DeFi, or Decentralized Finance, stands for the combination of traditional financial products and financial concepts, as they are known from the banking sector, in connection with blockchain technology. The main focus is on transferring well-known principles into the world of cryptocurrencies and their distributed ledger technology. DeFi therefore uses a wide range of instruments, such as currency exchange, bonds and loans.
What exactly is DeFi (Decentralized Finance)?
The potential of this division is very promising, which has caused a small boom in applications in the DeFi sector in 2019. In 2020, this has strengthened once again and it is expected to continue.
The term DeFi does not always mean only the one already described, which covers all transactions (in the DLT area) with a monetary reference. Therefore, the term is more synonymous with open finance. In the narrower sense, however, the above-mentioned use cases are referred to.
But why do you want to connect traditional finance with blockchain? At the beginning of Bitcoin in 2008, it was intended to offer the financial world a completely new alternative. Today, about 12 years later, Bitcoin and other decentralized digital currencies have their place in global competition when it comes to transactions. The far-reaching adaptation has not yet taken place, but that could change with DeFi. Many concepts in the field of banking have been successfully applied for many centuries. In this area, for example, there are many legitimate financial products, such as borrowing to invest or bridging short-term payment difficulties.
These don’t need to be fundamentally changed and DeFi comes into play right here.
These concepts are to be gradually integrated into the blockchain sector and further expanded with corresponding products. In the future, users will be able to benefit from the best of both sides, which also makes the long-term investment in cryptocurrencies interesting. The crypto-coins must therefore gain in profit in the future, this should be achieved by the use of DeFi.
So-called “smart contracts” are also to be used. This is a blockchain-based technology, in the smart contracts there is a contractual arrangement that is written down as code.
This follows a conditional logic, i.e. certain conditions are met, then a certain contractual clause automatically enters into force. As usual, therefore, no third instance is required, because the technology itself ensures compliance with the contract. This technology is expected to facilitate business operations and also increase contract security. This is an important point in the DeFi area for working and secure transactions.
What are the types and possibilities of DeFi?
There are different applications in the decentralised financial sector. A large part of the users appreciate the opportunity to make money with DeFi applications. Every application in the DeFi sector finds its counterpart in the traditional financial sector.
Lending – The decentralized credit market
The largest DeFi protocols include Compound or MakerDAO, and they have one thing in common: the main use case is built on lending and borrowing, german borrowing and lending. In this case, tokens/coins are lent, for which the lender receives interest in return, which is exactly the same as in the traditional financial sector. However, no bank is required for this, because the network itself handles all transactions due to the decentralized credit protocol. The own tokens are made available to other participants, in return there is interest on the borrowed tokens. A simple settlement for “borrowers” and “lenders” via Decentralized Finance.
The Staking – Mining Alternative as a Source of Revenue
The so-called “mining” has become very complex. High electricity costs and expensive hardware are needed for bitcoin mining today. But a good and effective source of income is “staking”. When staking, you make your cryptocurrency available to the network. In contrast to lending, no loan is granted, the network is only secured by the deposit of the respective cryptocurrency. In return, there are interest income for the stakers, which are paid out in the respective cryptocurrency. You can see how high the respective Staking Reward (interest) is on your own websites.
Das Yield Farming
When users exchange tokens for each other, it only works if other users have previously provided this liquidity. Users are rewarded with some of the transaction fees. At Yield Farming, the goal is to get the maximum return.
Das Liquidity Mining
Tokens are distributed to users of a specific Defi application. These tokens entitle users at a later date to share in the revenue. With the tokens you participate in a project, so to speak, the user receives a small share in a company for the use of the application.
Derivatives in the DeFi sector
As in the traditional financial sector, there are also financial derivatives in the DeFi sector. This is especially interesting for those users who also trade with traditional options, futures or other financial products. This is also possible with Decentralized Finance in a decentralized market environment. In principle, all underlyingassets such as gold or bitcoin can be mapped by derivatives in the DeFi sector. This opens up a whole new world for all users of Decentralized Finance, which previously existed only in the traditional sense.
Decentralized exchanges – crypto-trading without middleman
Decentralized exchanges never have access to traders’ assets. This is not the case with traditional stock exchanges, because there is a central authority here. This does not exist on decentralized exchanges and therefore no central authority can be hacked. Conversely, this means that assets on decentralized exchanges are particularly safe and well-kept. Registration on decentralized exchanges usually works very quickly and digital assets can be traded immediately afterwards.
Payments in the DeFi sector
DeFi applications already exist for payment processing in the decentralized area. On most blockchains, such as Those of Ethereum or Bitcoin, transactions cannot be processed very quickly. In addition, these can only be scaled to a limited extent, which is why alternatives are being sought. These alternatives include so-called “second-layer solutions”, here we are talking about additional payment infrastructures. To imagine this figuratively, one can say that these are”put on the actual blockchain, so to speak. With this approach, “Off Chain” is able to handle more transactions much faster. The “Bitcoin Lightning Network” is probably one of the most well-known.
Opportunities and Risks of DeFi
The benefits of DeFi
- The traditional financial sector is exclusive and people without a bank account are virtually excluded. Decentralized Finance does not have a restriction of access.
- There are no regulatory restrictions and there are no opening hours as in the traditional financial sector. Trading with assets is possible seven days a week.
- One of the biggest advantages is the particularly high level of privacy protection. No data is processed by third parties, while at the same time providing high transparency, through transactions that are publicly available.
- Cost-intensive financial intermediaries are eliminated and financial services costs are significantly reduced. The degree of automation enables fast processing.
- This market is still relatively new and is only just beginning. Especially in the DeFi sector, there are therefore particularly high chances of return.
The disadvantages and risks
- Decentralized Finance is still in its infancy. There is almost no experience to look back on and there are no long-term observations yet on how this sector will develop over a long period of time. The potentially high returns therefore represent a high risk at the same time.
- Smart contracts can be flawed and, in the worst case, vulnerable to hacker attacks. When it comes to technical solutions, they are currently immature and partly unfriendly to the user.
- Self-responsibility has its advantages, but at the same time this can also be a disadvantage. Each user is responsible for the custody of his or her own tokens, there is no bank or other institution that is in the event of the tokens being lost.
- At present, there is still a lack of regulation in this area. There is no consumer protection and this can be detrimental to legal certainty in decentralised transactions. Pure speculation as well as bubble formation in certain assets can spread particularly quickly in this case.
Especially in the decentralized credit sector, very high returns can usually be achieved with “lending”. Thus, if tokens are deposited and lent at the same time, users of this system have been able to generate high returns in the past. But the market is still very immature and therefore the following applies: only invest as much as one is willing to lose. Highly recommended (as in the traditional financial sector), a wide spread of assets is best not to put everything on a company or product.
The speculative method of liquidity mining and yield farming has been particularly popular lately. The DeFi sector is currently very complex and difficult for “normal users” to assess. However, you shouldn’t just tie your coins to a wallet, use them via DeFi applications and get interest if necessary makes more sense. In the future, all these possibilities and channels will most likely establish a connection between the traditional financial and blockchain worlds.
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