In 2022, the concept of decentralized finance, or DeFi, became a hot topic on Wall Street. It’s believed that this technology could disrupt the traditional financial services industry. DeFi would allow users to make transactions without banks or brokers through its peer-to-peer payments system.
Although it’s easy to see the potential of DeFi, it’s essential to keep in mind that this technology could potentially expose investors to various risks. For instance, due to the lack of regulation in the space, investors might need to be made aware of the multiple dangers of decentralized finance.
Understanding What DeFi Is
Decentralized finance is a type of financial technology based on secure distributed ledgers commonly used in cryptocurrencies. In the U.S., the SEC and the Federal Reserve have regulations governing financial institutions’ operations, such as banks and brokerages. These entities are responsible for providing financial services to consumers. Through DeFi, individuals can easily access financial services and capital through peer-to-peer digital exchanges.
Unlike traditional financial services, DeFi does not charge fees for using its services. It allows individuals to hold their money in a secure digital wallet and send and receive funds in minutes.
The Three Basic Types of DeFi Applications
Developers can create applications using DeFi’s smart contracts framework. Multiple tools allow users to test and deploy smart contracts, such as Ganache and Truffle. After downloading a framework, one can create a token that can be used to implement a protocol on Ethereum, Solana, or Binance’s Smart Chain.
DeFi applications commonly use a token to interact with the layer-1 blockchain. Some projects have also started promoting their tokens to push decentralization. For instance, the Lending Protocol Compound uses a governance token called Comp. This allows users to decide on the protocol’s treasury allocations and code.
Lending and Borrowing
One of the main types of applications that can be used by DeFi is lending or borrowing. For instance, if you’re a cryptocurrency owner, you can easily lend it to a particular protocol in exchange for rewards or interest. However, be careful, as some DeFi protocols require that you put up more collateral than you want to borrow. If the value of your asset falls too low, the protocol may take your investments to avoid losses.
For many DeFi users, this type of activity is called yield farming. Through this process, they can earn rewards by locking up funds in a pool of assets. Since the rates vary depending on the asset and protocol, skilled yield farmers can take advantage of the best rates.
Another type of DeFi application is trading. One of the main advantages of decentralized finance is that it eliminates the need for a central exchange. Instead, it allows people to trade directly with one another. Another advantage of this activity is that it will enable people to get in early on new assets. Due to the lack of vetting, many DEXes, such as Uniswap and PancakeSwap, allow users to list new tokens.
The third type of activity commonly used by DeFi users is derivatives. These platforms, such as dYdX and Synthetix, allow people to perform different types of trading. For instance, they can make leveraged trades and create assets similar to traditional commodities and stocks.
What’s Next for DeFi
Due to the nature of decentralized finance, it is constantly evolving. Its ecosystem is prone to infrastructural issues, scams, and hacks. The laws governing the operations of decentralized finance are based on the idea of multiple financial jurisdictions. With DeFi’s borderless transaction capabilities, regulators must understand its nature.
When investigating financial crimes that happen across different platforms and applications, such as DeFi apps, the authorities should have the necessary resources and control to do so.
Among the issues that regulators consider when investigating financial crimes are system stability, carbon footprint, and hardware failures.