DeFi (decentralized finance) is the finance component of Web3. It simply represents all decentralized applications that fall under the category of finance
DeFi protocols replace the traditional intermediaries, such as banks, with smart contracts that execute transactions when conditions are met.
Anyone can become a market maker in DeFi, just as anyone can lend/borrow crypto or stake their crypto to earn yield.
Advantages of DeFi
When compared to traditional finance institutions, DeFi excels in many areas, including:
Trust is not required for a DeFi protocol to work
Protocols rooted in blockchain have high security
Transactions are settled in minutes
Much more efficient than traditional finance
Another advantage of DeFi is that is democratizes financial activities typically reserved for the elite in traditional finance. Decentralized applications (dApps) in the DeFi space allows any participant to partake in numerous financial activities:
Lending/borrowing crypto
Speculating with derivatives
Market making
How Does DeFi Work?
In order to best understand how DeFi works, it will help to have a basic understanding of both Bitcoin and Ethereum.
DeFi uses cryptocurrencies and smart contracts to provide services that don't need intermediaries. In today's world, financial institutions act as guarantors of transactions, which gives them immense power because your money flows through them. Ethereum takes it one step further and allows its users to store both transitions and smart contracts in its blocks.
How Much Does DeFi Cost?
There are two primary costs associated with transactions in DeFi:
DeFi protocol fee: most protocols charge a nominal fee to transact
Gas Fee: After a transaction is sent on a protocol, it ultimately goes to an Ethereum validator to get added to the blockchain. Validators get paid for their work in securing a network gas fees
These fees vary on the current demand for validations, the traffic on the network, and how many validators are currently staking
What Are The Risks Of DeFi?
DeFi protocols have very little human interaction. Some protocols, called DAO's, (decentralized autonomous organizations) are run completely by software programs. All of this code introduces risk to investor. Here are a few of the more predominate risks of DeFI:
Hacker/coding: poorly written code can allow hackers to gain access to a protocol, which can lead to a complete failure
Counterparty: in DeFi, loans are usually over collateralized, which helps reduce counterparty risk, but it is still possible in incredibly volatile markets.
Impermanent Loss: refers to the opportunity cost of placing your crypto in a liquidity pool
Regulatory Risk: at any given time, a government could theoretically outlaw any aspect of crypto
In order to assure your risks in DeFi are mitigated, it is recommended to make sure at least one independent audit has been done on your chosen protocol. It is best to interact with widely used protocols (Uniswap, Aave, Curve, etc.) as the vast majority of these have had at least one audit performed