Decentralized Finance (DeFi) has blown up in the past years. With it being such a new trend, there may be some new concepts you should know. We’ve got you covered with our introduction into the world of DeFi, its working mechanism, as well as its pros and cons.
What Is DeFi & How Does It Work?
Basically, DeFi is an entire financial system built upon cryptocurrencies and digital assets. DeFi can be seen as an evolution from traditional finance, pushing for a decentralized financial ecosystem that removes many, if not most, intermediaries in financial transactions and grants end users more control over their money through personal e-wallets and greater access to financial services.
Defi allows for transactions (trading, lending and borrowing) involving digital assets (cryptocurrencies, NFTs and many others). Transactions are executed by smart contracts, which are computer coded programs, all of which are built on top of blockchain networks. This is where the Finance comes from in DeFi. The Decentralized aspect of blockchain revolves around the distributed ledger — the record of all transactions — being a common reference across the different nodes of the blockchain network.
Pros Of DeFi
DeFi offers many benefits for users over traditional financial systems. First and foremost, DeFi makes financial services accessible for anyone with an internet connection and smart device. As per data released by the World Bank, 1.7 billion adults worldwide still don’t have access to a bank account (2017 data) (2021 data forthcoming). With DeFi, your e-wallet is considered your bank account and with an internet connection, you have full access to financial products and services on offer. By the end of 2021, Crypto.com reports the global crypto market had 295 million users. Given the day and night availability and accessibility of financial products and services, which is a major barrier, DeFi is poised to grow at a faster pace than traditional finance.
In general, DeFi offers lower transaction costs; by largely removing intermediaries and their associated fees. These points are clearly illustrated in McKinsey’s 2021 Global Payments report, which reports that banks globally generated, from retail users, 294.5 Billion dollars in revenues related to transfers (both domestic and cross border) and a further 245.2 Billion dollars in revenues related to account related fees (e.g. maintenance and overdraft fees). While users still incur transaction fees (including gas fees) in DeFi, these fees pale in comparison to traditional finance and banking. Wire transfer fees are generally between $25 and $30 for outgoing transfers to a bank account within the US, and between $45 and $50 for transfers going out of the US. However, the average fee on Ethereum is approximately $15.8, much lower than that of traditional banking. Furthermore, while “cash cows” of traditional banking such as account maintenance and overdraft fees are inclusive, these kinds of fees simply do not exist in DeFi.
Cons Of DeFi
DeFi and its benefits do come with some risk, which include scams, hacks, and the lack of extensive insurance coverage. As DeFi exploded into existence, governing laws and regulations were vague or unclear and developers nonetheless rushed to market with their solutions, fully accepting of the associated risks. This type of environment is conducive to scams and hacks, something we see all too often. Statistics show in 2021, crypto scammers took a record of 14B, and in the first 4 months of 2022, Defi protocols had lost a total of $1.57 billion to hacks. The mismatch of the pace of technological innovation in DeFi and regulatory governance has created vulnerabilities that directly impact the end user.
Another risk aspect is the lack of insurance coverage. Given its decentralized and open nature, where there could not be a federal deposit insurance program (i.e. FDIC), the responsibility of insurance coverage shifts to the financial services provider. As of April 2022, three pre-eminent blockchain insurance companies only covered 0.69% of the total lock-up value of DeFi. Further, the growth rate of insurance coverage does not match that of DeFi and there is no certainty as to when the value locked in by DeFi will be fully insured.
Decentralized Finance offers huge potential to end users. Using blockchain technology, new waves of applications make DeFi 24/7 available, accessible, and help reduce costs. However, proper solutions to prevent scams and hacks and offer insurance are still missing. These significant issues need to be solved in order for DeFi to fully evolve financial systems on the basis of blockchain technologies.
We hope our short guide helps you on your journey into the Decentralized Finance ecosystem.
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Disclaimer: The article should not be taken as, and is not intended to provide any investment advice. Claims made in this article do not constitute investment advice and should not be taken as such.