We are constantly looking for newer, faster, and safer methods of payment. Using plain old cashiers is no longer considered safe which is why most of us switch to credit cards. It makes all transactions so much simpler, faster, and safer. But, what if I told you there is something that is even faster while providing more security? Of course, and talking about decentralized finance or more commonly referred to as DeFi. Decentralized finance is an innovation that was inspired by cryptocurrency or more specifically, blockchain technology.
The amazing part about the blockchain technology and method of payment is the fact that all the transactions made with certain cryptocurrencies such as Bitcoin are not handled by one single entity. In other words, there is no middleman that has direct control over the money. The payments go directly from one party to another. This essentially makes any kind of purchase or sale is completely anonymous and processed much faster. DeFI protocols follow that same principle while trying to make this kind of service available to everyone and not just to owners of cryptocurrency.
Since these kinds of services are still quite new, I wanted to write this article and share the most important things everyone should know about decentralized finance.
1. How does decentralized finance work?
Before we can delve deeper into this topic, I think it would be smart to talk about exactly how DeFi works. Once you understand how this entire industry works, you will be able to decide whether you want to be a part of it or not.
Previously, I talked about how decentralized finance is very similar or even based on blockchain technology. This is why they are so similar in the way they operate. Basically, there is no single entity such as a bank or payment processing companies like PayPal, Visa, or MasterCard controlling the transactions and the money.
One such entity having control over your money is not exactly a bad thing, but that kind of control hinders the speed and performance of the deal. When you pay with a regular credit card, the financial institution that controls the funds of your account will record the two parties making the deal, slowing down the process considerably. If you remove the need for those records, the entire process becomes much smoother and faster.
2. What about DeFi protocols?
Now that you have a good understanding of how decentralized finance works, we can now expand on DeFi protocols that rely on this technology.
Basically, this kind of protocol works without a middleman’s slowing down or complicating the process. Instead, everything can be done through a smart contract. The borrower can provide the money directly to the lender. Of course, and most of the DeFi situations, the funds will be in the form of cryptocurrency. This makes the entire process safer for both parties. The funds will not enter any kind of term contract or staking period. The funds will be entirely yours.
3. Compound interest
These days, your bank will suggest storing all of your funds on your account because you will be paid at a certain interest rate. That sounds like a favorable option, but the interest rates on these banks are so low, it is really not worth your time. Some banks do not even offer any kind of interest.
This is where DeFi protocols come into play. They offer you to story your wealth with cryptocurrency while offering a considerably higher compound interest rate that is paid regularly. Some companies offer a compound interest of more than 10% as suggested by Clever DeFi. That is a lot more than the measly 1-2% that regular banks offer.
So, if you are looking for a way to safely store your wealth and maybe even improve it over time, this is probably the solution.
4. Possible risks
With any kind of financial investment, there are bound to be some kind of risk. No matter how safe or convincing DeFi might sound, it is still smart to be careful. Being too careful will not hurt anybody. It will just help you make better decisions.
From what I can see, there are no risks in the transactions themselves or in the smart contract. Most of the time, all of those risks have been accounted for and avoided.
However, the risk of DeFi is in the crypto market. You probably already know this, but the cryptocurrency market is very volatile. One day, a certain coin could have a worth of $100 and the next it could be just $1. So, as you can see, there is a big risk that the value of a certain coin might drop considerably. Bitcoin is a great example. It was just $3,000 a year ago and today it is almost $20,000 per point. That is an amazing increase in value, but it could also drop considerably in just a few days.
The smart contracts cannot protect you from such a loss in value.
Another risk to consider is the possibility of getting hacked. Many of these exchange websites have been hacked previously and a lot of money has been stolen. Although that is quite rare considering the level of security on these websites and crypto wallets, it is not possible.
All of this information about risks should not scare you away from the potential of making money. As I said previously, all investments have a risk, you just need to be aware of them.
5. Room for growth
If you do not like how decentralized finance protocols work right now and if you do not like current risks, you should know that there is still a lot of room for growth. The whole idea surrounding DeFi protocols is still quite new which means there is a bright future ahead. In a few years, we will probably see better safety and a lot more benefits. I think that it would be smart to be patient and see what the future brings for DeFi.
As you can see, the whole idea behind DeFi protocols is quite complicated, but I think that more and more people will start to understand how it works as time passes.