DeutschRarely before has the world of digital currencies experienced such an upswing as it has these days. A term that hovers above the new trend: DeFi. Behind it is the English term “Decentralized Finance”, i.e. decentralized finance or financial economy. While many banks are still rather slow to discover the opportunities of the crypto world for themselves, the sector of financial projects that focus on blockchain technologies is booming. And thus achieve great success worldwide and attract many interested parties, but above all investors. While many experts agree on the potential of decentralized finance in many points, opinions on opportunities and risks sometimes differ quite widely. Of course, it is often the supporters of the traditional banking and financial system who point out the supposed dangers with a raised finger.
The boom is reason enough for a detailed analysis of the topic of DeFi – of course, in addition to the latest trends, the pros and cons should not be neglected.
Astonishing Developments in just a few Years
Like all new technologies, the DeFi industry has not had it easy outside of its core area. But the willingness of financial service providers to embrace innovative and, in this case, often very inexpensive opportunities is growing. One area that has received particular attention so far is the sector of decentralized lending via credit platforms. Of course, this is only one potential application of the still young technology. The promise of the industry is reflected, among other things, in current investments. According to recent reports in the specialist media, over two billion US dollars flowed into the new projects in July 2020 alone. The number of developers who are involved in creating new applications within the blockchain in order to create “real” offers is also increasing. “Real” in the sense that the programs can have a real benefit not only for “crypto nerds”. The development work has been in full swing for some time, but Decentralized Finance has only recently become a true trend for investors.
Ethereum’s Blockchain Dominates the DeFi Sector so Far
In most cases, the basis for DeFi is the blockchain of the Ethereum community. More than 90 percent of all current protocols in the DeFi sector are currently based on this variant of blockchain technology. As a result, the ETH currency has risen sharply in recent weeks. Credit platforms in the DeFi sector are currently becoming particularly suitable for the masses. For July 2020, the specialist portal THE BLOCK determined the capital deposited in applications in the industry to be a total of 4.3 billion US dollars. Barely two months earlier, the estimate was not even 900 million USD. One of the big, if not the biggest, winners of recent times was the Compound credit portal. It works with its own stablecoin. Users secure interest there by lending their cryptocurrencies or borrow digital currencies from other members themselves.
Several Service Providers Recently Recorded Massive Increases in Value
Compound’s value has since multiplied since its launch in early June 2020. Due to the high potential interest rate, the number of customers increased rapidly. In general, lenders within the DeFi industry can expect substantial returns. Interest rates of sometimes more than ten percent are not uncommon. Compound was not the only one to benefit from the boom. There are several examples of startups whose value has increased by several hundred percent since the spring of this year. In addition to interest, the issuance of Compound tokens (and the counterparts of similarly operating providers) is an important aspect of many DeFi services. The acquisition of the tokens gives owners the right to influence platform decisions. They thus get into a situation that is very similar to that of a shareholder.
Time Flexibility Convinces Investors
Established giants in the industry often act as lenders to the startups. Exchanges such as Coinbase invest a lot of money in the growing DeFi market. Some of the scene giants of the first crypto wave, who have often become billionaires in the meantime, also belong to the circle of patrons of the industry. Not exactly out of self-interest, but rather they are attracted by the prospect of further enormous returns. But also investors from the “normal” world are discovering the DeFi world for themselves. The traditional financial market rarely offers comparably high profits these days. The fact that products in the DeFi sector have now outgrown their infancy makes the services and platforms particularly interesting for representatives of the B2B world. Hand in hand, both divisions could steadily record new growth. The advantage can be seen in one of the most important characteristics of the DeFi protocols.
Your advantage:
They are not limited in time. Anyone who wants to invest in the stock market or “put” money into financial products at banks knows about the restrictions on their own scope of action. The old rule of investing from “9 to 5” is undermined in the crypto and especially DeFi areas. Anyone who is active in the Defi market can use services around the clock and on any day of the year.
No more Binding of Products to Individual Portals
Another, at least equally important, advantage of the new portals is presented when looking at the criteria of security and brokerage. For example, anyone who takes out or grants a loan in cryptocurrencies acts more freely than in the traditional system. Assets are no longer linked to a provider and its platform. Instead, they can be transferred to others at any time. Assets are also convertible. The focus of a comparison of various comparable portals will be on the quality of service for interested parties. Users receive products that are tailored to their interests and needs. In the classic market, providers alone set the framework for services. Individual adaptation to customer wishes, on the other hand, is becoming an important feature in the DeFi area that can and will determine success and failure, as many experts emphasize.
Low Costs Compared to the Normal Financial System
The direct processing via the platform also has an impact on costs. To stay with the example of lending: lenders and borrowers come into direct contact with each other or get in direct contact with the operator. High brokerage fees, as with the well-known credit brokerage outside the DeFi industry, are known to be a problem for investors. However, the central orientation is arguably not only obsolete for many users for cost reasons. Analysts also explain the increasing popularity of DeFi services by the parallel decline in confidence in the “old” market. As the corona pandemic steadily spread around the globe, many consumers lost confidence in the financial industry and its representatives. One person’s joy is another person’s sorrow. The alternative, digital currencies and the associated systems benefit. But also in general, many people understand that there is a second innovative system in addition to the well-known one.
The creation of Bitcoin in 2009 was the foundation for what we know today as Decentralized Finance. The developers of digital currencies wanted to move away from the central financial system of central banks. Also, the term system dictatorship and lack of transparency were and are popular buzzwords in the industry when it comes to the weaknesses of the old financial world. Systems should be secure, free and, above all, accessible to everyone. Censorship should be impossible. Decentralization instead of centralization. What is now possible through the DeFi world about a decade later? The mentioned loans are of course only a noteworthy topic complex. The so-called Smart Contracts open up many exciting possibilities. The decentralized applications – digital Apps or “DApps” – are precisely tailored to individual products. And they can be programmed and combined as desired, basically according to a modular principle. Once an application has been integrated into the blockchain, it runs there completely independently.
Internet Access & Wallet are Sufficient as Access to the DeFi World
An elementary point of the DeFi Smart Contracts: They not only work without the influence of a bank; once recorded in the code, information is also unchangeable and therefore “law”. The low fees mentioned also make DeFi developments interesting for investors. If you ask about the target group of DeFi DApps, the answer can actually be: For everyone. Because the blockchains are mostly openly accessible. Anyone who feels addressed can become part of the community. An internet connection and a crypto wallet are the only prerequisites for access. The wallet or digital wallet takes over, so to speak. Portals such as DeFi Pulse, which allow a sorting of countless DeFi DApps according to different categories, provide a good overview of established and new DeFi offers. Of course, there are other platforms that work more or less similarly.
The Reason for the Strong Investor Interest
Crypto investors who do not only want to proceed according to the “buy and hold” strategy (also known as “Hodln” in the crypto world) will find more and more new offers in the area of DApps to invest equally cheaply, quickly and easily – also lengthy and tedious legitimations are eliminated on the portals. However, the increasing crypto regulation in many countries could bring about changes in this point in the coming years. Unlike banks, there are often no minimum or maximum requirements for investments in DeFi offerings. Small investors can be just as active as large investors, DeFi becomes the great “equalizer” in this context.
Let’s take a look at the summary of DeFi advantages in bullet points:
- DeFi works decentrally and with spatially/temporally unrestricted access
- Investors only have to reckon with low costs
- Investors set investment amounts themselves
- Systems work completely transparently thanks to blockchain
- Smart Contracts & DApps work as open source, are accessible to everyone
As for the disadvantages: The fact that only cryptocurrencies can be used to participate in systems is only superficially disadvantageous. Because anyone who wants to enter the DeFi sector as an investor will also be willing to acquire digital currencies. The need to open your own crypto wallet is also not a serious problem for beginners. The question of the tax treatment of crypto income as well as the risk assessment of the young asset classes is already more complicated in this regard. But here, too, many states worldwide are working on legal solutions.
Some Use Cases in the DeFi Sector so Far
We have already learned about two important areas of application. The stablecoins on the one hand and lending on the other. Here, the Decentralized Finance sector has triggered a real revolution in some parts. Stablecoins differ from normal cryptocurrencies in their link to other currencies, more precisely to fiat money. Tether, for example, is pegged 1:1 to the US dollar. Due to this property, stablecoins lack the volatility of Bitcoin and Co. Stablecoins are not real DApps, but they are essential for accessing many offers. Crypto exchanges such as Binance or Kraken are sometimes criticized because customer holdings are held by them. Over time, Decentralized Exchanges – also called DEX – have emerged, which eliminate this problem. Crypto derivatives such as options or futures are another DeFi growth market.
The offers can optionally be used as a speculation object or to hedge crypto holdings. Trading, in turn, is largely carried out via centralized portals – such as BitMex or Binance. No less interesting is the area of crypto funds. As in the traditional market, there are both actively and passively managed products. The providers promise lenders impressive returns. So far, this industry is still in its infancy, and some experts do not yet consider the approaches to be mature enough.
From Insurance to Gaming – DeFi Convinces many Providers
Insurance providers, in turn, are increasingly recognizing the opportunities of decentralized products and are launching insurance policies with which, for example, deposits in crypto funds are secured. The offers are not without risk for policyholders. The enormous capital deposits in insurance funds magically attract hackers. Service providers such as Nexus Mutual are constantly working on technical optimizations and higher security standards. In an analysis of the DeFi application examples, payment options must not be missing. The DeFi sector not only makes transfers dramatically cheaper and faster through the direct processing between two parties. Thanks to DeFi, people in countries with poor or no functioning banking worlds also gain access to a payment system. A wallet and a mobile device are enough to send or receive money. Lightning Network and xDai are two popular providers. In addition to these core areas, new niches are constantly emerging. The gaming and gambling sector, for example, has long recognized the opportunities that DeFi offers to increase sales and generate new customers from all over the world.
Is DeFi Always Decentralized & What are the Risks?
In fact, some industry experts emphasize in their analyses that not all offers work fully decentrally. That’s why terms like “semi-decentralized” emerged at some point. For example, if exchanges hold currencies for their customers, while interest rates and prices are determined decentrally, one can speak of semi-decentralization. Here, too, a number of other scenarios and combinations of decentralized and central functions are conceivable. A fundamental risk of DeFi is the unpredictability of developments. Even experts cannot make correct forecasts at every moment as to how the (Ethereum) blockchain will develop. A “run” of new users on the technology, for example, could cause the blockchain to become completely clogged, which has been noticeable several times in the past. A discrepancy between the number of transactions and newly created blocks in the chain can also occur. In addition, DApps can malfunction if transactions are not processed within a specified time window.
Large Crowds Can Fuel Fees
Higher transaction fees may be incurred for transactions to be completed successfully. Whoever pays will be preferred. Thus, the often praised equal treatment of all users would no longer be given. Excessively rising fees can lead to the failure of applications. Another sticking point of DeFi applications are possible technical risks. DApps are often interconnected, which poses the risk of interactions in the event of problems and errors. Hacks can also affect several applications at once. Critics often refer to the aspect of the admin key risk”. This is about the fact that in individual cases changes can be made by developers and administrators, which have consequences for users and investors. Theoretically, DApps can even be stopped completely.
| The golden rule for users:
→ Always keep the private key for smart contracts safe and without access for third parties! |
Last but not least, a possible liquidity risk should be mentioned. Here, the way exchanges and platforms work is crucial. If apps work with different currencies, transactions – i.e. buying and selling – can take place either via reserves in the system itself or via decentralized exchanges and thus externally. Here as there, depending on the utilization, liquidity problems can occur, and difficulties can also arise in providing the necessary collateral.
So What Can DeFi Bring for the Future?
If you ask supporters about their expectations for the development of the DeFi sector, the statements are largely optimistic. Especially if the service providers succeed in eliminating the small and large problems, the chances are good that the industry will continue to grow rapidly. The concerns of many bank representatives, in any case, are quite justified that the young competition can and probably will outstrip classic banks and financial service providers to an even greater extent in the coming years.
