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Deciphering DeFi: A Comprehensive Analysis and Visualization of Risks in Decentralized Finance by Tim Weingärtner, Fabian Fasser, Pedro Reis Sá da Costa, Walter Farkas :: SSRN


DeFi is primarily based on Ethereum, the top cryptocurrency next to Bitcoin. If you can imagine sending money, making a payment, or buying a financial asset without the assistance of a bank, brokerage, or other official intermediary, then you’ve grasped the essence of decentralized finance. Further challenges facing decentralized finance include its reliance on energy to power blockchain technology.

The difference between shared and smart pools is that in shared pools, the parameters are set, while in smart pools, they can be changed. Thanks to liquidity pools and the price being defined by a formula, a trade can always take place –– though spreads may still be wide on illiquid open Finance vs decentralized finance pairs. The automated market maker (AMM) model relies on liquidity pools, in which each token is paired with ETH, ensuring there’s always enough liquidity between any two tokens. COMP was distributed to users of the platform in proportion to the funds they have lent or borrowed.

  • Banks and financial institutions can help you transfer funds from one place to another, but the route isn’t direct.
  • DeFi has grown rapidly in scale and scope, forming a complex ecosystem with a high degree of interconnectedness.
  • Your money would be converted to a “fiat-backed stablecoin” and made accessible via digital wallet so you wouldn’t have to deposit funds into a bank.
  • Through peer-to-peer financial networks, DeFi uses security protocols, connectivity, software, and hardware advancements.
  • Regular consumers typically need to deal with a raft of financial middlemen to get access to everything from auto loans and mortgages to trading stocks and bonds.
  • But it also makes this digital money programmable, using smart contracts, so you can go beyond storing and sending value.

Further, he could apply for a mortgage through the same platform that will govern the ownership right and once mortgage payments are complete, it will transfer the ownership right of the concerned property to the borrower. In order to use DeFi, you will need a digital wallet that is compatible with Ethereum. The wallet allows users to securely store thousands of NFTs and cryptocurrencies.

Many DeFi supporters think CeFi has shortcomings, including creditworthiness requirements, high fees, lengthy wait times for wire transfers, limitations on access to funds, and other factors. They believe the remedy, of course, is DeFi—an ecosystem where developers are also able to create new products and services without the need for approval from centralized entities. DeFi is an umbrella term for apps, platforms, and organizations that enable users to lend, borrow, stake (we’ll cover more on what staking is shortly), and trade crypto assets. The exigent problem is that those trading such US dollar stablecoins must trust that the companies that create them are true to their word and that these tokens are always redeemable for US dollars. Lawrence Lessig’s dictum, “Code is Law”, motivated the rise of the decentralized stablecoin, whose peg to the asset it represents is determined by a complex, self-sustaining algorithm. Non-custodial means that the teams don’t manage your crypto on your behalf.

Founded in 2015 by Rune Christensen, MakerDao is an organization-building technology for savings, borrowing, lending, and a stable cryptocurrency on the Ethereum blockchain. Instead of conducting an initial coin offering (ICO), the project privately sold $MKR tokens to fund the development over time. $DAI, Maker’s stablecoin, was launched in 2018 and has experienced significant traction. Financial markets can enable great ideas and drive the prosperity of society.

Teams can build out interfaces where you can’t just see your balances across products, you can use their features too. A good example is the DeFi Pulse Index fund (DPI)(opens in a new tab). This is a fund that rebalances automatically to ensure your portfolio always includes the top DeFi tokens by market capitalization(opens in a new tab). You never have to manage any of the details and you can withdraw from the fund whenever you like. This lets you pay someone their salary by the second, giving them access to their money whenever they need it.

As crypto tokens are highly volatile, this peg is required to be overcollateralized, i.e. the cryptocurrency used as collateral to issue the stablecoin should be higher in value than the issued stablecoin. Although Bitcoin was intended to function as money, many limitations still exist. Bitcoin has unintentionally created new central authorities such as node operators, miners, exchanges, and wallets to control the flow of this cryptocurrency. Our company is proud to be at the forefront of this paradigm shift in finance. We offer a suite of tools and services that make it easy for you to launch and manage your own decentralized finance solutions. Our thought on the functionality of money is being challenged with every new disruptive launch.

A smart contract is a code-based agreement and whether the agreement will be honoured or not depends on the fulfilment of certain conditions. The contract will always run as programmed, and no one can alter it when it is live. The fact that the future of decentralized finance and the future of money lies in the hands of anyone who can code is nothing less than interesting for us as bystanders. We are also seeing a shift towards decentralized governance and decision-making. The DeFi community, however, is looking for ways to enable stakeholders to vote on decisions, introducing a much wider range of DeFi use cases.

what is decentralized finance

Some of the renowned yield farming platforms are Beefi.Finance, Yearn Finance, etc. To understand the DeFi to its core, we should understand the components which make the DeFi ecosystem. It is similar to the ecosystem of the traditional financial system, good infrastructure, and a stable currency at a broad level. With these two components, decentralized applications (Dapps) have developed many use cases, which we will discuss later in this article. To understand DeFi and its utility in our current ecosystem, we first need to understand the existing financial system, i.e., centralized finance that provides us financial services for over two centuries. The DeFi environment provides valid possibilities to innovate and create DeFi services and products.

For example, users can manage their own assets and decide which assets to transact with. This allows them to conduct transactions without having to go through a third party, and it also makes it more difficult for someone to steal their funds. As a result, decentralized finance gives users more control over their own finances and helps to protect them from fraud. All DeFi services are based on crypto, but not all crypto projects are part of DeFi.

More information on potential profits from yield farming can be found on sites like With DeFi smart contracts, the terms and conditions of a transaction are also transparent and available as code, which means they are viewable by others to audit and analyze. There is no need for a central authority to enable a smart contract with DeFi as the system works in a P2P model.

what is decentralized finance

Flash loans are a more experimental form of decentralized lending that let you borrow without collateral or providing any personal information. Today, lending and borrowing money all revolves around the individuals involved. Banks need to know whether you’re likely to repay a loan before lending. But Ethereum also creates opportunities for creating financial products that are completely new. According to their site, you can “Swap, earn, and build on the leading decentralized crypto trading protocol.” Using traditional financial systems, you apply for a loan and may be rejected based on your credit.

Traditionally, currency-issuing nations and banks had control over financial markets and the ability of individuals to borrow and invest money. That was a paradigm that appeared unlikely to change until blockchain technology emerged, enabling a decentralized finance ecosystem that is now fully operational and poised to revolutionize finance. DeFi consists of applications and peer-to-peer protocols developed on decentralized blockchain networks that require no access rights. The decentralized apps (dApps) are used for easy lending, borrowing, or trading of financial tools. Most DeFi applications today are built using the Ethereum network, but many alternative public networks are emerging that deliver superior speed, scalability, security, and lower costs.

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