Introduction to Defi
What is defi?
Defi is a new movement in the crypto space that aims to create a new financial system that is open to everyone. This financial system does not require any intermediaries such as banks. It achieves this by relying on decentralized applications which consists of many smart contracts that run on smart blockchains such as Ethereum and the Binance smart chain. Unlike traditional finance defi does not discriminate — anyone with a smart device and an internet connection can participate.
Since defi is decentralized and not owned or controlled by any centralized authorities the markets are always open and transactions occur 24/7 all day every day. Transactions can’t be blocked and no one can tell you what you can and cannot do with your money.
Smart contracts are the cornerstone and the building blocks of defi. They are built with a programming language called Solidity. They are deployed onto an existing blockchain where they can be executed automatically in a trust-less, secure, and deterministic way.
The smart contracts run inside a virtual machine called the Ethereum virtual machine which is Turing complete. These contracts also have capabilities such as receiving, storing, and sending funds. The aim of the contracts is to remove the human factor from decision-making, as human beings by history have proven to be unreliable, especially when it comes to money and power. Another great thing about these smart contracts is the fact that they get deployed to a public blockchain so anyone can look through the logic of the contract in a very transparent and open way.
Since smart contracts are programmable and can receive, store and send funds you can view them as “programmable money”. They enable us to create decentralized applications for borrowing, lending, insurance, escrow services, scheduling payments, investing, crowdfunding, lotteries, casinos and so much more.
Comparison between traditional finance and defi
|Your money is “held” by banks||Your money is held by you and you can store the key to your funds in any way you like|
|You have to trust a centralized authority||You have to trust cryptography and smart contracts|
|Your government or bank can seize your money for any reason they see fit||No one can seize your money for any reason|
|Financial activity is tightly coupled to your identity||You can be anonymous if you learn how to be|
|Markets are closed for longer periods than they are open||Markets are always open|
|Payments can be blocked for any reason the bank or governments see fit||Payments cannot be blocked by anyone|
|Payments that are allowed are slow||All payments are allowed and they are quick|
|You need permission to use traditional financial services||You don’t need anyone’s permission|
From the table above we can see a picture being drawn. Defi is all about monetary freedom whereas with traditional finance you are forced into the hands of others. You have to trust humans to do the right thing and not abuse their power — something history repeatedly has told us is impossible.
Defi applications run on open blockchains like Ethereum. Ethereum was the first blockchain that enabled these types of decentralized applications. Right now (2021) defi is getting extremely popular and the Ethereum blockchain is getting very crowded. Ethereum doesn’t scale very well and this has become a serious problem as of lately when we’ve seen transaction costs skyrocket.
Thankfully though, this scaling issue has been worked on for multiple years already and a much faster and scalable version is coming. In the meantime though, other layer 2 solutions have emerged such as Polygon and Binance smart chain. These have exploded in popularity recently and will probably continue to grow as the demand for defi services continue to increase. Both Polygon and Binance smart chain are capable of running smart contracts in an Ethereum virtual machine, but transacting on it is much cheaper and faster than the original Ethereum blockchain.
Up until now, we have only been painting a positive picture when explaining and comparing defi to traditional financial systems. But like anything, there are also negative sides to it.
Bugs! There are and will be bugs and vulnerabilities in these smart contracts. These happen all the time and hackers are constantly trying to find them and exploit them. The biggest and probably the most famous bug that resulted in a hack so far was the DAO hack. Millions and millions of dollars worth of Ethereum were stolen because of it and the Ethereum blockchain forked into two different chains — Ethereum and Ethereum classic.
Scammers & fake projects
Because defi is in its infancy and not well understood by many people there are those that try to take advantage of this situation. There are probably 100’s of freshly created scams within this space daily and sometimes it can be hard to identify which ones are actually legit. Many people get fooled by these scams and lose lots of money every day to them!
Therefore you should be extremely cautious when interacting with decentralized applications of projects that have not yet been proven and/or audited by external parties like CertiK. Even then, you should use them with caution and before interacting with any decentralized app you should always do your own research. This is very important!
Remember that these decentralized applications are all smart contracts that can be programmed to do whatever the developer wants. If you don’t understand how the project or the contracts work you are laying your trust in the hands of developers who are often times also anonymous.
Remember that all transactions that occur on a blockchain are final. If your funds get stolen for whatever reason you will never be able to receive them back!