DeFi, or decentralised finance, is a collection of trustless and transparent financial tools, protocols and platforms based on the blockchain.
Cryptocurrencies are digital currencies made up of digital code, traded as assets. The technology that creates and stores them is called blockchain, a type of Distributed Ledger Technology (DLT) that uses cryptography to make it difficult for malicious users to influence results in their favour. The blockchain is decentralised (meaning it has no central authority). It displays an unchangeable, immutable record of transactions across a public or private peer-to-peer network, which is accessible to all at all times.
DeFi aims to transform the traditional, centralised financial system, where a central entity, such as a bank, is replaced by cryptocurrency. DeFi offers similar services to traditional financial institutions, such as borrowing and lending. When compared to traditional banks, the interest rates offered by DeFi are often significantly higher.
The most significant benefit of DeFi is the lower barriers to entry. The lack of a central entity enables greater accessibility because there is no regulation to abide by. Aside from an internet connection and a crypto wallet, all that is usually required to access DeFi platforms are crypto assets as collateral. None of this lending impacts your credit score, and access to the loan comes almost immediately.
Like with many things crypto, DeFi comes with a significantly higher risk level than the traditional finance alternative. Here are the main risks to be aware of before getting involved with DeFi:
DeFi platforms require smart contracts to perform. A smart contract refers to computer code programmed onto a blockchain that automatically carries out all or part of an agreement, following a specific trigger or input. Being part of a blockchain, they come with the features of being secure, permanent and immutable. In short, smart contracts carry out instructions on the blockchain. In DeFi, they keep the counterparties involved in a transaction safe. But if the code of a DeFi platform has a fault, then the DeFi platform could potentially be harmed.
As mentioned earlier, the ability to put up crypto assets as collateral is often the only barrier to entry in securing a DeFi loan. However, there is a risk in doing this.
Example - Let’s say that Alex takes out a loan of $10,000 in USDT (Tether, a stablecoin pegged to the dollar), using Bitcoin as collateral. Once Alex has repaid the $10,000 plus interest, her Bitcoin will be returned in full. If, during repayment of the loan, the value of her Bitcoin had appreciated by an amount greater than the interest paid on the loan, then Alex would be able to profit on the difference (assuming she cashes out the Bitcoin). However, if Bitcoin had crashed in value while paying back the loan or she could not keep up with the loan’s terms, her Bitcoin would have been at risk. Alex must be wary of her Bitcoin dropping in value to a point where it impacts her required loan-to-value (LTV) ratio.
Historically, victims who trusted the wrong DeFi platforms have lost hundreds of millions of dollars.
DeFi Protocol Cream Finance Loses $130 Million in Latest Crypto Hack
Cryptocurrency has no consumer protection for things going wrong, so experts recommend investing nothing more than you can afford to lose. The general rule is to vet out any DeFi platform before using it and to stay away from interest rates that look too good to be true. A brand new protocol may be offering desirable interest rates but could well be untested.
Lending or borrowing crypto requires the signing of a smart contract, which establishes the following unalterable terms:
To become a lender, funds must be deposited into the DeFi protocol, similar to how one would make a cash deposit.
The key selling point to DeFi lending is that rates offered are significantly higher than under a regular savings account.
However, with greater potential rewards comes greater risk. When lending out crypto, it is essential to note that your returns are not guaranteed.
Exchanges offer two main types of loans: fixed and flexible.
Interest (APR) is often paid out daily, allowing you to benefit from compound interest even if you only lend for as short a period as a week.
As a borrower, you’ll be required to put up cryptocurrency as collateral. Cryptocurrency is notorious for its volatility, so crypto loans are always over-collateralised.
Let’s run through an example:
Does all this impact Jacinth’s credit score? No
How quickly does Jacinth have access to the loan? Almost immediately.
DEFI. COMPLETED. ✅
Sources:
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