Decentralized finance (DeFi) in brief
One phrase that has made waves in the financial world is decentralized finance (aka: DeFi). DeFi uses cryptocurrency and blockchain technology to handle financial transactions outside the control of traditional financial institutions such as banks, brokerage firms, and government-run exchanges. DeFi aims to parallel traditional and centralized institutions, to call them mediators, with direct peer-to-peer financial relationships for loans, mortgages and asset trading.
In the United States, regulators such as the Federal Reserve and the Securities and Exchange Commission (SEC) set the rules centralized financial institutions and brokerage houses; with Congress changing the rules after each financial fiasco (savings and loan crisis in the 1980s). As a result, there are few avenues for some consumers to directly access capital and financial services. They cannot bypass middlemen like banks, stock exchanges, and lenders, who earn a percentage of every financial and banking transaction as a profit. Apart from DeFi, we all have to pay to play.
DeFi challenges the centralized financial system by disempowering intermediaries and empowering ordinary people through peer-to-peer exchanges.
“Decentralized finance is an unbundling of traditional finance. DeFi takes the key pieces of the work that banks, exchanges, and insurers do today – like lending, borrowing, and trading – and puts them in the hands of ordinary people.
– Rafael Cosman, CEO / co-founder of TrustToken.
Today you can put your savings into an online savings account and earn 0.50% interest on your money. The bank then turns around and lends that money to another customer at 3% interest and pockets the 2.5% profit. With DeFi, people lend their savings directly to others, eliminating that 2.5% profit loss and getting the full 3% return on their money.
You might be thinking, “Hey, I already do this when I send money to my friends with PayPal, Venmo, or CashApp.” But you don’t. You still need to have a debit card or bank account linked to these apps to send funds, so these peer-to-peer payments still depend on centralized financial intermediaries to function.
Large public books
Blockchain and cryptocurrency are the core technologies that enable decentralized finance. When you make a transaction in your conventional checking account, it is recorded in a private ledger (bank transaction history), which is owned and managed by a large financial institution. The blockchain is a decentralized and distributed public ledger in which financial transactions are recorded in an encrypted computer code.
Thanks to blockchain distribution, all parties using a DeFi app have an identical copy of the public ledger, which documents transactions in encrypted code. Encryption secures the system by providing users with anonymity, payment verification, and a record of ownership of assets that are virtually impossible to alter by malicious activity.
Thanks to the decentralization of the blockchain, no intermediary or guardian manages the system. Transactions are verified and recorded by parties that use the same blockchain, through a process of solving complex mathematical problems and adding new blocks of transactions to the chain. DeFi supporters claim that decentralized blockchain makes financial transactions more secure and transparent than traditional systems used in centralized finance.
Bitcoin is certainly the most popular cryptocurrency, but the Ethereum-based code is used in many other applications. Find out how DeFi is being used all around you today:
- Traditional financial transactions. Everything from payments, securities trading and insurance, to lending and borrowing, already happens with DeFi.
- Non-fungible tokens (NFT). NFTs create digital assets from generally non-tradable assets, like videos of slam dunks or the first tweet on Twitter. NFTs commodify what was previously inconvenient.
- Decentralized exchanges (DEX). Most cryptocurrency investors use centralized exchanges like Coinbase or Gemini. DEXs facilitate peer-to-peer financial transactions and allow users to stay in control of their money.
- Electronic wallets. DeFi developers are creating digital wallets that can operate independently of the largest cryptocurrency exchanges and give investors access to everything from cryptocurrency to blockchain-based games.
- Stable rooms. While cryptocurrencies are notoriously volatile, stablecoins attempt to stabilize their values by pegging them to non-crypto currencies, like the US dollar.
Most centralized financial tools and technologies are released over time, governed by the rules and regulations of economies; but these exist outside of these rules, increasing their potential reward but also increasing their risk.
DeFi is an emerging phenomenon that involves various risks. As a recent innovation, decentralized finance has not been tested with long or widespread use. In addition, national authorities are taking a closer look at the systems they put in place, with a view to regulating the tools. Some of the other risks of DeFi include:
- No consumer protection. DeFi flourished in the absence of rules and regulations. But it also means that users may have little recourse if a transaction is unsuccessful. In centralized finance, the Federal Deposit Insurance Corporation (FDIC) reimburses depository account holders up to $ 250,000 per account per institution in the event of a bank failure. In addition, banks are required by law to hold a certain amount of their capital in the form of reserves, to maintain stability and to withdraw you from your account at all times. No comparable protection exists in DeFi.
- Hackers are a threat. While a blockchain can be nearly impossible to modify, other aspects of DeFi are at high risk of being hacked, which can lead to theft or loss of funds. Many software tools that cryptocurrencies run on are vulnerable to hackers, which is of concern. This is why it is always vital to have strong and unique passwords longer than 14 characters stored in a password manager with two-factor authentication enabled on all possible accounts.
- Requirements for private keys. With DeFi and cryptocurrency, you need to secure the wallets used to store your cryptocurrency assets. Wallets are secured with private keys, which are long and unique codes known only to the owner of the wallet. If you lose a private key, you lose access to your funds and there is no way to recover a lost private key.
- Long-term risks for DeFi: With direct transactions from item a to item b, there is a one-to-one ratio. In traditional banking and financial institutions, the ratio is 1 to many. The money supply directly benefits from traditional finance. The world survived a global pandemic thanks to fiscal stimulus measures that were only possible thanks to our centralized financial institutions. Taken to extremes, DeFi could undermine the world’s ability to respond to things like a global pandemic.
What to do?
It is important to make sure that all of the basic metrics are in place when dealing with financial information. Taking the following actions recommended by CyberHoot can save you a lot of headaches not only when dealing with cryptocurrencies, but with any account that has sensitive information:
- Adopt two-factor authentication to prevent password breach of your company’s VPN, email services, and other critical services directly accessible over the Internet
- Adopt a password manager for personal and professional use to improve password hygiene
- Back up data regularly by following the 3-2-1 backup method to back up all your critical and sensitive data
- Train employees on how to detect and avoid phishing attacks – the main way cyber attacks happen
- Test employees on their training to validate that they can spot and remove threats rather than click and succumb to an attack