Decentralized Finance (DeFi) – The Good, the Bad, and the Ugly

Data & Research / 14.11.2020

No one can argue that the Decentralized Finance (DeFi) movement is on fire at this moment. These next-gen financial systems continue to attract massive attention from investors. As this year’s big thing, DeFi has its share of benefits and risks. Understanding these factors will help you to make the most of your DeFi investment strategy moving forward. 

DeFi exploded in popularity this year due to a couple of factors. Primarily, users are making huge profits using these systems. Additionally, the simplistic nature of these platforms makes them ideal for new users. 

Staking your crypto in a reputable DeFi platform is far less risky than trading for new investors. It doesn’t require extensive research. Additionally, DeFi’s open nature means that anyone can participate in these platforms regardless of their location, identity, political affiliation, or age. 

What is DeFi?

DeFi is an umbrella term that encompasses a wide variety of blockchain-based financial systems. These protocols leverage smart contracts to create new and exciting financial opportunities for users. In this way, DeFi expands blockchain from a simple value transfer mechanism to more complex financial systems.

DeFi can be described as the merger of traditional bank services with decentralized technologies such as blockchain. DeFi developers constantly seek ways to leverage decentralized networks to transform old financial products into trustless and transparent protocols. 

Consequently, DeFi allows crypto entrepreneurs to recreate traditional financial instruments without the intermediaries. Defi flips the traditional financial system on its head and puts the power back in users’ hands. 

What Problems Does DeFi attempt to Fix

It’s no coincidence that DeFi is so popular. This new tech sector solves some of the most pressing issues facing investors and entrepreneurs globally. From providing new opportunities to the unbanked to shifting the banking paradigm, DeFi’s potential is endless.

  • Centralization

Centralization is one of the problems that DeFi eliminates. In the current market, central financial institutions hold all the control. Users must bow to these institutions if they need access to financial applications such as loans, insurance, crowdfunding, derivatives, and even betting. 

  • A Lopsided Market

Unchecked centralization has led to the creation of a lopsided market. Users are at the mercy of the central authorities. All the profits flow back to these central organizations. Worst of all, regular users have little to no recourse or options when the system fails them.

Benefits of DeFi

The introduction of DeFi tech has changed everything. Developers continually find ways to allow individual users to transact with each other in a peer-to-peer fashion that also protects both parties’ interests. Here are some of the main benefits that DeFi brings to the market. 

  • No Middleman

Intermediaries are expensive. You can always save when you find ways to remove them. Today, financial institutions sit between you and the business you desire to transact with. Sadly, these organizations have full control over your transactions. They retain the authority to stop, pause, or deny your transaction altogether. 

DeFi users don’t need intermediaries like a bank or lawyer to complete transactions. Instead, smart contracts automate all the core procedures of your transactions. This increases efficiency considerably. Today’s centralized systems and human gatekeepers limit the speed and sophistication of transactions severely. DeFi eliminates these issues through autonomous protocols.

  • Financial control

DeFi puts users back in control of their finances. You can decide what to do with your funding. Send it globally, lend it out, invest it, or save it. You have full flexibility in the DeFi ecosystem.

  • Interoperability

At the core of DeFi is a commitment to standards and interoperability. DeFi financial software built on the blockchain can be pieced together to create more complex systems. For example, you could have a protocol that automatically changes your holdings between different platforms based on the profit margins. 

  • An Open Financial System

DeFi was built on the belief that everyone deserves access to financial tools. DeFi platforms allow people that live in areas that lack access to these tools to participate in the global economy. According to reports, there are 1.7 billion people currently unbanked. The reasons for this lack of these services range from war to infrastructure concerns. If DeFi can help even a small portion of these individuals, the technology is a success. 

How does DeFi Work?

DeFi relies on automated enforceable agreements to provide higher transparency and automate services’ core processes. There are a variety of different types of DeFi platforms on the market today. Each has its own features and services. However, some DeFi services have become standard across most applications.

  • Staking

Staking is the act of locking your cryptocurrency in a smart contract for a predetermined amount of time. In exchange for locking up your crypto, you receive a reward. This reward is usually in the form of crypto. In many instances, it will be the governance token of the platform. 

Originally, staking was used to secure Proof-of-Stake networks. Users would lock their crypto into a network wallet in this process. Nowadays, various staking protocols allow you to put your idle crypto to work. 

  • Liquidity Staking

Liquidity staking is a hot ticket item in the market today. In a liquidity staking system, users lock their crypto into large liquidity pools for certain projects. These pools are then used to ensure the liquidity of new projects. 

  • Yield Farming

Another form of staking that is common in the DeFi sector is Yield Farming. Yield farming systems work very similar to liquidity staking systems. You lock your crypto in a liquidity pool for a predetermined time frame. The main difference is that this pool allows regular users to borrow from it with interest. 

Risks of DeFi

As a new technology, investors should be aware of the risks involved with DeFi investing. The market moves quickly, and there has already been a fair share of rug pulls to date in the sector. To avoid these risks, you must DYOR and stick to the most reputable development teams that communicate directly with users. Here are the biggest risks facing DeFi investors today.

  • New Technology

With any new technology, there are inherent risks. With DeFi, these risks are multiplied by the fact that the base technology, blockchain, is still fairly new. There is no guarantee that these networks will remain in the spotlight. There are also the risks that newer technologies will emerge that nullify the benefits and advantages of DeFi.  

  • Coding errors

With so many new platforms entering the space in quick succession, there is always a risk of coding errors. The best DeFi platforms feature a well-vetted open-source code. Open source projects are more secure because they must pass the watchful eyes of the community. 

Projects that are not open source could prove to be problematic. A perfect example of a coding error wreaking havoc on a system occurred this week. The Ethereum-based DeFi platform Akropolis lost two million DAI ERC-20 tokens following the successful hack of the platform. 

  • Losses

Akropolis is by no means the only DeFi platform to lose users’ funds spectacularly. One report puts the total amount of DeFi funding stolen to date at over $100 million, more than $10M monthly. Surprisingly, the report revealed that 45% of all thefts in the blockchain sector during 2020 were DeFi hacks. 

  • Shaky investors

Perhaps the biggest risk to the DeFi community is its speculative nature. Most investors are in the market to arbitrage trade their tokens at a later date for profits. Whenever you have a market fueled by speculation, there is more risk of run-off sales occurring. 

In October, the popular DeFi platform Yearn Finance saw its token’s value slide 67% in value in days. Researchers attribute the losses to a completely different DeFi project’s botched launch. The Cronje’s secret Eminence (EMN) was hacked for $15 million before it even launched. This hack sent shockwaves throughout the entire DeFi market.

  • Regulatory Concerns

DeFi investors should also be aware of the regulatory climate. Currently, DeFi is an unregulated financial sector. At its current size, this is a possibility. However, as the sector begins to take clientele from the centralized systems, you can expect some regulatory pushback. 

Regulatory concerns could prove to be the nail in the coffin for DeFi. This future will depend on the sector’s ability to organize a fair and effective market representation for lawmakers. Likewise, the DeFi sector will need to adhere to any blockchain regulations that go into place in the future. 

DeFi – At Your Own Risk

The moral of the story is that DeFi still has many bumps to overcome before it’s a smooth alternative in the market. Despite these drawbacks, various DeFi platforms continue to spark investor interests. Given the market’s current momentum, it’s a safe bet to say that the DeFi revolution is just beginning. 

David Hamilton aka DavidtheWriter is a long time Bitcoinist and cryptocurrency journalist. Currently, he has over a thousand articles published on blockchain technology. His expertise and experience makes him one of the most reputable writers in the sector.