Can you make money using DeFi?
Just like in the field of traditional finance, there are numerous ways to make money by using decentralised finance.
One way to do so is using a strategy called ‘yield farming’, a method that involves switching your investments between different lending pools, so you’re always getting the best return rates. This is similar to putting money into multiple high-interest savings accounts to maximise the interest you can earn. Yield farming is similar but with higher yields.
You can also make use of a liquidity pool, a concept where users can deposit two different cryptocurrencies or tokens of the same value to ensure that they have enough supply available in the case that traders want to make an exchange. In return for providing liquidity, the users receive a reward in proportion to the amount they staked in the pool.
And then there are also other more traditional lending services available. A lot of crypto investors around the world are holding their assets because they are anticipating a price increase. They also want to borrow from these assets, so they can finance their new ventures. When interests like these become overladen, all sorts of DeFi products are released. An example would be crypto-backed lending, wherein you invest in a borrower who stakes cryptocurrency as collateral, and in return receives interest.
But what are the risks involved with investing in DeFi?
Decentralised finance is definitely a promising concept, but in practice, there are some risks that beginners need to consider.
Aside from the typical risk factors that you would experience with normal investments, you would also need to know the technical and security risk factors involved.
Because of the lack of central authority, the power rests solely on the user. There is no institution or any help desk that you could consult in case something goes awry. You have nowhere to turn to in the instance you lose your account or forget your password. Having a solid backup plan now becomes very important to keep your account information secure. For cryptocurrencies, your entire investment is lost if you lose access to your digital wallet.
Any engineered attacks are also completely out of your control. If the older more traditional investments are prone to theft, then digital assets are even more so.
DeFi is a new and quickly evolving field that still has a lot of technicalities and exclusive jargon. Being tech-savvy and willing to pour hours into understanding exactly what you’re getting into is definitely an advantage. But if that doesn’t sound like you, then maybe it’s not the best decision to delve in.
Decentralised finance is a key part of how cryptocurrencies work. If that sounds like a system you could get behind to invest in cryptocurrency, you can rely on a trusted trading platform like Crypto Engine that can help you get started.
Eventually, though, the system will continue being ironed out. The system will improve along with its security until its way of operating establishes a standard. It will take some time, but DeFi will become more secure and dependable in the future.
DeFi solves a lot of problems that occur in traditional finance: the lack of transparency makes it difficult to assess risk, constantly changing rules and regulations, and the slow and sluggish pace of old banking technology. It’s even become more relevant during 2021, where digital transactions are becoming the norm. If you’re looking into something new to invest in, DeFi is a promising area that you should be looking into while it is still in its infancy.