Decentralised Finance: Explained | 💰 |
(Plus) 🌿 Discover 5 ways DeFi is used for financial inclusion
GM. 🫶
This is Web3 Espresso ☕—the Web3 Newsletter for creators, marketers, and coffee drinkers looking to understand how Web3 technology is changing the world we live in.
Hello 😎,
Few of you may know that my first job after getting my master’s degree was as a portfolio analyst for a large asset management firm. You’ve guessed it, I like numbers and have always had an affinity with money. I think this comes from the fact that, as a young girl, my mother made sure I understood the concept of money and its power, so much so that it drove me to become fiercely independent.
This week, I thought I would introduce you to the concept of decentralised finance, a.k.a. DeFi, a rather barbaric term for most people, especially if numbers have the tendency to create that little bit of fear in your heart.
While Web3 is predicated on using blockchain technology to create a more equitable internet, decentralised finance is Web3’s version of a more transparent financial system where banks, exchanges, and brokers’ roles are being challenged.
What is DeFi? What is it disrupting, and how could it change finance?
Read on.
What’s in store today:
🥡 The Weekly Roundup 5 in 5
☕+👧 TechyGirls NFT Collection #1
💰 A Beginner's Guide to DeFi
What is DeFi?
How does DeFi work?
DeFi Risks Everyone Must Understand
Blockchain: 4 Use Cases in the Financial Sector
Let’s go! 🥤
🥡 5 in 5 …
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☕+👧 TechyGirls NFT Collection
This NFT is called "Ms. Satoshi pays tribute to the Quattrocento"
Only when purchased will this NFT come to life for the purchaser. It will clarify why the woman who created Bitcoin has a special affection for the Quattrocento era.
Available on OpenSea here.
|💰| Decentralised Finance: Explained
Introduction
You’ve probably heard of Bitcoin. Bitcoin is a form of currency that is not under the control of any government or central bank. It can be transferred around the world without the need for a bank or financial institution. Bitcoin is what we would call “decentralised” money.
Now let’s imagine a world where you can make trades, deposit money into a savings account, or buy insurance all without going through an intermediary like a bank. This is the promise of DeFi.
The crypto winter of 2022 has exposed many cracks in the DeFi space; projects have failed, investors have lost money, and systems have been exposed to massive cyberattacks.
Can DeFi rival the mainstream financial institutions that we all know today?
What is DeFi?
DeFi is an umbrella term for a range of financial products developed around the blockchain that have no central authority. By using decentralised money, like cryptocurrencies, developers can build exchanges, lending platforms, and insurance companies that have programmed rules built into them. The DeFi market is estimated to be worth $60 billion.
At its simplest, decentralised finance is an open financial sector that runs on software built on top of a public blockchain.
With traditional finance, money is stored and managed by centralised institutions like banks. These firms make money by lending out your money and charging interest on top of the loans. They also collect various fees and commissions for providing additional financial services. The modern financial system is riddled with third party providers (intermediaries) who take a cut from daily transactions.
Today, the financial system is completely centralised, i.e., controlled by an entity. The risks associated with a centralised financial system can include mismanagement, fraud, and corruption.
4 Advantages of DeFi vs Traditional Finance
People hold their money in secure digital wallets instead of keeping it in banks.
DeFi eliminates the fees levied by banks and other financial institutions in exchange for their services.
DeFi is permission-less; anyone with internet access can use it without securing approval from a central authority.
Funds can be transferred in a matter of seconds.
How does DeFi work?
Decentralised Infrastructure
In the land of DeFi, new infrastructure is built that takes out these banks and institutions. This means that anyone with a computer can create the necessary software to launch a decentralised financial system on a blockchain, meaning that the barriers to entry are much lower.
The most common blockchain used is the Ethereum blockchain, which lets developers create automated code (smart contracts) that can manage any financial service, non-fungible tokens (NFTs) or decentralised autonomous organisations (DAOs).
In all these cases, a certain number of rules can be established as to how a service will work; these rules are coded into a smart contract, and once they are deployed on the Ethereum network, they are executed automatically once the conditions are fulfilled. Once deployed, the smart contract is set in stone.
Smart contracts are also used to build decentralised apps or DApps. While they are similar to normal apps in terms of function, the main difference with DApps is that they run on a peer-to-peer network (like the blockchain).
Decentralised Money (DAI)
Now that the infrastructure is in place, the next step is currency, which would take the form of a cryptocurrency. The volatile nature of Ethereum and Bitcoin makes these unsuitable choices; instead, a new type of cryptocurrency has been created called “stablecoins”. Stablecoins are cryptocurrencies that are pegged to the value of a real world asset, for example, the US Dollar or the Euro.
DAI is a decentralised cryptocurrency based on the Ethereum network. It is a stablecoin, which means that it is pegged to the U.S. dollar, resulting in lower price volatility compared to other blockchain-based currencies. Although not the biggest stablecoin, DAI, through its autonomous governing body, MakerDAO claims to be a truly decentralised stablecoin.
Decentralised Financial Services - Exchanges (DEX)
A decentralised exchange (DEX) is a peer-to-peer marketplace where transactions occur directly between cryptocurrency traders. Decentralised exchanges operate according to a set of rules (smart contracts) that allow users to buy, sell, and trade cryptocurrencies. They also reside on the Ethereum platform. Connecting to a DEX does not involve any sign-up, identity verification, or withdrawal fees. There is no need to deposit funds into an exchange account before conducting a trade. Popular DEXs are Uniswap and Sushiswap.
Decentralised Financial Services - Lending
One of the most popular applications of DeFi is lending, where decentralised money markets will connect borrowers with lenders. You can basically lend your crypto out and earn interest on it, or you can borrow funds by putting your tokens up as collateral. Rates applied on these decentralised lending platforms are adjusted by an algorithm based on how much demand there is for the loans.
Decentralised Financial Services - Insurance
Insurance is a pooling of risk. When a potential event presents the risk of being financially punishing, individuals seek insurance to cover the risk. Insurance companies enable individuals to pool that risk by having each one pay premiums.
In a decentralised world, a Dapp platform connects people who are willing to pay for insurance with people who are willing to insure them for a premium. This happens autonomously. There are two main branches to consider in the fast-growing field of DeFi insurance. The first is blockchain-based insurance, which is used to replace traditional insurance policies. The second is blockchain-based insurance that mitigates the risks associated with DeFi activity. Two examples of decentralised insurance protocols are Etherisc and InsurAce.
Key Risks Everyone Must Understand
DeFi is still in its infancy, and things can go wrong. Smart contracts have had issues in the past when people didn’t define the terms correctly. Hackers have found creative ways to exploit existing loopholes in order to steal money. Additionally, since consumer protection laws don't apply to DeFi protocols, they are riskier than goods from regulated institutions. According to a report by Elliptic, overall losses caused by DeFi scams and thefts amounted to $12 billion in 2021.
Smart Contract Vulnerabilities: DeFi platforms rely heavily on smart contracts, which are subject to coding errors or vulnerabilities. Exploiting these vulnerabilities can lead to hacks or the loss of funds. It is crucial for developers to conduct thorough audits and security checks to mitigate such risks.
Price Volatility and Market Risks: DeFi platforms often involve volatile cryptocurrencies and tokens. Sudden price fluctuations can result in significant financial losses for participants, especially if they are exposed to highly leveraged positions or risky assets. Investors should exercise caution and conduct proper risk assessments.
Regulatory Uncertainty: DeFi operates in a relatively unregulated space. However, regulatory frameworks are continuously evolving, and increased scrutiny from authorities can introduce uncertainties and potential compliance challenges for DeFi projects. Participants should stay informed about relevant regulations and their potential impact on DeFi activities.
Liquidity Risks: DeFi platforms rely on liquidity pools for various functions, such as trading and lending. Insufficient liquidity or sudden liquidity shortages can impact users' ability to execute transactions or withdraw funds. Users should assess the liquidity conditions of a DeFi platform before engaging in significant transactions.
Governance and Centralisation Risks: While DeFi aims to be decentralised, certain platforms may exhibit centralisation tendencies due to concentrated voting power or control held by a few entities or individuals. This can lead to governance risks, where decision-making power may not be truly distributed among participants, potentially impacting the platform's direction and security.
Blockchain Use Cases in the Financial Sector
Money transfers
Digital financial services mean that individuals and companies can now expect to send and receive funds in a matter of seconds. The actual time it takes for the funds to settle into an account is usually much longer. Many banks use SWIFT (a third-party messaging system) for fund transfers. In DeFi, there is no central authority sitting in the middle of the transaction, meaning that money transfers can be near-instantaneous.
Inexpensive, direct payments
Moving money is expensive. Whether you’re using a credit card or a bank transfer, fees are being applied by the financial intermediary. DeFi apps bypass intermediaries and enable peer-to-peer lending and borrowing.
Tracking Data and Fighting Fraud
Decentralised finance protocols enable efficient data analysis, discovery, and decision making around finances and risk management. It is possible because it works on blockchain, offering transparent access to all transaction data and network activity. Tracking fraudulent transactions becomes easier and faster.
Financial inclusion
DeFi Apps can benefit a huge population of people who face financial discrimination, high fees, and inefficiencies in managing their funds. They facilitate peer-to-peer transactions and help the unbanked in low-income areas access financial services.
Kotani Pay, a project under the UNICEF Innovation Fund, allows Kenyans to convert crypto to fiat by dialling a shortcode (even if they do not have a smartphone). Another example is Leaf Wallet, built to give under-resourced communities and refugees access to digital financial services.
Here are other cool DeFi projects that promote financial inclusion:
Xend Finance - leverages blockchain to provide rural farming communities with better access to credit.
Bloinx - a community-based method for saving money and issuing loans for the benefit of those in the community. A common community-based approach is what is referred to as a “saving circle.”
EthicHub - a ReFi (Regenerative Finance) protocol helping unbanked farmers access capital at low interest rates in a win/win model where all stakeholders benefit from interacting.
Concluding thoughts
The rise of DeFi is revolutionising traditional finance by eliminating intermediaries, enabling borderless transactions, promoting transparency, and unlocking new opportunities. DeFi is poised to reshape the financial landscape.
However, DeFi does come with its fair share of risks.
One of the main concerns is the vulnerability of smart contracts, which can be exploited by hackers, and potentially result in financial losses. Additionally, the lack of clear regulations in the decentralised space poses challenges for investor protection and compliance. Finally, DeFi assets can be highly volatile, and I found that navigating the complex processes can be daunting.
DeFi is definitely not for the faint-hearted. The learning curve is steep and the processes are complex, making them more suited for experienced investors with a large appetite for risk.
I do think that investing time and energy to learn about DeFi makes a lot of sense, as the sector will continue to grow and will present interesting opportunities for alternative financing for those that know how to navigate the waters.
That’s all for this week… 🫶
Please note that I do not recommend or endorse the companies and organisations mentioned in this newsletter. This content is purely informative and not a recommendation. Always be mindful of where you connect your wallet. Always do your own research. 💛