The Ultimate DeFi Introduction: Prologue
So, you’re scrolling through Twitter and you see your friends posting about their 100% yearly gains through this thing called “DeFi”.
You scroll a little further down only to see a compilation of “DeFi Crimes”, and even an article where a well-known DeFi platform got exploited… just recently.
But, you’re still wondering — What exactly is DeFi?
For a start, DeFi refers to Decentralized Finance. In this article, I aim to make it as simple as possible to cover these things:
- Benefits of DeFi over TradFi
- What are the risks of DeFi
- What the future looks like with DeFi
Benefits of DeFi over TradFi
To understand DeFi better, we need to recognise the benefits of DeFi. This can be simplified into 3 words: DeFi is permissionless, transparent, and fair.
In my opinion, this is probably the most critical benefit of DeFi.
In emerging countries, there are an estimated 1.7 billion people who can’t access traditional finance because they do not have the capability to provide documentation or credit records required by financial service providers to assess their creditworthiness and perform due diligence.
Think about that for a second — 1.7 billion people have little to no way to hedge against inflation rates just because they don’t own a few pieces of paper or have history with the banks. The traditional system is not only disadvantageous for the ‘unbanked’, but for everyone as well. In a world where we have cars that are able to drive by themselves and robots that can deliver your food in hotels and restaurants, is it too much to ask for a more seamless experience worldwide in terms of finance?
Think of the last time you tried to buy a stock through a broker. It’s dependent on your location and they asked you for multiple other details such as your salary. They probably even called the banks for your credit reports. Not only was it inconvenient if you’re a relatively new trader who wants to buy stocks, but you might also be unnmotivated by the time your broker finishes the whole “know-your-customer” process.
However in DeFi, you are free to trade stocks 24/7 as long as you have access to the internet. You can do everything you would do in traditional finance — such as lending, borrowing, and transferring funds — with low transaction fees and it being virtually real-time, all within a few clicks. This negates the need for any middleman to check whether you are “worthy” of handling your bank/capital.
You don’t need permission to manage your personal finance.
DeFi is built on blockchain technology, hence everything is transparent, from the code to the total amount of money that is locked in a contract.
Not only that, but every piece of data is also immutable. No single person has the ability to edit or make a ‘fake’ record to fuel their greed.
I can’t say the same for traditional finance. If you were to call your bank for the total value locked in their savings account or ask PayPal for the daily transactions in real-time right now, they will most likely laugh first, then hang up on you.
Transparency in DeFi allows anyone participating to make better decisions whether it be for trading, or where to park his/her money. Any form of malicious activity can quickly be flagged by anyone following the various applications, giving a new layer of trust to financial systems.
We’ve seen the whole Gamestop saga where Robinhood halted trades, and how Barclays recently halted transfers into Binance — causing lots of angry people to come out. This is a downside when using TradFi applications.
In traditional finance, any major changes — such as changes to the fee structure or halting of trades — are done at the discretion of the top without any notice.
In DeFi, however, most of the applications are considered DAOs (Decentralized Autonomous Organizations). DAOs essentially shifts the leadership from a “top-down leadership” to “anyone has a say in this company” — as long as they own some of the governance tokens.
This means that no single person or a small collective has the power to make decisions within the DAOs. Every single parameter change is voted through a governance poll, giving everyone a chance to build the future of finance for themselves.
And in case you were wondering, “How is DeFi able to give interest rates of up to 20%?” — the answer lies in fairness through eliminating the middlemen.
Typically for banks and financial institutions, the reason why your interest rates are so low is that they profit whenever borrow rates are higher than deposit rates. The banks and financial institutions then give you a mere 0.05% as a form of appreciation for allowing them to profit.
But in DeFi, because you’re transacting peer to peer and directly through a smart contract, you get the whole share of the pie (minus the transaction fees of course).
This is why DeFi is so powerful — it essentially allows you to be your own bank — without any form of limitations or discrimination that’s available around the clock as long as you have access to the internet.
Although DeFi has been around for some time, it’s wrong to say that DeFi doesn’t come without risks. Here we will cover the major risks with DeFi, and how to manage them.
Smart Contract Vulnerability
Although Smart Contracts have come a long way and are primarily used in DeFi protocols to automate most of the processes, hackers are still able to find valuable opportunities to seize cryptocurrency by watching block explorers & then exploiting the vulnerabilities in smart contracts as they get deployed to various networks. To manage this, there are insurers out there, such as Nexus Mutual, Bridge Mutual & Insurace, that cover most dApps and platforms out there for smart contract exploits.
DeFi hasn’t been around for a very long time, hence it is hard to benchmark for risk-free interest rates and have in-depth insights with regards to the different dApps and DeFi platforms. Generally, this risk is managed by investors themselves, as it is their own responsibility to know the platforms they use inside out, and it is also based on the investor’s appetite for risk/reward. Usually, blue-chip DeFi applications can be found on DefiLlama.
Regulations for DeFi
Because DeFi is a tricky subject for regulators, there might come a day where stablecoins might get frozen, or regulated and taxed very heavily. On this note, it’s critical to use truly decentralized stablecoins such as UST, or partly decentralized stablecoins such as DAI. We will cover the different stablecoins in another article, but just know for now stablecoins aim to be non-volatile, such as UST/USDC/DAI where 1 UST/USDC/DAI = 1 USD
What the Future Looks Like with DeFi
Now, here comes the interesting part. You’re probably asking yourself after absorbing all the information, “So… what does the future look like with DeFi?”
Of course, I will cover these topics in-depth in future posts, but here are some scenarios for you to consider:
As an individual — personal finance reimagined
For a start, we already have Anchor Protocol that gives you roughly around 20% APY. This is much better than traditional banks or investments such as the S&P 500. And imagine you could make lossless investments, where the upside is huge and the downside is… nothing. This is already possible through Pylon Protocol.
If you want to invest in stocks 24/7 — anywhere, anytime — you can do so on Mirror Protocol. With the upcoming launches of Nebula and Mars, we can then extend the power of DeFi to custom-rebalanced ETFs and have multiple hedge funds where the capital is crowdfunded.
Not to mention, after hitting your financial goals, you’d probably decide that you want to donate part of your money somewhere. After all, you want your karma points to go up… right? Well, meet Angel Protocol — where you are able to give once and give perpetually with just one deposit — this is all possible through combining all the funds and then depositing it in Anchor Protocol, where the yields will then be forwarded to the respective charities that you have chosen. To put it in perspective, a collective 1 million in deposit gives a charity around $200,000 runway per year, perpetually.
For businesses — capital efficiency at its finest
Meet Superfluid. What if I told you that you could have access to real-time finance? A place where you can not only receive money in real-time but also set up multiple channels to then redirect those finances towards? This realizes money streaming, and companies are already testing it out.
Instead of having to manually track each and every single payment, only to spend another few hours having to manually pay your employees, and then reallocating money towards business expenses and savings, you can just set your multiple streams once.
After that, sit back and have money flowing into your account, and then out to wherever that money needs to go to — all in real-time. Not to mention, you can see it all under one dashboard.
There’s also this neat application called Alchemix, which allows anyone to have self-paying loans. Crazy right?
Conclusion & Further Reading
Hopefully after reading all these, your mind is filled with excitement and the different possibilities that will come out on DeFi sooner or later. Although DeFi is new and risks are still a thing, I feel that the risks are minimal as compared to the potential of DeFi.
If there is one thing I know for sure, it’s that DeFi is not going to go away any time soon.
If you have any discrepancies with this article, feel free to shoot me a DM or message me. Not financial or legal advice, do consult a financial professional before you decide to make a serious financial investment!