What is DeFi and how does it work?
Decentralised finance, or DeFi, is fast becoming an important part of the financial services system run in the blockchain network. However, it shouldn’t be mistaken for crypto. Discover what is DeFi and how it works.
What is DeFi?
Decentralised finance, commonly known as ‘DeFi’, is the term used to describe a blockchain-based financial services system that removes the need for transactions to be approved by government agencies. In simpler terms, the DeFi is like a blockchain financial institution or banking system where you can trade digital assets or cryptocurrencies without transaction costs from institutions like the central banks.
The Defi is also a free, open-source digital marketplace that enables users who code to innovate and develop their own decentralised apps (dApps). Defi platforms offer payment services, trades and investments, loans, insurance and asset management.1 While DeFi may seem appealing and beneficial to the user, there are some associated risks.
How does DeFi work?
DeFi uses a technology-led blockchain ecosystem to bypass the traditional financial services management systems and processes, or ‘middle man’. It achieves this by using digital wallets, smart contracts or digital agreements and oracles.
As a decentralised system, DeFi has a financial infrastructure that’s run on multiple computer networks serving as public ledgers that stores digital copies of the transactions. It uses cryptos and smart contracts or digital agreements on the Ethereum network, the second largest crypto marketplace to Bitcoin.
This emerging fintech uses dApps, which are made up of hardware, software and stablecoins. These enable users to lend, borrow and trade cryptos without receiving approval from the central banks or other government agencies.
The DeFi boom has seen US based company Coinbase adapt this concept and build a decentralised crypto stock exchange, known as a Global Digital Asset Exchange (GDAX).
The DeFi concept is a game changer and is also being adapted to mortgages, loans and other banking products.2
What are benefits and risks of DeFi?
There are a number of risks and rewards associated with using the DeFi. These are unpacked below.
The benefits of DeFi1
- Transact in real-time and with increased transparency. DeFi interest rates are updated several times per minute
- Increase the transaction transparency with accounts activity that can be listed publicly and verified by other users within the network
- Saving on transaction fees and other traditional financial services costs and charges
- Gaining higher interest rates faster than over a month as done by traditional financial institutions like banks
- Storing of peer smart contracts between parties on a public database on the blockchain that’s only closed when the outlined conditions of the digital agreement are met
- Programmed smart contracts ensure the automatic execution of terms of agreements. For instance, the agreement can be programmed to automatically release the collateral once the terms of a smart contract have been met
- Build your applications on DeFi since it’s open source. This means users seeking to view and make edits to the source code so no need special permissions
The risks of DeFi1
- Fearing the loss or sealing of funds from the system
- Hacking is a serious threat as sophisticated hackers can detect the vulnerabilities and break into system
- Malfunctioning of the system may occur if there are bugs or error codes in the programming of the blockchain
- Securing your account requires unique codes as private keys, which if lost might mean losing access to your funds
- Declining value of crypto assets used as collateral may result in a position being liquidated2
DeFi vs crypto: what’s the difference?
While cryptocurrency is decentralised, it’s not a DeFi, and vice versa. There are some differences between DeFi and cryptos. The value of cryptos such as bitcoin, is stored within its own blockchain. The DeFi, on the other hand, is a conceptual marketplace that offers various cryptocurrencies on the Ethereum network.
With the DeFi, those holding cryptocurrencies can lend their digital coins and earn interest on them. Alternatively, they can borrow against the cryptos they hold in their digital wallets.
DeFi summed-up
- DeFi is a blockchain-based financial services system that bypasses government agencies and associated costs that are currently within traditional banking and or investment institutions
- Cryptocurrencies differ from DeFi in that most crypto values are within the individual blockchain, while the DeFi is a crypto marketplace where various cryptocurrencies and altcoins can be traded
- DeFi is open source, meaning you can view and make additions to the code and develop your own DeFi applications
- Transacting on DeFi is in real-time and also has increased transparency as every activity is logged on a public ledger
This information has been prepared by IG, a trading name of IG Markets Limited. In addition to the disclaimer below, the material on this page does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients. See full non-independent research disclaimer and quarterly summary.
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