DeFi – what is that? DeFi is the abbreviation for Decentralized Finance. Translated into German, it means decentralized financial markets. What exactly is behind it, whether DeFi is really the future of finance and what risks and benefits arise from Decentralized Finance, you can read in the following text.

Topics in our legal advice

  • Blockchain
  • Cryptocurrency
  • Cardano
  • Ethereum
  • Non-Fungible Token
  • Smart Contracts
  • Token

Traditional financial services that are processed via a decentralized network such as a blockchain are referred to as Decentralized Finance (or DeFi for short).

In other words, DeFi is an acronym for “Decentralized Finance”.

Table of contents

  1. DeFi – what exactly is that?
  2. DeFi and dApps
  3. Decentralized Finance – the basics
  4. DeFi: current developments
  5. Decentralized Finance – possible applications
  6. DeFi: Lending, Staking, Derivatives and Decentralized Exchanges
  7. Payment processing – DeFi and cryptocurrencies
  8. Stable Coins and DeFi
  9. Decentralized Finance – Advantages
  10. Risks of Decentralized Finance
  11. DeFi: Outlook and legal advice

Decentralized Finance – Definition

DeFi is a broad term that does not mean much at first. It covers all financial applications that are not controlled by a single entity as in conventional finance. An institution that serves as a central point of contact and control for all transactions and services is an example of such an intermediary.

In DeFi apps, this task is performed by the network of actors, which is controlled by the “rules of the game” of the protocol.

Blockchain protocols offer decentralized organisation through smart contracts, as is the case here. When used in place of human or manual transactions, smart contracts function as a digital contract encoded in computer code.

Decentralized Finance (DeFi) and dApps

These decentralized applications, often referred to as dApps, enable the financial industry to offer the same services that are normally provided by traditional financial intermediaries. This may include, for example, securities trading or lending and redemption.

Currently, most DeFi apps are based on Ethereum, the best-known and most widely used smart contract platform. Tokens are used in a decentralized ecosystem to monitor one’s operations. These tokens can be used to coordinate network decisions and incentivise the operation of the decentralized service, he says.

Quite a few enthusiasts are calling DeFi the concept of future finance, as it is one of the fastest growing segments of the crypto business. Anyone interested in blockchain and cryptocurrencies such as Ether, Cardano (ADA) or Bitcoin should be familiar with this jargon.

The basics

The term DeFi is often used in connection with financial services based on decentralized blockchain technology. This stands for “decentralized finance”. In some circles, it is also called “open finance”.

The idea of decentralisation is in contrast to traditional financial services, which are often centrally structured, i.e. managed by a single organisation such as a central bank or financial institution. Many of the disadvantages of centralisation, such as central weaknesses, monopoly positions and bureaucratic hurdles, are to be eliminated by DeFi.

Smart contracts enable the decentralisation of financial services by automatically enforcing regulations and recording all transaction data in a distributed ledger. As a result, no single actor has complete control over transactions, making censorship and corruption impossible.

When a traditional bank offers loans to its customers, only the bank has the power to choose who gets what kind of loan and on what terms.

People who have smartphones and an internet connection can use a decentralized network to get a loan controlled by smart contracts instead of a traditional bank loan. The terms are available for anyone to see and review. Proponents of decentralisation claim that this move would make financial services more accessible and inclusive.

Issuing stablecoins, loans, trading, peer-to-peer payments and insurance are just some of the services offered by DeFi companies. Decentralized apps (DApps), most of which are based on Ethereum, allow users to access these services.

Current development in the DeFi sector

Because DeFi is such a young and fast-growing industry, it is difficult to conduct a thorough market study of it at this stage.

The size and trends of the DeFi market can be estimated using a number of indicators.

One of these indicators is the Total Value Locked (TVL), which shows how much money (in USD or ETH) is tied up in the sector.

In terms of market capitalisation, MakerDAO (the decentralized platform for creating the USD-linked stablecoin DAI) and Compound (a money market protocol for lending) are the two most important projects that currently exist.

The total number of users, on the other hand, is perhaps a better indicator of the uptake of decentralized financial services, as TVL can be driven up by the leverage of the system (as with many yield farming schemes).

So far, loans make up the bulk of the DeFi market.

Companies like Compound allow cryptocurrency holders to borrow money using their crypto assets as collateral or lend their crypto assets to other network members to earn interest. Interest rates on most platforms are set according to supply and demand, rather than being entered manually.

It is also worth noting that decentralized financial services such as stablecoins are becoming increasingly popular.

Stablecoins such as DAI or USD Coin are cryptocurrencies that are backed by a constant reserve value to reduce their price volatility.

Stablecoins can be linked to the value of a fiat currency or commodity price, or they can be controlled by an algorithm.

Stablecoins aim to provide consumers with a more stable asset, similar to fiat money.

Potential uses for DeFi

The decentralized financial sector offers a wide range of possible uses. The possibility of earning money with DeFi apps is very attractive to many consumers. albeit with risks. Virtually every application that exists in the traditional financial sector can be found in the DeFi sector.

Lending – what does that mean?

Among the most popular DeFi protocols is MakerDAO, whose primary use case is lending and borrowing.

Tokens are lent against an interest rate and the interest is paid back to the borrower.

By using the decentralized lending protocol, the network manages the transactions instead of the bank. The most common scenario is that you use “log-in” tokens that you already own for lending. In this way, you make your tokens available to other people. In return, you receive interest on the lent tokens.

Staking – briefly explained

Staking is a term used to describe the mining option as a promising source of income.

With staking, you can make your Bitcoins available to the network without having to engage in labour-intensive mining. Unlike lending, no funds are paid out and the network as a whole is only secured by a deposit.

In return, Staker can expect interest income in the respective cryptocurrency. The larger the amount of cryptocurrency deposited, the larger the share of the blocks’ settlement volume. On sites like Staking Rewards, you can see, among other things, how high the payout will be.

Derivatives in the DeFi sector

Financial derivatives, as they are known from the traditional financial sector, also exist in the decentralized financial sector. If you prefer to trade options, futures or other financial instruments, you can do so on a decentralized market.

Derivatives in the DeFi sector can theoretically represent any underlying asset, such as bitcoin or gold.

Decentralized exchanges in cryptocurrency trading

Decentralized exchanges (DEXs) are exactly what they sound like. The buying and selling of cryptocurrencies takes place directly and without intermediaries.

Traditional exchanges have access to traders’ assets, but decentralized exchanges (DEXs) do not. The assets are exceptionally safe as they are not controlled by a single central organisation. Anyone can trade digital assets instantly and anonymously on decentralized exchanges.

Payment options in the DeFi sector

Decentralized payment processing is already possible with DeFi apps. As many blockchains like Bitcoin and Ethereum are not able to process transactions quickly or scale up or down, people are looking for other options.

Second-layer solutions, i.e. additional payment infrastructures “on top” of the actual blockchain, could be one of these options. This speeds up the processing of “off-chain” transactions. The Bitcoin Lightning Network is perhaps the best known of these solutions.

Stable Coins and their function

Stable coins, as the name suggests, are intended to offer security and predictability. Therefore, they are replicas of fiat currencies such as the US dollar or the euro, which are less volatile. This protects you from the risk of losing money due to exchange rate fluctuations.

Due to the volatility of cryptocurrencies, problems such as difficulties in repaying a loan are possible.

The stable coin is a token-based derivative that tracks an underlying asset – usually US dollars – and is suitable for developing token-based applications. There are several ways to collateralise stable coins. They can be backed by cryptocurrencies, fiat money or an algorithm.

DeFi: 5 opportunities and benefits

These are the 5 most relevant opportunities made possible by Decentralized Financial Markets:

  1. The traditional financial industry is exclusive and essentially excludes those who do not have a bank account. This restriction does not exist with DeFi.
  2. Financial services, such as asset trading, are available 24 hours a day, seven days a week. There are no business hours or regulatory restrictions.
  3. No third party personal data is processed and all transactions are publicly available.
  4. Due to the increased level of automation, the cost of financial services can be significantly reduced by eliminating expensive financial intermediaries.
  5. DeFi, like any new market, is only at the beginning and still has a lot of potential.

DeFi: 5 disadvantages and dangers

The use of decentralized finance also entails risks. We have summarised the 5 most significant ones for you here:

  1. As DeFi is still in its infancy, there is little empirical data and no long-term studies that can be conducted.
  2. For example, smart contracts could be vulnerable to hacking due to vulnerabilities, and technological remedies are often complex and not yet intuitive for the average person to use.
  3. The advantage of personal responsibility can also be a disadvantage, as one is responsible for the custody of the tokens.
  4. The legal security of decentralized financial transactions can be jeopardised by a lack of regulation or consumer protection. And speculation and bubble formation can also spread quickly.
  5. Basically, there is a high risk of loss and fraud when trading cryptocurrencies in the decentralized financial sector.

Risky speculation

Yield farming has become popular in the DeFi industry as a way to make disproportionately high profits.

Yield farming

The basic idea is this: tokens are used as a kind of collateral and interest is paid in return.

In the next step, part of the deposited money is lent out and registered with other lending institutions. To increase the return on the invested money, one has to repeat this process again and again. In a further step, one uses liquidity mining to further optimise the already attractive interest rates.

Liquidity mining

Some protocols, such as Compound (COMP), allow liquidity mining to further increase the overall return. This means that when liquidity is lent or provided, the network or governance token is produced or mined. When a user lends or borrows compound, COMP is distributed.

The goal of DeFi speculators is therefore to generate as much COMP as possible. The effect of yield-mining can therefore be prolonged by an increase in the price of the underlying token, allowing for yields that are far above the norm.

This is of course pure speculation and carries enormous dangers.

Outlook and summary

Decentralized financial services (DeFi) are undoubtedly a very popular topic in the crypto economy and are one of the fastest growing industries. The exponential expansion of DeFi and the general hype around it have attracted new crypto investors and developers and also piqued the curiosity of traditional financial players.

It will certainly take some time before a broad base adopts this technology.

DeFi’s future opportunities depend on whether it can deliver on its promise of open and accessible services while adding value for its clients.

There are a number of dangers in investing in the DeFi business, as it is still very young. Fierce competition in the DeFi market could encourage developers to offer new services and more user-friendly products and to reduce transaction costs (e.g. through second-layer solutions).

Is DeFi the way of the future for the financial industry?

There are many crypto enthusiasts who believe that decentralized finance is the future, but this depends on the value that decentralized financial services generate (e.g. lower costs, faster settlement and innovations such as fast lending).

And on the general adoption and acceptance of crypto solutions by people around the world.

Taking advantage of legal advice

Many people want to benefit from the possibilities of new technologies. Criminals, too. Thus, cases of investment fraud in the field of cryptocurrencies are accumulating.

The Herfurtner law firm conscientiously and competently advises you on the legal topics: Fraud, Internet Fraud, Cybercrime, Bitcoin Fraud as well as Blockchain, Ethereum, Smart Contracts, Cardano, Tokens and Non-Fungible Tokens.

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