low fidelity, high fidelity, definition? If you have followed the world of NFTs, blockchain, or cryptocurrencies even a little bit, you have probably come across the term “defi”. stands for “decentralized finance” and may be the future of the financial system as we know it.
defi is still in its relative infancy. Similar to how the early days of the internet had a “wild west” feel of basic chat rooms, rudimentary websites and early online service providers, crypto enthusiasts say a growing number of chain networks of blocks, decentralized exchanges and defi protocols are paving the way. for the future.
Reading: Is bitcoin defi
but are they really creating the future of finance? And what does it mean for crypto investors today? here’s what the experts say.
decentralized finance (defi) defined
Decentralized finance refers to a financial system that is not built on or around a central figure or institution, but is instead driven by a number of distributed actors and organizations that often work independently or together.
for example, the traditional finance industry (cefi, or “centralized finance”) revolves around large key institutions such as the federal reserve, payment processors, and large banks. the defi space aims to sideline those big players, allowing individual projects and teams to take on those roles.
“In the defi space, there is no central authority to report to,” says shirin bucknam, co-founder of the crypto witch club, a brooklyn-based online education community dedicated to blockchain and web3. “It’s really a radically new way of doing things.”
In reality, cryptocurrencies and decentralized finance are attracting more and more scrutiny and attention from lawmakers and government regulators as public interest and adoption grows. however, these decentralized ideals continue to inspire new crypto and other defi projects.
In the defi world, the established intermediaries that make the financial system work are all replaced by software or code, called “smart contracts”. therefore, when you execute a transaction, a smart contract handles the heavy lifting, connecting the right parties and ensuring that the transaction goes through. This is, in general, how the cryptocurrency ecosystem works, and one of the reasons why defi continues to grow in prominence and importance.
“defi enables applications, which are built using smart contracts; the idea behind defi is that all products and services found in today’s economy can be run automatically by automated code,” says dr. Merav Ozair, Blockchain Expert and Fintech Professor at Rutgers Business School.
To summarize, defi is, by and large, a collection of lending platforms, exchanges, and many other institutions that were designed and created apart from the traditional financial system, and operate on their own, with no central authority or vision directing it.
defi vs. cefi (centralized finance)
While an unregulated financial system may sound great, there are also some obvious drawbacks. The most obvious is that the defi ecosystem lacks the consumer protections of the traditional system, things like deposit protection or the security measures provided by the rigorous IPO process that stocks go through before being traded on the markets. public markets, which helps investors to have a clear idea of what they want. you are investing.
Perhaps the biggest problem with defi, currently, is that it is riddled with bad actors looking to make a quick buck. that’s one of the reasons for the prevalence of scammers and pump-and-dump schemes in crypto markets, for example.
There is also the possibility that defi projects could run into issues with fundamental smart contracts, says ozair. “Any app can have bugs,” she says. “You have to be careful because sometimes the algorithm can go crazy. the codes [smart contracts] are just rules. it’s not really smart, it’s just as smart as the person who wrote it.”
ozair adds that without a central authority checking the many algorithms and defi projects for problems before they become publicly available, there is always the possibility that consumers will bear the brunt of an algorithm gone haywire.
With that in mind, cryptocurrency experts and enthusiasts believe that defi may offer some advantages over the traditional system. Bucknam says that for people who want “complete control over everything” regarding their finances, Defi is a godsend, for example. she also says that people can get higher interest rates by staking their crypto than they are likely to get by using a savings account at a bank.
With an online savings account, Bucknam says he only earns 0.5% per year in interest. but “by staking defi with stablecoins, I can get an 8% annual return,” he adds.
Of course, the higher potential reward of cryptocurrency staking comes with a fair amount of additional risk compared to a classic high-yield savings account. For starters, you will not benefit from fdic insurance when staking your crypto. fdic insurance guarantees your money in the unlikely event of a bank failure. With crypto, a similar institutional failure offers no such guarantee that you will be able to get your funds back.
In addition, online savings accounts and even conventional savings accounts are steadily increasing rates lately as the cost of borrowing rises amid the Federal Reserve’s efforts to reduce inflation. and a smart conventional investment strategy can easily deliver returns of 8% or more over the long term. therefore, while it is possible to reap higher rewards by staking crypto than by storing it in a savings account, it is not as favorable a comparison to conventional investing.
It’s still early days for defi, so if you’re comparing conventional financial products to crypto networks, it’s smart to weigh the risks against the potential rewards. experts say it’s best to have no more than 5% of your total portfolio invested in cryptocurrencies, and only go so far after you’ve built an emergency fund and paid off any high-interest debt.
what does defi do?
another key question: what is the point of defi? What does he do? you’ll likely get different answers depending on who you ask, but it usually boils down to one central goal: giving people more control over their own finances and, to some degree, over the financial system.
In a word, defi has to do with freedom. Depending on the person, it is possible to use the defi space to have full and complete control over their assets (either in crypto or a fiat-backed stablecoin, etc.). blockchain technology acts as a permanent record of transactions and ownership data, and transactions can often be executed faster than they would in the cefi system.
But again, that freedom and control comes at a cost: there are fewer security measures to keep defi consumers or participants and their assets safe. it’s truly a “wild west” feel, where if you lose your assets to hackers or other means, there may be no recourse to get them back.
how does defi work?
the defi system works on the basis of smart contracts. and smart contracts are, in simple terms, pieces of computer code. they are basically instructions that tell a software program what to do under certain circumstances.
“Smart contracts are just code. they are instructions to run an application,” says ozair. “everything is based on rules.”
See also: Bitcoin&39s impact on data centers
That means when you execute a transaction in the defi ecosystem, smart contracts read the details of the request, and those smart contracts follow a series of protocols to push the transaction through the system. For example, if you press the “f” key on your computer keyboard, you send instructions through the computer system to display “f” on your screen. smart contracts work in a similar way, says ozair.
In the cefi system, several players are involved, which can cause serious delays in the transaction. If you execute a transaction, for example, the bank needs to work with another bank, and often other intermediaries, in exchanging funds and instructions. even a simple transaction can involve numerous companies or institutions.
defi effectively smoothes all that out, making things easier, faster and cheaper, if all goes according to plan.
what is defi based on?
You are likely familiar with the fundamental tools that defi projects rely on: specifically, ethereum blockchain networks and smart contracts. Essentially, projects or applications (often called “dapps”) are commonly, but not exclusively, built on the ethereum blockchain and then automated using smart contract protocols.
Blockchains are basically distributed public ledgers and are commonly used in the crypto space to record transaction information. Combined with smart contract technology, dapps can execute transactions on their own, without the need for intermediaries (banks, etc.). it’s automated, which can be nice, but then again, there’s always room for error.
“It’s good that there’s no middleman and no bias, but it’s not good if the app isn’t written correctly,” says ozair.
how to participate in defi and what it means for crypto investors
If you’re interested in getting involved in the defi space, there are several ways to get involved. But perhaps the easiest thing is to start buying cryptocurrencies or other digital assets using an exchange.
This would first involve setting up a crypto wallet, giving you a place to store and transact your assets. then choose an exchange to work with, or even which specific coins or cryptocurrencies you would like to participate with. Since some work on certain blockchains and not others, this might require a bit of research.
then you can see your options to participate, either trading cryptocurrencies or lending them for rewards. Of course, you’ll need to be careful as the space is unregulated and fraught with risk.
For investors, the idea is relatively simple: the more sophisticated, practical and useful the application of defi networks and products becomes, the more people will be forced to participate and adopt new ways of doing things. and to do things in defi, new entrants will first need to buy crypto to gain access, which remains the clearest path to increasing the value of crypto.
is bitcoin considered decentralized?
Bitcoin, the grandfather of all cryptocurrencies, is a good example of a defi project. There is no central bitcoin authority: it is not issued by a central bank or managed by any central institution. And naturally, it works with a blockchain network, instead of being stored on a central server.
if you already knew, then you already had a basic understanding of how defi works. but it is important to know that defi projects are not based on the bitcoin blockchain, but are usually based on ethereum. Bucknam says that’s because the ethereum blockchain is faster and more efficient, which is essential for dapp developers.
“bitcoin [blockchain] is like the netscape of the crypto world, it’s like a [version 1], it’s slower than the others,” she says. and, more importantly, she says that the defi space is rapidly evolving in a way that resembles the early world wide web. “Right now, it’s defi like when Google came out in the early 2000s,” she says.
ozair agrees. “Blockchain technology today is in its early stages and is similar to the internet in the early 2000s,” she says. With that in mind, there will be some bumps and bruises along the way, she says, but over time, “there could be an amazon or google of the future in defi space.”
what’s next for defi? further refinement, says ozair. “The next step is to figure out how to make good code and improve everything.”
See also: What Does Staking Mean in Crypto?