New to DeFi? Here’s what you need to know before digging deeper

Initially, the famous Bitcoin (BTC) and crypto meme was "bank the unbanked," signifying that these technologies might offer bank-like services to individuals who can't access them for various reasons. Now, another meme is gaining traction – "unbank the banked." This is how the nascent industry is challenging traditional banking service providers by offering their clients BTC and crypto-related services through centralized or decentralized platforms.

Below is a quick primer to some of the key components in the highly complex ecosystem of distributed ledger technology (DLT)-enabled solutions that are reshaping the global financial services market. Blockchain, which underpins most crypto assets, is just one example of DLT, but it has opened the door to numerous opportunities that can enhance financial inclusion worldwide and create new economic prospects by granting individuals greater control over their money and improved access to both traditional and new financial services.

Why? Because it reduces dependence on the goodwill of third parties, such as banks. However, it's essential to remember that some actors in the BTC and crypto space remain centralized, despite claims to the contrary, and you may still encounter challenges similar to those in traditional banking when using their services.

A simple example could be a centralized crypto exchange, such as Binance, Coinbase, or Kraken, where you are required to undergo Know Your Customer (KYC) procedures and do not have control over your crypto assets. In contrast, a different situation arises with decentralized exchanges (DEXs), such as Uniswap or Curve, where all you need to do is connect your wallet, and you retain control over your funds.

These DEXs fall under the broader and sometimes vaguely defined term of decentralized finance, or DeFi for short. This is where some of the most intriguing developments occur, particularly in terms of helping people circumvent traditional financial services, including lending and borrowing, thereby promoting financial inclusion.

Multi-billion market

However, it's crucial to remember that, at this stage, DeFi may not be as promising as it initially seems, primarily for two reasons. Firstly, many decentralized finance platforms are not as decentralized as they claim to be, and they are primarily used for speculative purposes within the crypto industry rather than practical real-world applications, such as securing a car loan through a DeFi platform. In either case, you can find various mortgage offerings where you can use your BTC or crypto as collateral, but it's worth noting that these offerings are predominantly provided by centralized companies.

In either case, at the time of writing, there are approximately $14 billion in crypto assets locked in DeFi protocols that allow users to borrow and lend assets, according to DeFiLlama data.

Nonetheless, the DeFi ecosystem, primarily based on the Ethereum (ETH) blockchain, with growing DeFi projects on the Bitcoin blockchain as well, is continually evolving. Therefore, let's take a quick look at current developments that may indicate what the future holds and whether these technologies can be applied to more real-world use cases.

Currently, several multibillion-dollar DeFi platforms offer opportunities for lending your crypto assets or taking out loans, including Maker (MKR), Aave (AAVE), and Compound (COMP).

Key things

Without delving too deeply into the details, here are the key points you need to understand before using a DeFi platform:

• Borrowing. When taking a loan via a DeFi platform, you won't need to undergo a creditworthiness assessment, and no one will check your background. The amount you can borrow depends on the quality of your collateral (a crypto asset) and the available liquidity on the platform. For instance, if you use ETH as collateral, you can borrow more than if you use an altcoin. Liquidity, in simple terms, is restricted to what's available on the platform. Liquidity is provided by other crypto asset users who offer their funds for lending in a liquidity pool. Additionally, the platform is generally governed by a decentralized autonomous organization (DAO).
• Why? DeFi loans are typically overcollateralized, which means you need to post a larger sum as collateral than what you can borrow. Why would someone do this? Borrowers can retain ownership of their assets and avoid selling them, potentially incurring taxable income, especially if they anticipate their assets will appreciate in value. This allows them to access the necessary capital for various purposes, even though it's currently primarily used for speculative activities in the crypto markets. As for the loan rates, borrowers have the option to choose between stable rates, which are higher, and variable rates.
• Liquidations. Another important aspect to keep in mind is that your collateral can be liquidated if its value falls below the required threshold. Given the volatility of the crypto markets, this is a very real risk, and borrowers should remain vigilant and take preemptive measures to reduce the risk of losing their collateral. While using stablecoins as collateral can mitigate the risk to some extent, there are no guarantees that the value of a stablecoin or a digital token, often pegged to a fiat currency like the USD, won't decline, as the market has witnessed on multiple occasions.

The risks

The risk of liquidation is just one of the risks that DeFi users need to be aware of. In fact, this October, even the European Securities and Markets Authority (ESMA) published a report on DeFi developments and risks. Among the dangers, ESMA highlighted certain factors that are also present in traditional markets:

• Market and liquidity risks: These risks are related to changes in the market and price volatility.
• Counter-party risk: Smart contracts running DeFi platforms are not immune to bugs, which can lead to unexpected problems such as erroneous collateral liquidation and exploits.
• Scams and illicit activities: Unfortunately, there have been multiple instances of scammer-run "DeFi" platforms that deceive victims, take their money, and abscond with all the funds.
• Complexity and risky products: Some products in DeFi are exceedingly complex to use, increasing the potential for errors and losses.
• Operational, technological, and security risks: These risks are associated with the multi-layered infrastructure of such platforms, potential problems with the underlying blockchain the platform is based on, and security breaches, which are not uncommon in the DeFi space.

Upcoming regulation

Meanwhile, it will take several years for the EU to adopt legislation that may better protect DeFi users and bring greater clarity to this industry, similar to what was done with the Markets in Crypto Assets regulation set to come into force in the EU next year, providing more clarity to the centralized part of the crypto industry. Other jurisdictions are also grappling with the challenge of establishing appropriate regulations for this market.

However, it's highly likely that by the time the legislation is in place, the DeFi industry will have undergone a significant transformation from what we see today. Hopefully, many of the issues currently prevalent in DeFi will have been mitigated by then, making platforms more user-friendly for regular individuals who can access loans without needing third-party approval.

Until then, DeFi platforms can already be used by those who truly understand what they are doing and are willing to accept all associated risks and know how to manage them.