If you recently ventured into the cryptocurrency industry, you might have come across various terminology. For newbies, it can be confusing when you hear about yield-farming and DeFi. If such terms make you scratch your head, you are not the first to experience such. And likely not to be the last one either experiencing such thing.
Today, everyone has their perception of Defi. However, what is DeFi, and why is it a trending topic in crypto right now? It’s a question many haven’t found an answer to. Hence, in this article, we will look at What is DeFi and why do we need it? And several other points related to it.
What is DeFi?
DeFi is a word that encapsulates different financial applications in blockchain or cryptocurrency. And is geared towards unsettling financial intermediaries. DeFi stands for Decentralized Finance. It takes away the middlemen that exist in the traditional financial system. Today, you can perform every transaction such as borrowing, lending, buying, and selling securities on a decentralized network without any third-party. And that makes it truly standout.
DeFi is supported by distributed ledger technology. With the aim to disrupt our current financial order and provide an equitable and transparent financial system. Furthermore, it expands blockchain technology from simple data to more complex financial cases. This includes the following: lending, trading, derivatives, flash loans, and yield farming.
The challenge with the traditional Financial system
Besides being costly and slow when performing transactions, our traditional financial systems are vulnerable to data breaches, hacks, and security failures as seen in the past. Now just consider having all your money in a particular bank. And suddenly, the bank makes a bad investment, increases its fees, or gets robbed. To make matter worse, if the bank goes bankrupt; what happens to the customer? Of course, the customer loses out on all their savings/investments. And that could truly be soul-destroying for anyone.
However, in a DeFi system, everything, including the applications, assets, products, and services, are decentralized. This makes it hard for any failure that might happen with a centralized system. The traditional system is unreachable to millions of people who can’t meet the criteria of opening an account. For those in developed countries, it might sound odd when certain people don’t meet banking criteria. However, not so much so in developing countries.
Notwithstanding, DeFi and cryptocurrencies don’t discriminate, unlike traditional systems where insufficient identification and government oppression can restrict someone. DeFi allows people with access to the internet to access financial services economically and rightfully.
Why DeFi is a Trending Topic in the Crypto Industry
Interestingly, regulators have been in the industry, even though DeFi has flourished within these regulations. For example, there is a legal requirement in traditional lending in which both lenders and borrowers must know each other. While assessing if the borrower has the financial capabilities to repay the debt. However, in DeFi, such requirements aren’t there. Instead, everything is done based on privacy and trust.
Moreover, regulators weigh the delicate balance between stifling innovation and failing to protect society from risks as people placing their money into a bank or unregulated space without intermediaries. However, embracing change is more sensible than not accepting it. This seems to be happening because the US Securities and Exchange Commission (SEC) in July 2020 made a significant shift towards accepting DeFi. That by approving Arca, an Ethereum-based fund, for the first time.
It is a welcome development since a significant issue towards financial innovation is the aggressive environment created by outdated regulations. Previously, it contributed to the failure of some DeFi projects such as Basis. This New-Jersey company has to return over $133 million to its investors in 2018 due to the SEC’s stiffer rules.
Further evidence for DeFi Surge
Another reason for the recent DeFi surge is that many mainstream players are getting involved in the cryptocurrency industry. Many high-street financial institutions are accepting and seeking ways to participate in DeFi. For instance, over 70 of the world’s biggest banks have indicated an interest in using blockchain technology to Fasttrack their payment system. It is part of the Interbank Information Network.
Thirdly, the recent effect of the COVID-19 pandemic has contributed to lower interest rates globally. Some jurisdictions like the eurozone are in negative territory. Whereas others, such as the UK and US tend to follow suit. In this situation, DeFi offers increased higher returns for savers compared to traditional financial institutions. For instance, Compound offers its investors an annual interest rate of 6.75% using its platform to save with Tether.
Besides getting returns from your investment, you also get the Comp token. It serves as an added attraction for investors.
Two-thirds of the population without a Bank account
With over two-thirds of the world’s population without a bank account. And in possession of a smartphone, DeFi has created opportunities to open up the financial world to them. Another crucial reason why DeFi is a trending topic in crypto is that most people don’t want to be isolated from the explosive growth in the cryptocurrency industry. Notwithstanding, many tokens are practically close to nothing as what some people are seeing is merely irrational enthusiasm.
Nevertheless, whether you support it or not, we are in a new financial system. And it is decentralized and more liberalized than it was before. The primary question remains that how can we check and balance the risks. Along with extracting the potential benefits. Indeed, it is a challenge the world will continue to face in the years to come.
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How safe is investing in DeFi?
Investing in DeFi is risky similar to any financial investment. However, most people believe DeFi is the future of the financial world. Therefore, investing in it during the early stage can lead to high returns. Nevertheless, it is hard for new investors to differentiate between a good and a bad project. Since we cannot shy away from the circumstance that there will be many bad ones.
Since the popularity and increase of DeFi in 2020, we have seen the crash and burning of different DeFi applications such as YAM. The $60 million to $0 within 35 minutes. YAM is not the only platform as Pizza and Hotdog have faced a similar fate with investors losing their money.
Unfortunately, DeFi bugs are widespread. In as much as smart contracts are powerful, once the rules are integrated into the system, you can’t change them. It makes bugs permanent and increases risk.
The future of DeFi indeed looks promising. Even though the world still continues to work towards crossing the hurdle from the traditional financial system to a decentralized future. Already, things are gearing up for more tokenized assets, including Non-Fungible tokens, digital gold, and artworks.
Governments are looking to set up central bank digital currencies (CBDC). It is a hint that is signifying that DeFi is a welcomed project. Notwithstanding, it is crucial to invest wisely in each DeFi project as the potential and risks are high. So, get yourself ready for the new financial system – DeFi.
What is the best DeFi project you have heard of recently? We would love to hear from you.