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Lesson 1
3 min

What is decentralized finance?

An introduction as to what decentralized finance is.

Key Points:

  • Decentralized finance, abbreviated to DeFi, refers to financial services that exist and operate on public blockchains.
  • DeFi expands upon the initial premise that Bitcoin set out to achieve, providing an alternative to traditional centralized financial institutions and services.
  • Benefits include: pseudonymity, accessibility, permissionless, efficiency, transparency and openness.
  • Downsides include; regulatory influence, price fluctuations, volatility, usability, record keeping and limitations of smart contracts.
  • Decentralized Apps, otherwise known as dApps, are the main way in which a user will engage with DeFi.

What is DeFi?

Decentralized finance, abbreviated to DeFi, refers to financial services that exist on public blockchains, as opposed to those operated by centralized institutions such as banks.

DeFi offers a decentralized alternative to many centralized services, such as borrowing and lending. DeFi differs in that it does not require a third party to operate, opening up exciting synergies between a global set of network participants, allowing for more efficient operation through the removal of intermediaries, and removing barriers to entry - all someone needs is an internet connection to participate. Additionally, anyone is free to contribute to the global DeFi ecosystem, whether through building their own protocols, improvement proposals, or voting through decentralized governance.  

One of the most successful DeFi applications is Uniswap, a decentralized exchange (DEX) originally built on the Ethereum blockchain, but is now available across multiple networks. Uniswap enables participants to swap various ERC-20 tokens without the reliance of a third party, and has amassed millions of users and processed billions of dollars in transactions since launching in November 2018. 

How does DeFi work?

Decentralized applications, commonly known as dApps, are the primary way in which users engage with DeFi. Ethereum enjoyed a first mover advantage in the dapp for a long time, but as competitors like Solana and Avalanche become more prominent, development and deployment is slowly spreading to other chains. 

When it comes to transacting using DeFi, there’s no onboarding process or account to open. Instead, a user will interact with a dApp through a website and connect their crypto wallet, such as UpHODL. From there, you can perform operations made directly on the underlying blockchain. 

Why is DeFi Important?

DeFi expands upon the initial premise of Bitcoin, providing an alternative to traditional centralized financial institutions, which are often burdened with high operational costs that are then passed to the user. The disintermediation of these processes not only makes them more affordable and efficient, but drastically reduces the barriers to entry - granting access to anyone with an internet connection. Through this, DeFi has become a huge force for financial inclusion. 

From a control and censorship perspective, DeFi operates on decentralized networks - meaning that third parties, such as governments or banks, cannot interfere or block transactions. In countries where there are strict regulations, political instability, or security concerns, this can be an attractive quality. This also heavily reduces, to outright eliminates, counterparty risk, as smart contracts can autonomously operate based on predefined terms. 

Benefits and downsides of DeFi

To ensure a holistic perspective, let’s dive into the benefits and disadvantages of DeFi.

Benefits:

  • Pseudonymous: no requirement to provide personal details such as name, email or address. 
  • Accessibility: available to move your assets anytime, anywhere.
  • Permissionless: no permissions are required for you to move your assets.
  • Efficiency: wait times for moving assets are typically faster than traditional banks, and without the high fees that centralized institutions pass onto their customers.
  • Transparency: all individuals involved in the network can see all the transactions, as documented by the blockchain.
  • Open: accessible on a global scale to anyone with an internet connection.
  • 24/7: DeFi functions 24 hours a day, 7 days a week without any border restrictions.


Downsides:

  • Regulatory issues: There’s numerous regulatory challenges due to its decentralized nature. DeFi poses concerns regarding regulatory clarity, KYC/AML compliance, smart contract risks, consumer protection, market manipulation, cross-border regulations, and tax compliance. Though the regulatory landscape is evolving, it is struggling to keep pace with new innovations across DeFi platforms. In particular, addressing issues like identity verification, financial crime prevention, and market integrity in decentralized systems.
  • Price Fluctuations: the price of transactions on the Ethereum blockchain fluctuate often, meaning for active traders it can become expensive due to the increased competition for transaction confirmation.
  • Volatility: depending on the dApp you choose, investments can experience high volatility.
  • Usability: DeFi platforms don’t have the same user experience as traditional financial institutions, the lack of intuitive usability can limit some users’ experience.
  • Record Keeping: the regulatory environment and requirements differ by region, from a tax perspective you’ll be required to keep your own records, and must do so accurately.
  • Personal Responsibility: In addition to keeping your own tax records, you’re also responsible for your wallet security. Unlike with a traditional financial institution, there is no safety net.
  • Limitations of Smart Contracts: smart contracts can be vulnerable to human error, as well as risk of malicious intent. In these cases it can lead to risk of potential financial losses or fraud.

Lesson 21: A roundup

  • Decentralized finance, abbreviated to DeFi, is the terminology used to reference financial services that exist on public blockchains as opposed to those that run through an intermediary such as a bank.
  • DeFi can be considered as having the potential to open up financial markets, making them fairer and more accessible to any individual with access to the internet.
  • Benefits include; pseudonymous, accessibility, permissionless, efficiency, transparency and openness.
  • Downsides include; price fluctuations, volatility, usability, record keeping and limitations of smart contracts.
  • Decentralized Apps, otherwise known as dApps, are the main way in which a user will engage with DeFi.
  • When it comes to transacting using DeFi, there’s no onboarding process or account to open.
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