Decentralized Finance (DeFi) In A Nutshell

25th May 2021 | Blog, Sticky

A phrase that has been making waves in the financial world is Decentralized Finance (aka: DeFi). DeFi uses cryptocurrency and blockchain technology to manage financial transactions outside the control of traditional financial institutions such as banks, brokerage firms, and government-run exchanges. DeFi aims to parallel traditional, centralized institutions, call them mediators, with direct peer-to-peer financial relationships for loans, mortgages, and asset trading.

In the U.S., regulatory bodies like the Federal Reserve and Securities and Exchange Commission (SEC) set the rules for centralized financial institutions and brokerages; with Congress amending the rules after each financial fiasco (Savings and Loans crisis in the 1980s). As a result, there are few paths for some consumers to access capital and financial services directly. They cannot bypass middlemen like banks, exchanges, and lenders, who earn a percentage of every financial and banking transaction as profit. Outside of DeFi, we all have to pay to play.

Decentralization

DeFi challenges the centralized financial system by disempowering middlemen and empowering ordinary people via peer-to-peer exchanges.

“Decentralized finance is an unbundling of traditional finance. DeFi takes the key elements of the work done by banks, exchanges, and insurers today—like lending, borrowing, and trading—and puts it in the hands of regular people.”

– Rafael Cosman, CEO/Co-Founder of TrustToken.

Today, you might put your savings in an online savings account and earn a 0.50% interest rate on your money. The bank then turns around and lends that money to another customer at 3% interest and pockets the 2.5% profit. With DeFi, people lend their savings directly to others, cutting out that 2.5% profit loss and earn the full 3% return on their money.

You might think, “Hey, I already do this when I send my friends money with PayPal, Venmo, or CashApp.” But you don’t. You still have to have a debit card or bank account linked to those apps to send funds, so these peer-to-peer payments are still reliant on centralized financial middlemen to work.

Public Ledgers

Blockchain and cryptocurrency are the core technologies that enable decentralized finance. When you make a transaction in your conventional checking account, it’s recorded in a private ledger (bank transaction history), which is owned and managed by a large financial institution. Blockchain is a decentralized, distributed public ledger where financial transactions are recorded in encrypted computer code.

‘Distributed’

By blockchain being distributed, all parties using a DeFi application have an identical copy of the public ledger, which documents the transactions in encrypted code. Encryption secures the system by providing users with anonymity, verification of payments, and a record of asset ownership that’s virtually impossible to alter through malicious activity.

‘Decentralized’

Through blockchain being decentralized, no middleman or gatekeeper is managing the system. Transactions are verified and recorded by parties who use the same blockchain, through a process of solving complex math problems and adding new blocks of transactions to the chain. Advocates of DeFi assert that the decentralized blockchain makes financial transactions more secure and more transparent than the traditional systems used in centralized finance.

DeFi Today

Bitcoin is certainly the most popular cryptocurrency, but the Ethereum-based code is used in many other applications. See how DeFi is being used today all around you:

Traditional Financial Transactions. Anything from payments, trading securities, and insurance, to lending and borrowing, is already happening with DeFi.
Non-Fungible Tokens (NFTs). NFTs create digital assets out of typically non-tradable assets, like videos of slam dunks or the first tweet on Twitter. NFTs commodify the previously uncommodifiable.
Decentralized Exchanges (DEXs). Most cryptocurrency investors use centralized exchanges like Coinbase or Gemini. DEXs facilitate peer-to-peer financial transactions and let users retain control over their money.
E-Wallets. DeFi developers are creating digital wallets that can operate independently of the largest cryptocurrency exchanges and give investors access to everything from cryptocurrency to blockchain-based games.
Stable Coins. While cryptocurrencies are notoriously volatile, stable coins attempt to stabilize their values by tying them to non-crypto currencies, like the U.S. dollar.

Most centralized financial tools and technologies release over time, governed by the rules and regulations of economies; but these exist outside of these rules, increasing their potential reward but also increasing their risks.

Risks of DeFi

DeFi is an emerging phenomenon that comes with various risks. As a recent innovation, decentralized finance has not been stress-tested by long or widespread use. In addition, national authorities are taking a harder look at the systems it’s putting in place, with an eye on regulating the tools. Some of the other risks of DeFi include:

No consumer protections. DeFi has thrived in the absence of rules and regulations. But this also means users may have little recourse should a transaction go foul. In centralized finance, the Federal Deposit Insurance Corporation (FDIC) reimburses deposit account holders up to $250,000 per account, per institution if a bank fails. Moreover, banks are required by law to hold a certain amount of their capital as reserves, to maintain stability and cash you out of your account any time you need. No comparable protections exist in DeFi.
Hackers are a threat. While a blockchain may be nearly impossible to alter, other aspects of DeFi are at large risk of being hacked, which can lead to funds theft or loss. Many of the software tools that cryptocurrencies run on is vulnerable to hackers, which is a concern. This is why its always vital to have strong, unique 14+ character passwords stored in a password manager with Two-Factor Authentication enabled on all possible accounts.
Private key requirements. With DeFi and cryptocurrency, you must secure the wallets used to store your cryptocurrency assets. Wallets are secured with private keys, which are long, unique codes known only to the owner of the wallet. If you lose a private key, you lose access to your funds and there is no way to recover a lost private key.
Long-term risks to DeFi: with direct transactions of item a for item b, there is a one-to-one ratio. In traditional banking and financial institutions, there is a 1 to many ratio. Money supply directly benefits from traditional finance. The world survived a global pandemic through fiscal stimulus that was only possible because of our centralized financial institutions. Taken to extreme, DeFi could undermine the ability for the world to react to things like a global pandemic.

What To Do?

It’s important to ensure that you have all the basic measures in place when dealing with financial information. Taking the following actions recommended by CyberHoot can save you many headaches down the road not only when dealing with cryptocurrencies, but with any account containing sensitive information:

Adopt two-factor authentication to prevent a password breach of your business’s VPN, email services, and any other critical service that is directly Internet accessible
Adopt a password manager to use personally and professionally to improve password hygiene
Regularly backup data following the 3-2-1 backup method for backing up all your critical and sensitive data
Train employees on how to spot and avoid phishing attacks – the primary way cyberattacks occur
Test employees on their training to validate they can spot and delete threats rather than click and succumb to an attack