What's decentralized finance?

Decentralized finance, or DeFi, is a catch-all term for financial products that live on decentralized blockchain-supported protocols like Ethereum. The basic idea of DeFi is to rely on smart contracts to automate financial products. The most widely used DeFi products currently are in the realm of borrowing and lending, trading, and derivatives.

Using DeFi apps, you can, for instance, deposit cryptocurrencies into a smart contract that entitles you to a certain yield. This is analogous to a high-yield savings account with a traditional bank, although both the yields and risks involved are typically much higher. The principle, however, is the same in that, behind the scenes, your capital is generally pooled together with the capital provided by others and put towards a variety of yield-generating strategies. For example, it may be lent out to other market participants at interest. The difference from "traditional finance" (aka 'Tradfi') is, since the system is built on smart contracts, it not only functions in a transparent and verifiable manner, but much of the process is automated. For example, your share of the profits made from the yield-generating strategies are automatically distributed to you in the ratio and at the intervals written into the contract. This reduces some of the overhead in the traditional finance industry, potentially reducing the cost of capital and enabling more equitable profit distribution amongst participants. Importantly, because Ethereum is permissionless, anyone with an Ethereum address is free to contribute capital and benefit from the yield it generates. In other words, anyone can become, in effect, a bank that earns interest by lending out money.

Another example of a DeFi application is decentralized exchange. Here you can trade one digital asset for another without handing over either asset to a centralized exchange service provider. Instead, the smart contracts that define the protocol move the assets around transparently and in accordance with the logic of the code. Critically, the system also incentivizes the creation of liquidity on trading pairs. This is important because, for an exchange platform to be useful, deep liquidity is required. Decentralized exchange protocols generally incentivize liquidity creation by rewarding liquidity providers (those who deposit assets into the smart contracts that define the protocol) with a percentage of the fees generated when assets in a given pair are traded. In this way, such protocols enable "crowd-sourced" liquidity, a phenomenon that has the potential to drive efficiencies in markets. From the end-user's perspective, decentralized exchange is an improvement on the status quo because it eliminates the counter-party risk associated with centralized exchanges. In other words, you don't need to rely on a centralized exchange provider to take custody of your digital assets if you want to trade them. Another key benefit (as with all DeFi products) is, again, the fact that anyone can participate. Decentralized exchange is 'permissionless,' meaning it doesn't require you to provide your identity and you can participate even if you live in a country with limited financial infrastructure.

Automated risk management

To illustrate how smart contracts help to automate yield-generating strategies while managing risk, let's look in more detail at smart contract-based lending. Imagine you send 1 ETH to a smart contract that holds your 1 ETH as collateral in exchange for a USD loan. To minimize risk on the loan, the smart contract might be written such that an over-collateralization ratio of 2:1 is required. In other words, you can only borrow up to a maximum of 0.5 ETH worth of USD. If, for example, the value of ETH falls relative to the US dollar below a certain threshold, you'll be required to either pay back the loan (plus interest) or add more ETH to the smart contract, thereby bringing back the collateralization ratio to a safe level. Failing to do either, would, at a certain point, result in the liquidation of your ETH. In other words, if the USD-value of ETH falls far enough while you do nothing, the smart contract will take your ETH, leaving you with only the US dollars you borrowed.

Given the deterministic nature of smart contracts, we can see that yield-generating strategies based on over-collateralized loans and governed by smart contracts have the potential to carry effectively no risk.

Is decentralized finance riskier than traditional finance?

In theory, DeFi has the potential to be less risky than traditional finance, where human error and fraud add to the risk. Unfortunately, human error still very much exists in the realm of DeFi, and so does fraud.

Regarding human error, the deterministic nature of smart contracts combines with the fact that they are open source to make them vulnerable to exploits (at least at first). Hackers can and do find errors or loopholes in smart contracts that allow them to steal money, in many cases without technically even committing a crime. On the other hand, the open-source nature of DeFi protocols means that the longer a protocol exists in the wild, the more battle tested and secure it becomes as the community of developers fix bugs and patch vulnerabilities in response to attacks. This means that, over time, open source software tends to be more robust than closed source equivalents.

As for fraud, the lack of regulation and the anonymous nature of DeFi significantly increases its prevalence in the space. While consumers of traditional financial products can rely on rules and regulations that are backed up by the threat of legal enforcement, this is often not the case in the DeFi realm. Entrepreneurs can write and deploy any kind of smart contract they want and it's entirely up to the consumer to judge whether the contract is 'safe.' Safety in this context may refer to both the exploitability of the contract's code as well as to the yield generating strategies deployed. This, perhaps unsurprisingly, has led to a number of so-called 'rug-pulls' in the DeFi space. Here, what typically happens is a core group of anonymous insiders either retain control over what is advertised as a decentralized project or personally own a majority of the project's native tokens (many DeFi projects issue their own token, the use cases for which most often include governance and yield payments). When enough value has flowed into the system - often thanks to the dangling of extremely high yield-rates for early participants - the insiders simply trade their native tokens for something else and walk away from the project entirely. This almost invariably results in total abandonment of the project and corresponding collapse of the native token price. Another potential scenario is that the insiders deliberately leave a bug in the code, allowing funds to be siphoned off to themselves while claiming they too were the victims of an exploit.


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