Have you ever wondered what it would be like to lend money to a friend and not have to worry if they paid you back? How about having the ability to make an excellent return on your money while it sits in a bank account? What about setting parameters and having your cash deploy when those objectives are met?
In today’s world, you would need to go through a banking institution to handle most of these transactions. Sure, you could lend your friend $1,000 on your own, but good luck on trying to get your money back.
Currently, the financial world that we deal in the most is called centralized finance—we never call it that because we never had an alternative. Almost every transaction that deals with money must be processed, approved, and routed through a central banking institution like your local bank or a national bank like Wells Fargo or Bank of America.
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If I want to send my mom $1,000, I have to either put her on my official transfer list or go through another application like Zelle, where she has been authorized. It is a mess, and it takes a while to accomplish anything.
Decentralized finance, or DeFi, promises to improve on many of our day-to-day banking processes, including making loans, betting, and investing. But what is DeFi, and how will it change the future?
DeFi is what is known as finance that we conduct over the blockchain. If you remember from earlier articles in the CryptoCurrency 101 series (101, 102, 103), the blockchain platform was the central creation along with Bitcoin.
Using a system of computers that can verify everything that people write onto the blockchain allows it to be safe, secure, and visible to all. DeFi uses the same blockchain technology but over the Ethereum blockchain, or smart chain.
Bitcoin was seen more as a store of wealth with parallels to gold. Ethereum is more of a computer operating system where applications and transactions can take place more efficiently.
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Using these applications over the Ethereum smart chain will allow us to do things like loans, crowdfunding, and execute smart contracts. But Josh, if everything is so great on the smart chain, why haven’t we already moved everything over?
Great question. One of the significant drawbacks of DeFi is that there is a cost associated with writing anything to the blockchain. This cost is called the gas expense, and you pay it using Ether (ETH). In the past, it could get quite expensive to write these transactions onto the blockchain.
The good news is that the community is coming up with solutions to speed up transactions and significantly reduce costs. I won’t go into the details because they are very complex and above my paygrade, but let’s say that they want to combine many transactions together and then write them onto the blockchain. This will increase speed and reduce cost.
When they work out some of the nuances associated with DeFi, there will be some fantastic things that we will conduct over the smart chain. DeFi is so vital to the world because it gives actual purpose to cryptocurrencies.
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Right now, the main negative for crypto is that the general public does not think that it serves a purpose. The public believes that it is just a market where you speculate and get rich selling your coins to a bigger fool. With smart chains, smart contracts, and DeFi, there is a way for us to form an investment thesis. Let’s take a look at some uses of DeFi.
Smart Contracts. Smart contracts are agreements between people or institutions where the contract can execute a transfer of money when certain conditions are met. For example, I can write a smart contract to transfer my son money if he obtains a 3.5-grade point average.
Decentralized Exchanges (Dex). These are places where you will find some of the newest coins on the market. Dex’s can be a little riskier because more coins appear that may not have been vetted. The risk/reward is exceptionally high on a Dex.
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Stablecoins. I love stablecoins. They are coins that are pegged (follow) a fiat currency like the US Dollar. My favorite stable coin is USDC, and it has a one-for-one attach rate. So for every USD people invest in USDC, they produce a coin. Stablecoins are an excellent place to earn interest on your cash.
Lending platforms. Lending platforms are where you can earn interest on your stablecoins and other cryptocurrencies. Lending over DeFi is based on leverage which means that people have to put up a certain amount of collateral to borrow against it. Let’s say the rate is 50%. Then I would have to put up one Ether to borrow ½ Ether—this keeps everyone safely invested. Because of this leverage, there are no credit checks and loan officers involved. You either have the leverage or not. Also, the lender and borrower do not have to give out their identities in DeFi lending schemes.
Prediction markets. These markets are kind of like sports betting. If you want to bet on who will win the next presidential election or if Will and Jada Smith will get divorced, the prediction markets are for you. Remember what we talk about with smart contracts; they can execute when certain conditions are met.
Yield Farming. Another great example of risk/reward is yield farming. Traders search through the DeFi networks to find high yield opportunities. Usually, if a new coin is trying to stabilize, it will over yield to entice new cash. Again, just like in the stock market, you get a higher yield when taking more risk.
Liquidity mining. Again, liquidity is the key for new coins to get off the ground. To attract people to their coins, groups will offer high yield to entice new money.
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What is the future of Decentralized Finance? No one knows the future, but I am personally betting big on the future. Again, I will equate this new world of DeFi to the internet in the 1990s. We did not have a clue what the internet was going to become back then.
The internet had to go through many protocol transitions while it kept improving. The same with DeFi. It will have to keep improving, but it will be huge in the long term. Make no mistake, banks and other financial institutions stand to lose a lot of money if DeFi comes in strong.
So there is a political aspect to all of this, like with things like cigarettes. There are a lot of people lobbying against cryptocurrencies; you just might not see it. So, the price action in the crypto space will see a crazy amount of ups and downs, fits and starts.
That is why it is so nice to be an investor and not a trader. I invest for the long term. I look at coins that are trying to solve problems and invest my money there. My Voyager app may even pay me interest while I wait. I couldn’t ask for more.
What are your thoughts on Decentralized Finance? Will you bet big on DeFi? Whatever you choose, ensure you have an outstanding investing thesis, and you will make the right decisions for your portfolio. Good Luck!
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Disclosure: I am not a financial advisor or money manager, and any knowledge is given as guidance and not direct actionable investment advice. I am an Amazon Affiliate. Please research any investment vehicles that are being considered. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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