The Decentralized Finance Hype Explained

Cryptocurrencies are mostly traded with other cryptocurrencies on these platforms. It should be fast, unbureaucratic and cost effective. Since most platforms are based on the Ethereum blockchain, the focus is on buying, selling, trading, and lending Ethereum tokens. There are many touchpoints on the internet where you can buy Ethereum.

What exactly is Decentralized Finance?

Decentralized finance, DeFi for short, describes a range of trading instruments and trading platforms that do not require central exchanges, brokers and platforms. Blockchain technology makes it possible. These “decentralized exchanges” (DEX) do not belong to any company, person or institute. All transactions executed on the decentralized blockchain are stored on the blockchain and verified by it.

Smart contracts determine exactly how trading takes place. These are programmed, self-executing and self-verifying contracts. Smart contracts offer many advantages. So they act impartially and even-handedly, just as they were programmed. In addition, their programming is transparent to everyone. Trust between the different parties is therefore not necessary, because each party can assume that the transactions will take place exactly as stipulated in the smart contract.

Liquidity is provided by the users themselves. With lending platforms, it is users who deposit their own cryptocurrencies and make them available for lending. You get a return for that. On other platforms, it’s your own token that developers provide as liquidity using various incentives. Here you have to be careful. Even though these platforms are supposed to be decentralized, there are still developers who issue their own cryptocurrency and can influence the DEX with their decisions. In the end, decentralization is just a lofty ideal.

The origin story of the DEX

It all started with the DAO and MAKER cryptocurrency. DAO is the abbreviation of “Decentralized Autonomous Organization”. It is a decentralized managed organization that aims to fund Ethereum-related projects. Participants can deposit their own ETH and then vote on how to use it. This project was launched in 2015. If users want to take out a loan, they deposit collateral in the form of cryptocurrency and receive the DAI token in return. It is a stablecoin and is directly tied to the value of one US dollar.

It would take a few years for the supply of DeFi platforms to increase. Aave (AAVE) was one of the first true DeFi blockchains, although this cryptocurrency was also based on Ethereum. Aave makes borrowing quick and easy. Merchants mainly take out these loans to buy cryptocurrencies elsewhere and resell them for a profit.

Many DEXs have the suffix “Swap” in their name, including SushiSwap, PancakeSwap, Uniswap, and many others. “Swaps” describe the rapid exchange of one cryptocurrency for another. Traders want to take advantage of token price differences. Such trades should be done quickly as prices can change in a flash in the volatile crypto space.

A market for synthetic derivatives has also developed. These are tokenized digital assets that represent a different value. These can be stocks, ETFs, precious metals or other cryptocurrencies. “Wrapped Bitcoin” (wBTC), for example, are tokens that track the value of a BTC one by one. These assets are traded on Synthetix, among others.

“Yield farming” continues to enjoy great popularity. Investors diversify their investments across different trading platforms and instruments to maximize returns. This practice is considered very profitable, but also carries a high risk.

benefits and risks

The benefits of decentralized finance are not just about fast and cheap transactions. It is also accessible to all and accessible to all. Anyone with seed capital and internet access can participate in DeFi, even people without access to a bank account. At least in theory.

The freedom offered by DEX comes at the expense of poor security. These platforms are not regulated and are not intended to be. There are no financial regulators dictating what trading on a DEX should look like. There are also no controls or protection mechanisms for this, although at least a crypto insurance market is now forming. Even though DeFi platforms should be decentralized, they are still in the hands of developers, who in most cases issue their own cryptocurrency. This serves as a means of payment or governance token. The Exchange FTX crash shows that problems can result. The FTX exchange had deployed its own token as collateral. The house of cards had to come crashing down at some point.

The hype that DeFi platforms have seen, especially in 2020/2021, had a lot to do with the crypto bubble. They may have played their part, similar to the ICO hype in 2017. It remains to be seen how many currently existing DEXs will remain after the crypto winter. However, the concept itself has become indispensable. Perhaps over time new forms will emerge that will give people around the world access to finance and thus a way out of poverty.