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What is DeFi?

DeFi or Decentralized Finance is a blockchain niche where all financial services are provided in a decentralized manner and executed in an open, trustless, and permissionless manner. The latter three traits are the core of DeFi. 

  • Openness: This means that all projects would be developed in an open-source format while being transparent to the world.
  • Trustless: This means that any operation or task can be carried out without the need for a trusted third party’s intervention. 
  • Permissionless: This means that no permission is required by any authority or governing body to perform an operation. 

Let us give you a small example of a DeFi operation to help you understand this better. Sushiswap is a decentralized exchange. It is an open-source project where any developer can contribute and build the platform. 

Trading using a DEX exchange

If any trading needs to occur, it is executed by a smart contract and not a person. The smart contract is a program that has the criteria and parameters written into the code and helps execute all the transactions. This means that a program is running the exchange. 

Hence, all operations are open, trustless, and permissionless. A few other DeFi projects include Yearn Finance, Compound, Uniswap, and Fantom. 

A Brief Overview of Decentralized Finance (DeFi)

The blockchain and cryptocurrency space has been booming since 2020. Both Centralized Finance (CeFi) and Decentralized Finance (DeFi) were growing, but CeFi had a much larger market share, and DeFi wasn’t that popular. 

However, things started to change. In January 2021, the market cap exceeded $45 billion. Today, the market cap is about $167.84 billion. This means that DeFi has grown more than three times in the last year. 

Experts believe that these numbers will increase, and the DeFi space is well on its way to becoming more mainstream than it ever was. But, we’re sure you must be wondering what DeFi or Decentralized Finance is. 

How Does DeFi Work?

As mentioned earlier, DeFi eliminates the need for intermediaries through smart contracts. While the example in the above section was of a DEX (Decentralised Exchange), smart contracts go beyond these. In fact, people can code smart contracts to perform any operation they want. 

This is why numerous projects and services are emerging within this space. Traditional financial institutions also provide these services. A few of those include:

Lending and Borrowing

With this, people can lend/borrow money directly from each other. The smart contract will have preset conditions of how much collateral needs to be given and lets people borrow the money accordingly. 

Stablecoins

Stablecoins are cryptocurrencies that attach their value to fiat currency. This way, the volatility issue of the coins isn’t a problem. USDT or Tether is a stablecoin that pegs its value to USD. This means at any point, 1 USDT = 1USD. 

Decentralized Exchanges (DEX)

In a DEX, the smart contracts execute the transactions, and the order books are maintained by smart contracts known as the Automated Market Maker (AMM). This is responsible for ensuring that liquidity of all assets is available since there is no one authority working towards providing liquidity. It also enables people to become liquidity providers in return for rewards. 

Swapping Cryptocurrencies using a Decentralised Exchange

Insurance

Projects such as Nexus mutual help insuring your cryptocurrencies against failures of smart contracts and cyberattacks, which are becoming increasingly common. 

Derivatives

These types of projects apply a similar concept to stablecoins, where the crypto asset can be attached to stocks, commodities, fiat currencies, and other real-world assets.

These are a few types of services the DeFi space offers, but there are plenty more. This is because DeFi is still in its nascent stages and is rapidly growing. The vision of the people working within this space is to provide all services that one would get access to in the traditional system. 

Pros of DeFi

The DeFi space is closer to the core blockchain philosophy, and this has numerous advantages for the people leveraging it. Some of the most prominent ones are:

Accessibility

In the traditional system, accessibility was a major challenge. According to the World Bank, about 1.7 billion people remained unbanked in 2017. This is due to multiple challenges such as lack of infrastructure, a bias of authorities, and more. 

DeFi solves this challenge because it puts people on a level playing field. All one needs is a phone and an internet connection to access and leverage the most fundamental financial services to grow their wealth. 

Transparency

DeFi prides itself on being transparent right from the development process. The code is open source, and the world can contribute to it. Furthermore, all operations take place in full view of the world, which means people will see what’s happening with their money. 

This is a major solution for the visibility challenge people face regarding CeFi and conventional institutions.

Control Over Assets

DeFi allows people to have complete and absolute control of their assets, which isn’t the case in CeFi platforms or real-world institutions. This is another major challenge people face. Their money and transactions were ultimately not in their control, which changed with DeFi. 

These are some of the significant benefits of DeFi. However, like all things, it has its disadvantages too. 

Cons of DeFi

Considering DeFi is in its early stages, it is immature, and there are a few gaps and loopholes in the system that causes challenges. A few of them are:

Tech-Glitches

Soustechnological errors or glitches get in the way of the smooth functioning of these protocols. This affects the user in terms of experience and sometimes leads to loss of opportunities and security issues, which brings us to the next disadvantage.

Security in mining facilities which handle DeFi transactions is a risk

Security

DeFi and their smart contracts are vulnerable to attacks, and hackers sometimes leverage the opportunity to steal funds. For instance, in 2021, someone stole a total of $610 million from the Polygon Network. 

These are the two main disadvantages of the DeFi system. 

Final Thoughts

When it comes to compiling taxes it’s important to keep records of all your DeFi transactions. Remember, everything you do in blockchain is there for everyone to see via your wallet address. The Crypto Tax Australia team is on hand to help you navigate the DeFi space and can assist in compiling your records. We’re experts in the field, so if you are talking with your accountant about DeFi, cryptocurrencies or NFTs and they look confused, come to us – we are here to help.

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