In 2020, the total value locked (TVL) of decentralised finance increased by 2,000 per cent. In 2021, decentralised finance is still on the rise. Before investing in this financial ecosystem, read ahead to learn the benefits, drawbacks, and emerging trends.
What Is decentralised finance?
Decentralised finance (or DeFi) is a relatively new way to execute financial transactions through applications called DApps. These are built on a blockchain network, most commonly Ethereum and don’t need to rely on mainstream financial intermediaries like banks, brokerages or exchanges.
The DeFi platforms allow people to lend or borrow money as well as earn interest in savings-like accounts. With DeFi, rather than making transactions through a centralised intermediary such as a cryptocurrency exchange or securities exchange, transactions are made directly between participants using smart contract programs with open-source software that is built and maintained by a community of developers.
Emerging trends in decentralised finance
DeFi not only provides a platform for cryptocurrency trading but also other financial services such as loans and insurance on a decentralised blockchain platform. These services are likely to trigger emerging trends that will impact the financial world. A few notable examples include DeFi insurance, Stablecoin, and decentralised lending.
DeFi Insurance is designed to protect cryptocurrency assets and cover investors from associated risks. In addition, it can help investors protect their DeFi deposits against crypto volatility as well as safeguard against the risk of theft on crypto wallets and hacks on exchange platforms.
Popularity of Stablecoin
Stablecoins are cryptocurrencies that peg their market value to external references such as the US dollar or gold.
While cryptocurrencies such as Bitcoin are highly volatile and are unsuitable for everyday use by the public, Stablecoin serves as a medium of monetary exchange that stores value over a longer period of time. As such, traders and investors are always on the lookout for Stablecoin that stores value and hedges risks.
Another financial product that is emerging from the Defi platforms is Crypto Lending. Crypto holders can lend on decentralised lending platforms to earn passive income on their holdings through interest fees paid by borrowers. This is an attractive option to lenders as they can earn relatively low-risk interest and the collateralised borrowing method ensures that lenders will be repaid even if the borrower never repays the loan.
Benefits of decentralised finance
A healthier system
One of the greatest benefits of DeFi is decentralisation. The pandemic has shown the world how the centralised financial systems are vulnerable to global uncertainties because many are based on direct contact between individuals.
On the other hand, with DeFi, the level of physical contact is greatly reduced and such a model has evidently brought success to cryptocurrency prices and companies.
Fewer human errors
Financial crises are often a result of mismanagement of central banks and intermediaries. That’s why DeFi is developed with smart contracts where protocol advocates seamless fulfilment of contracts that are free from human errors.
Traditional financial transactions can require time-consuming paperwork or queuing at the bank. However, DeFi enables seamless operations anywhere and anytime as long as you have an internet connection.
Drawbacks of decentralised finance
While decentralised lending is an attractive service, it can also suffer from over-collateralisation when the value of borrowers’ assets are much higher compared to the loan amount. This is an essential part of DeFi’s protocol because the high collateralisation can help remove issues such as credit ratings.
DeFi interacts with a high volume of smart contracts and decentralised blockchain applications to develop new services from existing ones. However, because DeFi is an open-source system, if the blockchain that hosts a DeFi project is unstable, the project spontaneously inherits this instability from the host.
Security risks due to administrator keys
When using the DeFi protocol, an administrator key can be used to renew contracts or suspend contracts in an emergency. This key is a double-edged sword; it can act as a precautionary measure but at the same time it could pose a threat if the key lands in the wrong hands.
There are different types of blockchains such as Bitcoin, Ethereum, Binance Smart Chain, and more. Each is a siloed DeFi ecosystem and community that does not interact with one another. The low interoperability limits the development of a unified platform for more flexible transactions.
New paradigm shift in the financial world
If you’re eyeing the crypto market, a little research about decentralised finance can go a long way in helping you understand the evolving ecosystem.
This article was first published in ValueChampion.