If you’re looking for new ways to handle your money, you’ve probably heard of Decentralized Finance, or DeFi for short. While at first, it seems like a broad term used to describe finance without third parties, DeFi has many specific connotations and uses within the world of Web3 finance.
So How Does it Work?
The idea of decentralization is at the center of most Web3 concepts, and there are countless ways to implement it. When a blockchain, cryptocurrency, or wallet implements it to a satisfactory level, it is referred to as DeFi.
A DeFi blockchain has no governing body, a DeFi cryptocurrency has no one pulling the strings, and a DeFi crypto wallet lets you store cryptocurrency in a way that’s not governed by any institution.
The majority of DeFi assets and operations are centered around the Ethereum network, a decentralized blockchain where financial operations can be executed through code rather than through a bank.
Many networks do this, but the Ethereum network is especially unique in the level of complexity that the transactions can have. While other networks might let you do very little beyond simple cryptocurrency transfers, Ethereum can allow you to do much more, from signing digital insurance contracts to betting on the outcome of sporting events.
Why Do People Use it?
There are a number of reasons why people use DeFi. First and foremost is that it’s often cheaper. Your money doesn’t pass through the hands of anyone but the people making the deal. That means there’s no one around to charge fees.
More than that, though, is the level of privacy and independence that comes with DeFi. When money is transferred, it never passes through anyone’s hands except the sender’s and the recipient’s. When money is held, it’s never held by a bank or other entity that might have interests contrary to your own. DeFi completely cuts out third parties in finance, and that empowers the individual in a way that few other things in finance can.
This idea of self-reliance in finance has a long history in the world of cryptocurrency. In the early days, it was seen as the main attraction. The early Bitcoin investors, for example, were mostly drawn in by the idea of removing the need for government in finance.
Nowadays, although many parts of the crypto world have developed their own institutions, there are still people that seek out places and tools that let them make their deals away from any higher authority.
What If I Don’t Want to Trade in Volatile Cryptocurrency?
If volatility scares you, you might choose to seek out and buy stablecoins, crypto assets whose value is tied to real-world assets. These coins each have a real-world asset or currency that they share a value with, from an ounce of gold to the US dollar. Often, common currencies like the dollar will have several stablecoins tied to them, each made by a competing group trying to provide the best, most secure financial experience to users.
Stablecoins themselves can be DeFi or centralized, and it can be impossible to tell the difference without doing research beforehand. For instance, Tether, the most popular stablecoin, is entirely managed and manipulated by the company Tether Limited. In practice, this has little effect on its use in DeFi networks, but for some, it’s an important ideological barrier. After all, the point of decentralization is that there is no third party.
Additionally, stablecoins can be less than stable if they’re poorly designed. Recently, a dollar-based DeFi stablecoin called TerraUSD dropped in value to less than two cents due to poor programming and financial mismanagement on the part of its creators. After some deliberation, those creators decided to drop support for the coin entirely rather than restore its value.
This seems like a scary precedent, but no other stablecoin on the market even comes close to the conceptual faultiness of TerraUSD. The coin relied on a unique “mint and burn” system in collaboration with its volatile sister token. When the sister token got too volatile, the system ceased to function properly. Other stablecoins take a far safer approach, backing their value up with asset and currency reserves.
Is DeFi Ever Used for Crime?
Yes, DeFi cryptos and networks have been used by organized criminal organizations to launder stolen funds. However, the proportion of illicit activity on DeFi is far smaller than it is in banking or other centralized finance networks, and it’s largely confined to its own little corners of the internet.
The fact that there are people out there using it for crime isn’t something that should scare you away from DeFi entirely. Aside from the fact that all forms of finance are used for crime, DeFi’s effectiveness in cutting out third parties helps empower you to only make deals with the people you want to deal with. Each transaction is private, and no one can observe or interfere.
Does DeFi Mean Additional Risk?
Using DeFi means you accept a different type of risk. Dealing with a bank makes you vulnerable to the bank, and dealing with a centralized cryptocurrency asset/service makes you vulnerable to its creators. In turn, dealing with DeFi makes you vulnerable to the code that replaces creators and banks.
For example, if you were to set up a contract on a DeFi network, the network will only understand the code of the contract rather than the intent behind it. This means that your money is being handled by a hyper-literal machine instead of a human. If something goes wrong as a result, and the other party refuses to reverse the transaction and help you program a new contract, no one has the authority to step in and fix everything.
The hyper-literalism of DeFi code isn’t just limited to virtual ‘smart contracts’ either. A DeFi wallet might be programmed to delete its valuable contents after too many failed password attempts, regardless of any other circumstance.
A DeFi network might be open to hackers through a vulnerability that can’t be fixed without a lengthy community voting process. A DeFi coin might end up like TerraUSD. In the end, independence always comes with greater risk, and crypto is no exception.
Should I Get Involved with DeFi?
It’s really up to you. Do you think the financial benefits outweigh the risks? Are you looking to support the cause of decentralization in finance? These aren’t easy questions, and no one can answer them for you.
Until you’re secure in your conclusions, consider crypto’s oldest and strongest advice: Do your own research, make your own decisions, and don’t make any investments you can’t afford to lose.
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NFA: Not Financial Advice. IYOPS or the author(s)/editor(s) are not registered investment advisors or brokers/dealers. All investment opinions expressed are from the personal research and experience of the author/editor and are intended as educational material. Despite our best efforts to make the information available as accurate as possible, occasionally, we err, as humans do.
DYOR: Do Your Own Research before making any investment decisions based on your personal circumstances. We recommend taking professional advice before making any investment decision.
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Daniel Speth is a content writer at the International Youths Organization for Peace and Sustainability. He is also a final-year student at the University of Cincinnati, majoring in Rhetoric and Professional Writing as well as Creative Writing.
Inputs and Edits by Aswin Raghav R.