Decentralized Finance (DeFi) may sound confusing, but this guide will help beginners to understand this complex topic with ease. In the article, we talk about the definition, the idea, the connection with centralized, traditional finance, and the main types of platforms, which include products built by Qoda Finance. Let's get started!
Decentralized Finance Definition
What is DeFi?
Decentralized Finance (DeFi) is a blockchain-based financial system without traditional intermediaries like banks or financial institutions. Instead, it uses smart contracts built on networks like Ethereum to automate transactions, enabling users to trade, lend, borrow, and earn interest directly through peer-to-peer networks. DeFi aims to provide more open, accessible, and transparent financial services by removing central control and offering users more control over their assets.
Why do we need DeFi?
Decentralized Finance is a new way of using money in the digital economy created by the Internet and blockchain technology. Thanks to DeFi protocols, crypto users can deal with each other directly and permissionless. It’s also cheaper and easier to work with such products as loans, international trades, or investments without intermediaries or financial checks.
Short History of DeFi
The history of Decentralized Finance can be traced back to the launch of Bitcoin with the idea of decentralized direct p2p transfers.
DeFi has flourished since the creation of Ethereum in 2015. This network revolutionized the blockchain space by enabling the creation of smart contracts. These programmable contracts could execute transactions autonomously, leading to the development of decentralized applications (dApps), which are the backbone of DeFi.
Today's largest and most well-known DeFi protocols utilize smart contracts and were born on Ethereum, such as Aave (crypto loans), Uniswap (decentralized crypto exchange), and others.
In 2020, there was a boom in Decentralized Finance, known as DeFi Summer. The number of products, their users, and the total value locked (TVL) in DeFi grew exponentially, reaching billions of dollars as users saw better returns than traditional financial products.
At the time of writing, according to the Defillama analytics platform, the total value locked in DeFi protocols across all networks is 84 billion.
Today, DeFi remains one of the most popular sectors across web3 and blockchain-related narratives.
Main Types of Decentralized Finance Platforms
DeFi protocols can be divided into categories based on their financial services. The main types of Decentralized Finance Platforms are:
1. DEX (Decentralized Exchange).
These platforms allow their users to trade crypto directly with each other. Liquidity is provided through automated market maker (AMM) models rather than order books. Examples are Uniswap, Sushiswap, and Pancakeswap.
2. Lending and Borrowing.
Typically, crypto loans are overcollateralized. The rates are mainly floating and depend on supply and demand. However, innovative platforms like Qonstant offer fixed rates. Examples are Qonstant, Aave, and Compound.
3. Yield Farming.
Users deposit their crypto into liquidity pools and then take their LP tokens to deposit them elsewhere. This creates more liquidity across multiple platforms, and users earn interest or compound rewards as a passive income stream. Examples are Curve Finance, Balancer, and Lido.
4. Derivatives.
These platforms allow decentralized trading of financial contracts, including futures, options, and other synthetic assets that derive value from underlying assets. Examples are GMX, dYdX, and Aevo.
5. Payments.
Platforms of this type usually focus on fast, low-cost transactions and financial inclusion, often targeting underbanked regions. Examples are Celo and Stellar.
6. Asset Management.
Allow users to track and manage their crypto portfolios. Examples are Threebalance, DeBank, and Zapper.
When talking about DeFi platforms, it’s essential to understand they’re not 100% decentralized. Every product has a team behind it. The team does operations, finance, marketing, etc. The main indicator of decentralization is not the decentralization of the product and its management but how users interact with it.
Risks Related to Decentralized Finance
Decentralized financial products are permissionless and can provide a greater level of freedom compared to traditional finance. This is both an advantage and a disadvantage. Cybercriminals and money launderers have easy access to the protocols, just like ordinary users, which regularly causes discussions about regulation.
Possible regulations or bans in certain jurisdictions can also affect average users. What are the other downsides of using decentralized financial applications?
Smart Contract Vulnerabilities
Smart contracts, which are used to automate processes on DeFi platforms, may contain bugs or vulnerabilities. These loopholes can be exploited by malicious actors, potentially resulting in financial losses for users.
Over-Collateralization Risks
DeFi lending platforms typically require users to provide collateral that exceeds the amount they intend to borrow. If the market value of this collateral decreases, it may lead to forced liquidations, putting borrowers at risk of losing their assets.
Crypto Market Volatility
Cryptocurrency markets are notoriously volatile. Sharp and unpredictable price drops can cause substantial losses, especially for individuals involved in leveraged borrowing or lending on DeFi platforms.
Lack of Liquidity
DeFi platforms often rely on liquidity pools to operate effectively. When these pools have insufficient liquidity, it can cause significant price fluctuations during trades or prevent users from withdrawing their funds efficiently.
Impermanent Loss
Liquidity providers on decentralized exchanges (DEXs) may experience impermanent loss, which occurs when the value of the tokens they deposit into liquidity pools fluctuates. This can result in lower returns than if the tokens were simply held.
Rug Pulls and Scams
Some DeFi projects are created with the intent to defraud investors. In these scenarios, project developers may withdraw liquidity, commonly known as a rug pull, leaving investors with worthless assets.
Regulatory Uncertainty
We’ve already mentioned this, so just a short reminder: DeFi operates largely without regulation, but this may change. Emerging regulations could impact the functionality of DeFi protocols, potentially restricting user access or leading to asset freezes.
Centralized Finance VS Decentralized Finance
Centralized financial institutions, like decentralized ones, work with the money of their clients, both private and other companies and institutions. However, they differ in their work and approaches.
Among crypto fans, it’s often said that centralized finance (CeFi) is hopelessly outdated. This criticism is often justified, but at the same time, the DeFi sector is too young and can’t yet compete with CeFi. However, these two areas are not mutually exclusive; they can complement each other. This potential complimentary relationship explains the interest of large traditional financial institutions in tokenization and blockchain (ETFs, BlackRock's BUIDL token, etc.).
Decentralized finance provides people worldwide with more flexibility and access to financial tools. Their users don’t need intermediaries, can quickly send each other money or get loans without a credit history, and are fully responsible for the safety of their savings, to name a few benefits. On the other hand, the traditional financial system is more inflexible and bureaucratic, requiring unconditional trust. Still, at the same time, it’s more secure and has the support of the authorities. It’s regulated, predictable, and carries fewer risks than the young and vulnerable DeFi sector. The range of investments offered by CeFi institutions is incomparable to decentralized finance.
However, we shouldn't forget that DeFi has existed for only 15 years. It’s a fast-growing sector that often combines the best of both worlds. At least, that's what we strive for at Qoda Finance.
Qoda’s Mission and Products
At Qoda Finance, we agree that the existing system of centralized financial infrastructure is fraught with problems. One of these problems is how the best financial services are reserved for the wealthy. Most people across economies of all sizes cannot access the best transactional banking services, cheap capital, or unique investment opportunities.
Decentralized financial infrastructure offers a brighter outlook than its traditional counterpart: the finance industry must be open to everyone. Thanks to the trustless nature of blockchain technology and the prominence of digital assets, our global financial system can be re-imagined with financial accessibility in mind.
The core belief of the Qoda Ecosystem is that the future of finance is decentralized. This industry-wide transition will unlock new levels of capital efficiency that humanity has never achieved before. Its mission is to bring the best financial services from Traditional Finance to Decentralized Finance while making them accessible to everyone.
The ecosystem's current focus areas include on-chain asset management and credit markets. This scope may broaden further as new Partner Apps are onboarded.