But what exactly is DeFi? The term is often thrown around by experienced investors and crypto geeks alike, yet for the everyday or new investors it can seem like something out of a sci-fi novel.
Breaking down DeFi
DeFi refers to smart contracts and decentralised applications (DApps) that are built on decentralised networks, using blockchain technology. The most famous network that DeFi protocols are actively being built on is ethereum, which is the crypto with the second-highest market cap after bitcoin.
Some of the better-known DeFi platforms include decentralised exchanges, lending and borrowing markets, and tokenised physical assets such as gold. It has even expanded to include other financial services such as derivatives, payment networks and insurance.
Here are the three key elements that power DeFi:
- Smart contracts: These are at the core of what makes ethereum unique. They allow applications or scripts running on its network to create digital assets. This enables irreversible agreements, such as payments or transfers, to be authorised with no need for a “middle man,” which would traditionally be a bank or some other established financial institution. Essentially, smart contracts facilitate trust between two unknown counterparties.
- Decentralised applications (DApps): A DApp is a software application that runs on a distributed peer-to-peer network rather than being hosted on a centralised server. They can function like any app that you access using a web browser or your smartphone, except that it runs on a decentralised network, such as the ethereum blockchain.
- Decentralised exchange (DEX): A decentralised exchange is similar to an online trading platform like eToro, except that it is run by smart contracts using the ethereum blockchain. Instead of traditional assets, it allows you to invest in cryptoassets.
Benefits of using DeFi
- Less room for human error: Instead of relying on humans to manage operations, DeFi relies instead on rules written in code (smart contracts). Once your smart contract has been deployed onto the network, the DApp is able to run itself with minimum human interaction. Using blockchain also means transactions cannot be tampered with, creating negligible levels of fraud.
- Access anytime anywhere: DeFi and the DApps that power it are designed to be accessed globally 24/7/365, free from the constraints of international borders. Whether you are in Sydney or San Salvador, you will be able to access your DeFi services with just an internet connection, although it is important to remember that local regulations regarding digital currencies may still apply.
- Flexible user experience: Since DeFi is “permissionless”, anyone has the ability to build or modify them. Many DeFi projects are also built on open-source API, meaning anyone can leverage the building blocks of this tech to build their own application. The collaborative nature of this sector has enabled a vibrant, innovative community to flourish around it, which continuously drives new developments and functionalities.
Drawbacks to using DeFi
- Slower transaction speeds: Decentralised blockchains can be slower than their centralised counterparts, and this impacts the DApps that are built on top of them. Despite this, many developers are optimising their DApps to negate this shortcoming and the technology itself is improving constantly.
- No safety nets: Seen by some as a core tenet of crypto assets, and by others as one of its biggest hurdles for mass adoption, DeFi transfers all of the responsibility from the intermediaries to the user. If you accidentally transfer funds to a wrong address or forget the passphrases to your wallet, then your asset is gone. There is no bank customer support line you can call to undo a transaction or regain access to your account. There is also no insurance infrastructure in place to offer protection either.
- Steep learning curve: Blockchain tech is inherently complex and the additional steps required to use DeFi services can be quite daunting to newcomers. We’re also still in the early days of this technology and, like the internet, many believe (with good reason) that creating a more user-friendly experience is key to crypto assets achieving mainstream adoption.
Future of DeFi
The future of DeFi is bright. DeFi has the potential to evolve how global financial services operate, in a similar way that fintech ushered in the era of online banking and transacting that we take for granted today.
However, it is important to remember that blockchains and decentralisation are not a solution for everything. Identifying proper use cases that can truly benefit from this emerging technology will likely be the catalyst for mainstream adoption in the future.
Robert Francis, Australian managing director of global multi-asset investment platform eToro