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4 months ago

What is DeFi? Decentralized Finance explained

Decentralized Finance is one of the most important technological developments in the recent years. It became so popular that there is even competition between different blockchain technologies and each one is trying to capture as much market share as possible.

The most promising platforms so far are Ethereum, Binance Smart Chain, Cardano and Solana. Of course, there are even more blockchain technologies out there trying to built their own ecosystem, but in this article, we are going to focus on the most successful cryptocurrencies in this particular field and like to answer the question what DeFi really is.

What is DeFi?

The abbreviation DeFi stands for decentralized finance, which is an umbrella term for different technologies that share a specific trait. Namely that they all offer a particular financial service, but not as a centralized institution, but as a decentralized service. Therefore, DeFi applications are considered to be DApps that usually run on top of a blockchain that offers smart contact capabilities.

These DeFi services can include peer-to-peer lending, options trading, predictions markets, liquidity farming, insurances and many more. Each service is a protocol that is executed on the respective blockchain. This is why decentralized finance is considered a ground breaking technology, because any protocol could offer all types of financial services worldwide and without any restrictions to millions of people.

What DeFi services are available?

The most important protocols are offering the opportunity to swap tokens and serve as decentralized exchanges. In order to provide a working market most of them make use of an automated market maker (AMM). But the AMM needs liquidity in order to function, which leads to the second most important service: Liquidity providers (LP).

Basically, anybody could become a LP and provide liquidity to the protocol. The incentive for LPs is the shared revenue through fees. If somebody is making a trade that person has to pay a fee to the protocol. LPs gather their liquidity in a pool and if that particular pool is used to make a trade happen, a share of the fee is allocated to the pool and each LP is rewarded accordingly. The benefit of this system is that there is always liquidity available on demand.

To provide liquidity and actively managing a portfolio to maximize returns is also called liquidity mining.

Another very important service in the DeFi space is lending. In this case protocols built a decentralized market place for borrowers and lenders. Lending cryptocurrencies or stablecoins is usually rewarded with an interest rate that has to be paid by the borrower. In order to lend money, the borrower needs a collateral that he offers as a security. Should the borrower not return the money, he loses his collateral.

Trading, liquidity mining and lending are the three most important services that are currently available and easily accessible to anybody interested in getting involved into DeFi.

What risks are involved in DeFi?

Cryptocurrencies are generally a very risky investment, but they offer a lot of upside potential on the other hand. DeFi protocols are facing a lot of additional risks, not only because of the market’s volatility, but also because they are part of a complex system.

Each service is a DApp and embedded and depended on other protocols. Therefore, a single vulnerability in one of those interacting protocols can lead to catastrophic outcome if they are exploited. Since last year millions of Euros have been lost through exploits. Most of them targeted liquidity pools making use of flash loans to drain the liquidity leaving investors with nothing behind.

But there are more than just the smart contract risks, e. g. LPs carry financial risks through possible rebalancing of their provided assets. Another factor are fees. If the demand for transactions is high, then a single interaction with a DeFi protocol on Ethereum can easily cost up to 200 Euros. This is especially a pain for retail investors who wish to invest a smaller amount of money.

How to mitigate DeFi risks?

One possible option to take part in the market is not to get involved into DeFi itself, but trade the relevant assets. The biggest DeFi platform is Ethereum and the price for Ether has seen tremendous growth in the last couple of months. Competitors like the Binance Coin (BNB) or Cardano (ADA) have seen also appreciation in price.

The demand is usually driven by the people using DeFi applications on the respective platforms. LiteBit offers to buy, sell and hold the most relevant tokens and cryptocurrencies in the DeFi space. Customers can trade them without the risks that are involved using DeFi platforms and most importantly with reasonable fees. This allows our customers get involved and participate even with a modest investment that would otherwise eaten up by the fees on decentralized exchanges.

What to expect in the coming years?

The DeFi market is the driving factor for altcoins in the year 2021. Only matched by the increasing demand for marketplaces that offer non-fungible tokens it is expected that DeFi will grow into something bigger. For now, most use cases focus on the demands of the crypto industry and these are usually connected to speculation and trading. But there are more options like identity management or insurances.

These use cases could attract big companies and lead to maturity of the market, because they can offer their proven services on the blockchain and expand their business models. But there is also a lot of risk involved. Namely that these companies could adopt blockchain technology, but using their own tech instead of open and public blockchains.

These private blockchains already exist and companies could choose to build their services on a white label or inhouse solutions. Decentralized Finance has to prove that it is indeed superior to these private applications solely controlled by single entities. It remains a challenge in the coming years to show that the market and the technology is mature enough to attract big names and also big money.

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