DeFi Demystified!

Among the coverage of NFTs, Bitcoin, blockchains, and everything else related to cryptocurrencies, another phrase is gaining traction: DeFi.

What Exactly Is DeFi?

DeFi is an acronym for decentralised finance. It is often referred to as “open finance.” It is a financial system in which middlemen are eliminated. Like the majority of Web3-related concepts, it is a utopian vision of a financial system. It runs without a central authority. Rather than that, smart contracts and other peer-to-peer (P2P) technology, most notably a blockchain, would control transactions.

To understand De Fi, we would first have to understand Centralaised Finance

As the name implies, decentralised finance is the polar opposite of centralised finance. For instance, if we purchase anything online and pay with a credit card, the credit card company and our bank operate as middlemen before the money reaches the shop’s coffers.

In the scenario described by the majority of DeFi proponents, instead of using our credit card, we would use a cryptocurrency to avoid the costs levied by the credit card company and the bank. However, DeFi’s scope would be considerably broader than simply paying for online goods and services; it intends to completely eliminate banks from the equation.

Loans are an excellent example. Currently, in order to qualify for a loan, we must visit a bank and jump through a number of hoops. Under DeFi, you may execute an online transaction with another party, document the terms and conditions in a smart contract, and then proceed. Rather than engaging with a bank or other type of lending organisation, we would deal directly with another individual.

How DeFi Functions

DeFi is reliant on a few key components to function, most notably smart contracts and cryptocurrencies. Rather than the highly volatile coins with which the majority of people are familiar the majority of DeFi applications rely on so-called stablecoins such as Dai or Tether. These currencies are typically tethered to an existing real-world fiat currency. It is most frequently the US dollar. Hence they do not exhibit Bitcoin’s wild upward and negative price swings.

Additionally, smart contracts are an intriguing new concept. The name “contract” is somewhat deceptive, as these are not true contracts in the traditional sense. Rather than that, they are decentralised applications, or dApps, that exist on a blockchain (often the Ethereum blockchain), self-contained little programmes that execute when predefined conditions are met.

Conditions might be quite straightforward, such as a payment being transmitted on the first of each month, or they can be as esoteric as the signatories like. However, because these dApps are decentralised, once a transaction is made, it cannot be altered. If you agreed to transfer 100 Tether on the first of each month, the transaction will occur every month until you and your counterparty agree otherwise.

Difficulties With DeFi

The idea of eliminating banks from the financial equation surely sounds utopian. However, decentralising your finances entails a number of practical considerations that are difficult to overlook.

The reliance on cryptocurrency is a significant issue. These currencies, including stablecoins, are fundamentally unstable: the majority of stablecoins experience some fluctuation over time, albeit not as dramatically as Bitcoin’s swings. Still, it might make a significant difference, especially if the currency used to repay a loan increases in value; this would increase the cost of your loan, which is a frightening prospect.

Another, perhaps even more serious concern is the question of smart contracts. While they have numerous advantages, there is an enforcement issue: if you sign a contract with a friend to lend him $1,000 and he does not repay you, you can take him to court and obtain the money that way. If someone breaches a smart contract, you’re out of luck because there is no authority to enforce the smart contract.

While their deed is visible to all, and their reputation may suffer as a result, the money is still gone, and you cannot impose payments as you would if you won a court case.

As a result, DeFi, in its current form, is very much a playground for risk-takers. If that is not the case, you may wish to avoid it, as well as crypto and NFTs in general—for more information, see our article on the problem with NFTs. Having said that, if you enjoy being on the cutting edge, DeFi may be the place for you.

To know more about other fascinating concepts of Web3, check out the Crypto101 series by Coin Crunch India.