There has been a sharp rise in disruptive cryptocurrency innovation in recent years that has rapidly changed the digital currency landscape. One of the fastest emerging areas of the cryptoverse today is decentralized finance or DeFi.
It is the hottest and most shocking crypto trend that is revolutionizing the traditional financial system with the promise of a borderless, frictionless, decentralized, cheaper, and faster alternative.
For the uninitiated, DeFi comprises a network of applications designed to replicate conventional financial products with cryptocurrencies.It works within a peer-to-peer ecosystem that eliminates the intermediaries necessary to make decisions or approve transactions in the traditional financial system.
“DeFi is financial services, controlled not by humans or any entity, but by public smart contracts available on the blockchain,” says Viktor Prokopenya, a tech entrepreneur and founder of Capital.com and Currency.com. “The operation of the service is published in the public ledger so that anyone can see them.” This is usually why people say that there is no legal entity behind DeFi, which gives us the concept of entity-less financial services.
The DeFi market is booming as more crypto enthusiasts, app developers, and opportunistic investors are attracted to it. As of October 5, there is $55 billion worth of DeFi-related contracts in funds, a huge jump from $15 billion in 2020, but significantly down from its peak of $180 billion in November 2021, according to DeFi Llama.
While this year’s unrelenting cryptocurrency volatility may have slowed things down, experts say it’s still early days for DeFi.At its current growth rate, it is poised to become a major element of the digital economy as the world continues to pivot toward DeFi. Investors looking to take advantage of the latest wave of cryptocurrencies may want to dig deeper into this handy DeFi guide.
Much of what DeFi applications do is underpinned by blockchain-based smart contracts that are used to design financial products that people can use without the need for intermediaries like banks or brokers.
Ethereum is the world’s first and most widely used smart contract platform. Developers can build financial applications on top of these blockchains.
“A smart contract is simply the program behind the token and its code is published publicly on the blockchain,” says Mr. Prokopenya. “They are considered a fundamental building block for DeFi.”
These applications work autonomously and have a smooth interface with each other. This gave rise to a DeFi ecosystem that enabled developers to create efficient, faster, and highly profitable businesses, including exchanges, banks, insurance markets, derivatives markets, art markets, and robotic advisors, all running smoothly and without human interaction.
“The ways DeFi is being used include through decentralized exchanges [DEXes]where participants can exchange one token for another,” says Mr. Prokopenya. DeFi applications are also attracting yield-seeking investors who can secure capital in smart contracts in exchange for returns of 15 to 30 percent.
DeFi enables financial activities without an intermediary, allowing you to be your own bank. Investors can use DeFi platforms to earn returns, just like they do with their savings account, but without a financial institution involved. This process is called staking, in which it “locks crypto assets for a set period of time to help support the operation of a blockchain,” says Mr. Prokopenya. “In exchange for staking your crypto, you earn more crypto.”
Much like banks do with fiat currency in centralized finance (CeFi), DeFi lending allows users to lend cryptocurrency and earn interest as a lender. It is similar to having funds in a savings account and earning interest over time. “It’s similar to having funds in a savings account and earning interest over time,” says Mr. Prokopenya. “That money is then loaned out to other users or sent to market makers, providing the investor with passive income.”
While interest rates fluctuate in the CeFi and DeFi domains, the latter does not require borrowers to pledge tangible assets as collateral. Instead, DeFi borrowers provide crypto assets in a process that is completely anonymous and without human intervention.
DeFi generates higher profits for users because there are no bank branches, employees, or other operating costs for CeFi to deal with.
The divergence between the two systems becomes more significant in the event of a loan default. Unlike the conventional financial system, DeFi borrowers do not pay with physical assets in the event of a potential debt default.
Debt defaults are simply not allowed in DeFi.
When the price of the cryptocurrency used as collateral falls sharply, a preventive measure is activated. The cryptocurrency held as collateral is liquidated to recover the loan before the value of the collateral falls below the value of the loan.
Keep in mind, however, that DeFi also carries risks inherent to cryptocurrencies, including the prospect of intense regulatory scrutiny, extreme price volatility, and the technology itself. There is no provision or mechanism in DeFi to recover lost assets due to technological or human error.
Billions of dollars worth of cryptocurrencies are locked up in the DeFi ecosystem as funds continue to pour in. So how does it connect to the DeFi bonanza?
DeFi is built on smart contracts that run on the Ethereum blockchain. Therefore, the easiest way to invest in it is to own Ether or ETH, the native currency of Ethereum.
There are other DeFi-powered coins, such as Cardano (ADA), Chainlink (CHAIN), Aave (AAVE), Uniswap (UNI), and the Curve DAO token (CURVE), among others, that can link your portfolio to DeFi fortunes . These coins not only offer exposure to various segments of the DeFi industry, but each token is also a ticket to tap into the growth of their respective DeFi protocols.
For example, if you invest in Ether, and the Ethereum protocol grows and attracts more users, it will drive the demand for Ether, thus appreciating its price and the value of your investment.
Another way to play the DeFi field is yield farming, considered to be the most disruptive part of DeFi. It is a process of generating passive income by borrowing and borrowing on crypto lending platforms. “You lend your money temporarily and because the purpose of the business entity is to make a profit, you take a portion of the profit and earn passive income,” Mr. Prokopenya says.
In addition to performance, some protocols offer an additional reward, in the form of a new token called a liquidity provider (LP) token, which the owner can hold, use in DeFi applications, or sell for cash. “The easiest way to get started is through staking and other passive income options,” says Mr. Prokopenya, adding that it is a great way to “get familiar with smart contracts, wallets, and tokens with less risk.”
The continued convergence of blockchain technology and financial applications is expected to continue to expand the DeFi ecosystem. DeFi supporters say that it is a more efficient alternative to the current CeFi system.
However, there may be some speed bumps along the way. “This is a new technology, so regulation is coming,” warns Mr. Prokopenya. “It will also be brought into the realm of tax regimes and there is now an international consensus on that.” All virtual asset providers will be required to report transactions to tax authorities, which is a significant move, he says.
Investors should be on the lookout for various cryptocurrency fraud schemes. “The rule here is a double check, triple check: be suspicious,” he says. Fraudsters tend to exploit some technical risks inherent in the emerging DeFi system.
However, cryptocurrency investors have a lot to look forward to as the burgeoning DeFi economy opens the doors to once-in-a-lifetime opportunities in 2022 and beyond. It is a whole new way to gain access to the cryptocurrency market for both devoted investors and those just dabbling in it.
But be sure to research your investment thoroughly, do your due diligence, and invest only what you can afford to lose.
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