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While cryptocurrency and NFTs have taken the world by storm, many people remain unaware of the concept of decentralized finance (DeFi). If you’re one of these people, it’s probably a good idea to change that.
That’s because DeFi is being touted by some as a movement that will revolutionize the finance industry. It lies outside the bounds of regulators and big and established financial beasts. It’s fresh and exciting, but is it going to be the next big thing in 2022?
What is DeFi?
DeFi is a term used to refer to a variety of disruptive applications which run on blockchain technology away from the influence of institutions like banks and brokerages. These applications are commonly referred to as DApps.
These DApps work on blockchains, like the Ethereum blockchain, and use smart contracts. Smart contracts are essentially lines of code which denote an action that is programmed to take place when certain requirements are met.
When the smart contract is posted to the blockchain, an agreement for a transaction is effectively sealed without the use of a middleman. This could be anything from a bet to an exchange.
This is the concept at its most basic level, which makes it sound simple enough.
Blockchains now host a variety of DApps, which use smart contracts in order to facilitate business and match customers. These DApps vary widely in their services and include exchanges, lenders and stablecoins.
As cryptocurrency remains the most popular aspect of decentralized finance, the most utilised of these DApps are exchanges.
What are decentralized exchanges?
Decentralized exchanges (DEX) are cryptocurrency exchanges that allow for transactions to take place directly between two parties. These marketplaces rely on smart contracts.
These DEX often carry more risk than their centralised exchange, or CEX, counterparts. This is because a CEX will have more stringent requirements about the currencies in which it will deal. On a DEX a user has the freedom to list whatever they want, but that means that the currencies in question might be more volatile and riskier.
Of course, there are plus points to these risks. The cryptocurrencies which have gained the credentials to be listed on your standard CEX had to start somewhere. If you manage to invest in a cryptocurrency at this early stage and then it explodes to the point where it is listed on a CEX, you will have beaten many people to the punch.
Additionally, most DEX exchanges are non-custodial. If you fail to remember the key to your crypto wallet, there’s not likely to be a ‘forgot password?’ link for you to click. On the other hand, you won’t be asked to enter your personal details, allowing you to trade in the comfort of anonymity.
Here are some well-known DEX exchanges:
What are the advantages of DeFi?
Lending using DApps can give customers the chance to avoid using a credit score and simply use their funds as collateral.
Geographic restrictions do not apply. If you have an internet connection, you can access DeFi apps regardless of where in the world you are.
As DeFi is cut loose from the bounds of major financial institutions and governments it can offer an escape from the pitfalls of centralized systems. Promoters of DeFi think adopters would be better placed to withstand the shockwaves of major financial crises than users of traditional financial institutions.
DeFi can offer more favourable interest and lower fees than traditional institutions due to the lack of a middleman. When two parties are interacting directly, less people have to make money from the transaction.
The smart contracts negotiated by different parties can be viewed by anyone after being posted on the blockchain, though the details of the parties remain private.
What are the disadvantages of DeFi?
If an exploit leads to a transaction going through, there are limited mechanisms to correct it. For example, December saw $120.3m stolen from lending platform BadgerDAO. The platform said it had paused all smart contracts while it investigated the hack.
Similarly, if human error on the part of an investor leads to a transaction going through by mistake, there are limited safety nets. The decentralized nature of DApps means that the responsibility for human error falls on the user.
Though it is growing, DeFi is dwarfed by the size and financial clout of traditional institutions. As such, investors might not be confident in DApps handling large and important transactions or accounts.
DeFi is heavily reliant on new technology. This means that things can go wrong. For example, staking protocol Compound accidentally doled out $90m to its users due to a bug in October. While this might sound great, users wouldn’t be quite so happy if the shoe was on the other foot.
So is DeFi the next big thing, or is it just an eccentricity in the financial landscape? At this point it’s hard to deny that the growth of decentralized finance has been impressive.
According to Statista, the amount of cryptocurrency held in decentralized finance stood at $93.4bn on 15 October 2021. This compares to just $10.5bn 12 months prior.
However, some argue that this is not as impressive as it sounds. After examining the Ethereum network, JPMorgan argued that the growth of DeFi has been inflated by the rising value of ETH, which has seen its value leap by over 450% across the year to date.
Additionally, a study released in August by blockchain data platform Chainalysis found that it was nations with well-developed cryptocurrency markets which ranked highest in terms of DeFi adoption, with the United States, Vietnam and Thailand taking the top three spots on their 2021 Global DeFi Adoption Index.
Dydx growth lead, David Gogel, was quoted in the company’s research as stating that DeFi remained targeted towards “crypto insiders”, though he predicted that it would become more accessible “as ETH gas prices fall”.
For all we hear about it, cryptocurrency has only recently come to the fore. Even then, it’s only around 10% of Americans who have decided to invest in cryptocurrency. With DeFi adoption seemingly so linked to cryptocurrency engagement, it’s hard to see a huge wave of mainstream adoption just around the corner.
Even so, these things can explode quickly. When they do, it’s better to be on the gravy train than standing by the tracks watching it speed past. On that note, let’s examine a DeFi project.
A DeFi case study
Avalanche is a smart contracts platform which aims to promote DeFi apps. The blockchain is focused on low costs and high speeds.
Avalanche boasts that its blockchain can tackle a transactional throughput of 4,500 transactions per second, higher than Bitcoin, Ethereum or Polkadot. As such, the network is seen by many major DeFi players as a nice alternative to some of the more established competitors.
For example, noted DEX SushiSwap left Ethereum’s network in March to join Avalanche, citing increased congestion leading to high fees as the reason for the switch.
The switch to Avalanche made sense, as you can deploy smart contracts on the platform at just a tenth of the cost of doing so on Ethereum.
The platform’s AVAX cryptocurrency, which SushiSwap users will now need to have a chunk of, is a fixed cap supply token in a similar mould to Bitcoin, meaning that scarcity can be a factor in increasing its price.
Over the last year, the coin has seen its price rise by over 2,000% to around $80. However, the coin is on a downturn at the moment, having reached an all-time high of $146 in late November.
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