The basics of decentralized finance

News headlines mentioning cryptocurrencies, blockchain technology and peer-to-peer finance have become common over the last years. Despite this, not everyone understands how they work and the decentralized finance (DeFi) sector can appear intimidating. This limited awareness about the building blocks of DeFi has in turn resulted in many people missing out on the significant returns available in DeFi as they believe it is only about exchanging Bitcoin, Ether, stablecoins and other cryptocurrencies. 

As CEO of AQRU, an incubator specializing in decentralized finance, I’ve crossed paths with many people who think this way. This is why I’ve dedicated significant efforts to raising awareness about DeFi and explaining that decentralized finance is similar to the traditional financial system in the sense that it offers a wide range of services such as lending, savings and insurance. But, unlike its traditional counterpart, these services use peer-to-peer and blockchain technology to eliminate intermediaries and to offer higher returns for investors. 

So, let’s take a closer look at the building blocks of decentralized finance, how the system works and how it has managed to offer customers higher returns than traditional finance.

How does decentralized finance work?

Decentralized finance is built on blockchain technology, an immutable system that organizes data into blocks that are chained together and stored in hundreds of thousands of nodes or computers belonging to other members of the network.

These nodes communicate with one another (peer-to-peer), exchanging information to ensure that they’re all up-to-date and validating transactions, usually through proof-of-work or proof-of-stake. The first term is used when a member of the network is required to solve an arbitrary mathematical puzzle to add a block to the blockchain, while proof-of-stake is when users set aside some cryptocurrency as collateral, giving them a chance to be selected at random as a validator.

To encourage people to help keep the system running, those who are selected to be validators are given cryptocurrency as a reward for verifying transactions. This process is popularly known as mining and has not only helped remove central entities like banks from the equation, but it also has allowed DeFi to open more opportunities. In traditional finance, are only offered to large organizations, for members of the network to make a profit. And by using network validators, DeFi has also been able to cut down the costs that intermediaries charge so that management fees don’t eat away a significant part of investors’ returns. 

Clever contracts

In decentralized finance, all transactions, are run by smart contracts which are programs, or pieces of code, stored on the blockchain and are only enacted when certain preconditions are met.

For instance, a smart contract regarding the purchase of a nonfungible token (NFT) such as the popular ‘Bored Ape’ would be automatically triggered once the buyer has paid the seller. And, if the agreement is broken or the seller blocks the transfer of the NFT, the smart contract would determine that there has been a breach of contract and it wouldn’t complete the transaction.

As a result, decentralized finance has no need for a central or independent third-party to review that the contracts are fulfilled and, if there has been a breach, to determine where the issue originated and how the non-compliant party should compensate the victim.

Challenging traditional finance with decentralized finance

From this explanation, it may seem by removing intermediaries, DeFi can only offer users a few pence in savings from transaction costs. However, the reality is much more impressive — especially when compared to traditional finance — which is why it’s time to look at how a bank and the stock market work and why the way the DeFi system is built to give the upper hand to users. 

When money is deposited in a traditional savings account, the bank invests the assets in its diverse portfolio of holdings to generate profits which can range between 10% and 20%. However, running a bank is expensive. By the time the bank has covered all its costs (and taken its own share), there is not much left for customers, who usually receive returns of around 0.06% per year on their standard savings accounts. And, with inflation having just hit a 30-year high in the U.K., saving money in the bank is a highly effective method of becoming poorer in real terms.

Stocks and shares are not much better. While professional traders make investments with average returns of around 10% per year, the reality is that the returns for normal people are much lower, with the U.S. Securities and Exchanges Commission estimating that 70% of day traders lose money each quarter. Meanwhile, risk-averse investors who are focused on the so-called safe investment options may not lose money but, to pay for this ‘safety’, their returns will tend to be low so, if they’re lucky, they will only just outstrip inflation. 

This is where the peer-to-peer nature of the blockchain comes into its own. In collateralized lending, for instance, smart contracts usually require borrowers to deposit 150% of the value of the loan and automatically enforce the terms of the agreement, removing the risks of non-payment. And, as the entire process is run by computer code, there are no additional or hidden charges which means that most, if not all, the returns go to the lender. 

Another excellent example of how removing intermediaries has allowed decentralized finance to offer higher returns to investors is liquidity mining, when consumers receive yields from placing their assets in a decentralized lending pool. Like in traditional finance, the returns will depend on the risk of the investment, with newer and riskier coins paying exceptional high yields while trusted tokens, such as Bitcoin, stablecoins and Ether, offer healthy returns of more than 10% per year. Regardless of the investor profile, the share of the revenue that goes to the user is likely to be significantly higher than in traditional finance, as many DeFi platforms only require ‘gas’ to cover blockchain transaction fees.

There’s more than higher returns

Beyond ensuring that users can access significant returns, using smart contracts and blockchain technology has also enabled decentralized finance to offer an additional level of security and transparency to investors that is not currently available in traditional finance. 

Indeed, given that smart contracts have been battle-tested and improved for years, they’re now able to ensure that both parties deliver exactly what they’ve promised. And, if the terms of the contract need to be changed or loopholes need to be filled, the unidirectional nature of blockchain prevents changes from being made to the contracts without the support of both parties. This is significantly different from those letters we often receive from banks outlining their updated terms and conditions which we can either accept or deny, as long as we are willing to switch to another provider.  

When it comes to security, there’s more than ensuring that contracts are followed and that no changes are made without our approval, it’s about making sure that our assets are safe. As a result, we’re now seeing that many platforms, such as our own AQRU app, that allow users to access the decentralized markets are learning from traditional finance and implementing many of the security solutions that banks use. This has provided reassurance to users that through DeFi they can receive higher returns while also managing risk efficiently. 

Conclusion

Decentralized finance is an exciting financial ecosystem, which, by utilizing tight security controls, can allow everyday investors to simply generate high yields and generate income on existing holdings. The blockchain’s immutable ledger allows intermediaries to be stripped from financial transactions, greatly improving returns, as the only fees required are for the upkeep of the blockchain itself. Innovation on the blockchain has allowed smart contracts to be used to create impressive financial products, providing a real challenge to traditional financial institutions.

In inflationary times, DeFi is a means of maintaining and generating value without excessive risk or time requirements. We believe that investors should start seriously considering the decentralized markets as part of a diversified investment portfolio – the returns could be just too good to miss. 

Philip Blows is the CEO of AQRU plc.