DeFi - What It Is and How to Invest in It Wisely

With advancements in computer science and mathematics, a group of people discovered a new type of financial system known as Decentralized Finance or Defi.

Defi is a type of finance that is based on blockchain technology. It foregoes the usage of central intermediaries such as banks in favor of digitalized contracts, otherwise known as smart contracts.  

In a lot of ways, defi has outclassed the current system of finance, cefi ( centralized finance). 

 

In this article, we are going to cover the six main components of Defi;

 

Lending/borrowing, Stablecoins, decentralized exchanges, derivatives, margin trading, and insurance.

 

1. Lending/Borrowing

 

We can start with an example.

 

John deposits Fiat money through a decentralized application to earn interest. 

 

Alex on the other hand has Ether which he does not want to sell, but he needs money. Hence, he deposits his Ether as collateral and borrows money in return. 

 

These transactions are done via smart contracts, meaning no middlemen are required. 

 

This process saves the time we spend on long paperwork and hence, is a lot faster than traditional intermediaries. 

 

Moreover, these transactions are in a peer-to-peer format so the interest rate would be less as compared to the bank. 

 

A few examples of Defi applications that allow lending and borrowing include Compound, AAVE, and MakerDao. 

 

 

 2. Stable coins

 

Stablecoins are a type of cryptocurrency that is a lot more stable than other cryptos as they are pegged to an outside asset such as fiat money, gold, or other cryptocurrencies. 

 

Stablecoins aim to tackle price fluctuations.

 

People who prefer to play it safe in a long-term investment would prefer this coin because it is not as volatile as other coins such as Bitcoin or Ethereum.

 

When a country's economy is seen depreciating, many people tend to invest in stable coins that have been backed by another country's currency to preserve their wealth. 

 

While stable coins offer stability, they come with their own set of risks.

 

Widely known stable coins are Tether, DAI, Binance USD.

 

3. Decentralized Exchanges ( DEX)

 

Decentralized exchanges offer a peer-to-peer mechanism that promotes the non-reliance of a central intermediary such as banks and instead, uses smart contracts to facilitate trading.

 

Some of the major benefits of DEXs are:

1. Lack of central authority

2. Anonymity

3. High Security

4. Low Trading Fees

 

4. Derivatives

 

In Defi, Derivatives are contracts in which values are determined by the performance of an underlying financial asset. 

 

Stocks, interest rates, bonds, market indexes, currencies are a few examples of derivative assets. 

 

One of the key distinctions between Cefi and Defi derivatives is that a Cefi derivative can only be created by a central authority, whereas a Defi derivative can be established by anybody.

 

Moreover, Defi derivatives are easily accessible because they do not require proof/identity/eligibility. 

 

BitMex is considered an established decentralized platform for derivative trading.

 

5. Margin Trading

 

Margin trading is the process of borrowing money from a third party to trade assets that we previously couldn't afford.

 

Margin accounts enable traders to invest in assets with higher sums of capital, effectively doubling their profit. A quick drop in the price of a coin, while also being true, can result in significant losses for a margin trader.

 

Margin trading found its popularity in low-volatile markets, such as the International Forex Market.

 

A few of the best crypto margin trading platforms in India are:

1. Binance

2. FTX

3. Kraken

4. Bitmex

5. ByBit  

 

6. Insurance

 

Crypto insurance fulfills the same objective as centralized financial insurance.

 

Cryptocurrency insurance allows investors and organizations to protect their digital assets against a variety of dangers. 

 

Every week, millions of dollars in digital currencies are stolen, leaving investors and business owners powerless because the anonymous nature of this industry effectively masks the perpetrators' trail while leaving the investor out of money.

 

Popular Defi insurance projects include Nexus Mutual and Open.

 

Benefits:

 

1. Permissionless: Anyone with the internet has access to use apps( or decentralized apps).

 

2. Pseudonymous: Because there is no single entity in charge, you do not need to provide your name, email address, or any other personal information to anyone.

 

3. Hassle-Free: Since there are no physical intermediaries involved, there is no need to wait for any advancement that you have made. There is no need to wait for permission to move your assets, or long transfers to finish.

 

4. Fast: Transactions can be pretty fast as everything is done automatically via software. Updates are provided regularly.

 

5. Transparent: Unlike in centralized finance, every transaction is made transparent to the participants.

 

Downsides: 

 

1. Uncertainty: The benefits and drawbacks of decentralized finance are also influenced by worries about uncertainty. In the case that a blockchain hosting a Defi project becomes unstable, the project may immediately inherit the host blockchain's instability.

 

2. Lack of insurance: In the event of a hack or other fraudulent activity, insurance protects investors. In centralized finance, insurance is quite significant, but it is considerably less common in Defi.

 

3. Responsibility: Among all of Devi’s benefits and drawbacks, the shared accountability component is negative for users. The Defi projects are not liable for the mistakes made by its users. 

All they do is remove the middlemen, leaving the users to be responsible for their funds and assets. As a result, the Defi space needs solutions that can prevent human errors and mistakes.

 

Decentralized finance is slowly gaining acceptance as a much safer, transparent, and efficient financial option. By removing the need for centralized financial institutions, we create a more transparent and trustworthy financial system that is also far more accessible.

 

The risk of fraud, corruption, and mismanagement of your assets is reduced with decentralized finance, which is safeguarded by blockchain technology. 

 

There will be no overdraft fees, no wire transfer costs, and no need to wait for a transaction to be validated during banking hours, making financial management much more affordable and efficient.

Written By - Karthik Krishna