Tom Merritt tells us all about this new phenomenon in lending and borrowing.
DeFi has become a big target with the stealing then returning of more than $600 million in cryptocurrency from the Poly Network as one of the most prominent examples.
But what is it?
Here are five things to know about DeFi.
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- DeFi stands for decentralized finance. Broadly speaking, it's using blockchains and cryptocurrencies to allow bank-like functions like saving, lending, borrowing and trading, without involving intermediaries. Smart contracts replace brokerages, exchanges, banks and other traditional financial entities.
- Most DeFi apps run on the Ethereum blockchain. A smart contract executed on the blockchain enforces the terms of the deal. The risk associated with using a DeFi app is based a lot on the technology. If the code fails or gets hacked, you could lose money.
- Interest rates are better. When you don't have to pay staff and bankers and brokers, the amount of interest can rise, and the lender or saver keeps almost all of it.
- You still can use collateral. Not all, but many contracts have a hedge that says it will get something if you fail to repay. Usually it's stash of cryptocurrency but it might also be things like NFTs. As a lender, though, the volatility of that collateral is important to consider. It could be worth 150% of the loan at execution and 1% by the time you need it.
- Anyone can use it. There's no bank manager granting you an account. And there's no regulation and no external insurance. While there are versions of insurance within the DeFi systems, they all suffer the same risks as any DeFi app. There's no government agency or FDIC to bail you out if you lose your money.
DeFi is fascinating and could solve a lot of inefficiencies in finance. If you do decide to dabble, look at applications that share their code, are vetted by independent users and can handle heavy user demand.
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