I have to admit: Decentralized Finance – or “Defi” – is one of the most fascinating aspects of the blockchain and cryptocurrencies. In fact, it’s defi that got me really excited about crypto in the first place.
So, let’s get to it!
At its heart, defi uses the blockchain to make complicated things happen while cutting out the middleman in the process. Here’s what I mean...
Right now, finance is run by a hub-and-spoke model. And that model hasn’t changed much in a long, long time. In fact, it’s pretty much the same as it was before sophisticated computers and large financial networks.
And you can see why: The hub-and-spoke model organizes most financial transactions into large financial centers around the globe, such as New York and London. When financial transactions are made, activities are generated in one of these centers. Those institutions then determine the details of the transactions and make sure that they are carried out like all the parties intended.
Really, not very complicated. And for the most part, it’s not a bad system.
But if you dig a bit deeper, you can see that the flaws in the system are pretty glaring. All those financial transactions have to be approved by a central authority. And that central authority -- in order to make sure everything about the transaction is ok -- employs a ton of people, from clerks to bankers to lawyers. Plus, the central authority has to own and operate a lot of computer systems to make the process as efficient as possible. And then, they have to make sure all these people and equipment are properly supervised and secure.
Wow! That’s a lot of running around to make sure that my debit card transaction for groceries at Ingles is on the up-and-up.
And that’s just the beginning. When you get into the scope of more complex transactions – like buying a car or a piece of real estate – the number of resources required to make it happen can be absolutely mind-boggling.
Plus, concentrating all that financial activity into basically a handful of global institutions also means that the system concentrates all its risk. And all we have to do is look at the parade of financial meltdowns we’ve had in just the last 30 years to see how costly and dangerous that can become.
And finally – but certainly most importantly – a staggering 1.7 billion people are unbanked around the globe and don’t even have access to this system. That’s a tremendous number of people that can’t do financial things that we take for granted every day, like buying goods, getting loans, getting paid, or planning our financial futures.
How Defi Can Help
By using the blockchain, Defi solves many of these problems.
The blockchain uses a system of decentralized ledgers on a vast array of computers to transact business. When a transaction is made on the blockchain, it is recorded in every ledger on every computer on the network. Once the transaction is recorded, every computer on the network makes sure it’s right. If they all do, the transaction is deemed correct and added to the blockchain.
I used a version of this exact strategy to win the 2019 U.S. Investing Championship and have been teaching it to my students for a decade.
As you can see, making a financial transaction this way eliminates the need for a central authority to bless the transaction and say it’s ok. The blockchain itself accomplishes this task. That eliminates the need for a central authority and its expensive resources.
A financial transaction on the blockchain also greatly reduces the risk inherent in the hub-and-spoke model. Transactions are spread across a vast array of independent computers. And since all those computers are verifying the transactions, it’s virtually impossible to cheat.
And finally, decentralized finance opens up the financial world to the unbanked around the globe. A decent phone is now all that’s needed. That gets a lot more people onto the financial playing field.
Defi Works On Ethereum
Ethereum (ETH) is the second-biggest cryptocurrency on the planet. And for good reason: If you want to do Defi, you pretty much have to do it with Ethereum. That makes Ethereum the king of the Defi hill.
So what makes Ethereum so special to Defi? Really, it’s pretty simple: Unlike value-based cryptocurrency networks like Bitcoin (BTC), Ethereum was designed from the get-go to handle complex transactions. Built into the code itself are computational capabilities that other cryptocurrencies simply don’t possess. And that makes Ethereum perfect for Defi.
So what can you do with Defi cryptocurrencies like Ethereum and others? Plenty. Here’s just a smattering of the “dapps” or Defi applications:
• Everyday Transactions: Making payments, getting insurance, and trading securities without the need for expensive intermediaries.
• Lending platforms: Utilizing smart contracts to make lending easy and more transparent.
• Stablecoins: Linking a cryptocurrency’s value to a currency like the dollar to improve pricing.
• Decentralized Exchanges: Connecting cryptocurrency investors and traders directly, without the need for a centralized crypto exchange.
• Non-fungible Tokens (NFTs): Making trading in typically non-tradable assets – like art and music – possible and even prolific.
Beware Of Defi
OK, even though the value of Defi apps is in the billions, this business is anything but mature and established.
In fact, it’s nascent and unproven. And that means it’s risky:
• There are no consumer protections, which means if you get swindled, there’s nowhere to turn.
• While the blockchain itself is pretty much impenetrable, the software-driven applications around the blockchain are by no means hack-proof. And that can translate to loss or theft.
• Defi networks haven’t been tested by the stress imposed by wide global adoption. That means that the network vulnerabilities are still largely undiscovered.
• Smart contracts are hard-coded by terms and conditions. That means there’s no turning back if the conditions of the deal are met, no ifs, and, or buts.
If you do want to get involved with Defi, do it gently. No more than 1% to 2% of your assets. And since Ethereum is the big player in the space, I would start there.
Disclosure: This contributor may own cryptocurrencies mentioned in this article. This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.