The words “decentralized finance” or “DeFi” are used a lot these days, especially if you are into cryptocurrency. But what exactly is DeFi and what do cryptocurrency investors need to know about the industry?
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What is DeFi?
Decentralized finance is an umbrella term for a multitude of activities that exclude traditional financial service intermediaries like banking. It encompasses loans, paid accounts, money transfers, insurance, and cryptocurrency exchanges. For example, I could loan you $ 100 of Bitcoin (BTC) through DeFi, and then earn interest on that loan – without involving a traditional lender.
When Bitcoin was first launched, one of the amazing things about it was its decentralized nature. Previously, digital money required the support of a third party – whether a bank or a government – to validate transactions and secure payments. The same blockchain technology that powers Bitcoin is what enables the decentralized financial industry to cut out middlemen.
This can reduce costs and paperwork and speed up transactions. In the example above, you wouldn’t need a credit score to qualify for the loan, although you would need to provide cryptocurrency as collateral. But, as we’ll see, DeFi apps come with additional risks as well.
Here are four things crypto investors need to know about DeFi.
1. DeFi is booming
The decentralized finance industry has continued to grow, along with the increased interest in cryptocurrencies. Indeed, according to analysis and ranking site DeFi Pulse, there is currently around $ 90 billion stuck in DeFi.
DeFi Pulse tracks Total Locked-In Value (TVL), which represents the value of funds deposited into various DeFi applications, and it is a good indicator of the size of the market. Many DeFi applications are built on the Ethereum (ETH) network, which means the price of Ethereum has an impact on TVL as well as the amount of money invested in DeFi.
At the end of 2019, TVL was around $ 8.5 billion and by the end of 2020 it had reached around $ 25 billion. There’s a good chance it will surpass $ 100 billion by the end of this year.
2. DeFi does not offer the same protections as traditional banks
The protections we take for granted in traditional bank and investment accounts may not be present in decentralized finance. It’s important to ask yourself what will happen if something goes wrong, because there may not be a safety net.
For example, if a traditional bank goes bankrupt, FDIC insurance means your savings are covered up to $ 250,000 per qualifying account. (This doesn’t include brokerage accounts, but they do have another form of insurance called SIPC.) Most people don’t give it much thought because their bank didn’t nearly go broke. But there’s a higher chance that a decentralized financial platform will fail – and a lot less protection in place if it does.
Here are some other factors to consider before you jump into DeFi:
- Where your assets will be stored: Look for platforms that keep the majority of assets offline in what’s called cold storage – and find out if they’re insured against hacking or other crimes. Third-party audits and other security features like bug bounty programs are a plus.
- How your assets will be used: Some DeFi platforms promise to pay high interest rates on the crypto you deposit. They often do this by lending your funds and paying you a portion of the interest borrowers pay them. Transparency is important here because you want to understand who they might be lending your funds to and how risky these loans are.
- Technical risks: The downside of removing the middleman is that you are replacing an organization with a piece of code. It’s OK if the code is trustworthy, but problematic if it isn’t. Look for open source projects because that means anyone can see the code and check for bugs. And beware of new projects that may not have been road tested.
- Scams: According to CipherTrace, $ 471 million had already been stolen from DeFi frauds and hacks in August of this year – far more than in previous years. And once crypto funds have been stolen, they can be very difficult to recover. Look carefully for DeFi apps before depositing your money. Pay close attention to reviews online and on crypto forums in particular, as this is often the first sign of potential problems.
3. The regulations are coming
It seems that increasing crypto and DeFi regulation is no longer just a possibility – it’s a certainty. From the SEC to the Treasury, various authorities have raised the need for additional controls. One concern is that DeFi platforms offer banking-like services, but without the same levels of consumer protection as traditional banks. Another is the ease with which anonymous DeFi services can be used to circumvent existing laws that, for example, prevent money laundering.
4. There are many ways to get involved in DeFi
If you want to participate in DeFi action, one of the ways is by owning DeFi cryptocurrency tokens. As the DeFi industry has grown, the value of these currencies has also increased.
You can also earn interest on your cryptocurrency through DeFi. We mentioned borrowing and lending platforms above, which often pay much higher rates than what you’ll find with a traditional savings account. Another way is to use these platforms to stake your coins, which involves tying them up to help with the overall security and maintenance of this cryptocurrency network.
As with any form of cryptocurrency investing, if you decide to dive into DeFi, only invest the money you can afford to lose. And be sure to research the industry thoroughly to make sure you understand the risks involved. It’s an exciting new world, but it’s also a world that doesn’t have a lot of safety rails in place.