The DeFi (Decentralized Finance) Industry is rapidly expanding with its activity growing a whopping 1300% from April of last year to this past May. More and more people are leveraging the value, utility and opportunities for higher returns of decentralized financial offerings and assets. Consequently, DeFi investing is taking off in a big way.
Knowing more about Decentralized Finance systems, assets and investing will allow you to determine if it should be part of your investment strategy and financial services.
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What is DeFi?
DeFi, or Decentralized Finance, is actually a system of decentralized technologies that allows for decentralized assets – assets that are not cleared through a central institution such as a bank but verified through a dynamic data chain involving a distributed peer-to-peer network of asset holders.
Since the invention of blockchain technology and the first Bitcoin cryptocurrency, decentralized finance has been expanding by leaps and bounds. It is now high on the list of priorities for every world regulator and every central bank. Millions of people have begun to own digital assets that are distributed and held on a decentralized basis, through digitally verified blockchain ledgers (aka Distributed Ledger Technology or DLT).
How does DeFi work?
DeFi space makes possible the ownership and trading of digital assets and financial products without requiring centralized administration of these assets by some middleman like a bank or financial institution.
Decentralized Finance works by creating a system where users, assets and transactions are verified (aka authenticated) by digital data trails as they are created.
Blockchain Authentication refers to systems that verify users and transactions related to digital currency. The blockchain uses public-key cryptography (PKC) to encrypt wallets, or the places on the blockchain where value or work is securely stored.
Think about going to a wedding where there is no marriage certificate to file in a local courthouse. How does anyone know that the individuals involved were married? The verification is in the digital testimony of any of the hundred or so people who were in attendance on that day.
That's the principle of decentralized finance and how it works on a peer-to-peer basis – which means that the transactions and financial transactions around defi assets are verified by the stakeholders themselves.
Why is DeFi important?
In the “old days”, with traditional banking systems, central bank institutions were the holders of record. By depositing funds in a bank, the depositor or account holder got verification of value and the status of assets.
However, people have begun to realize the costs involved in maintaining the centralized infrastructures and how they were passed on to the depositors in the form of fees and other charges.
DeFi services provide a much more streamlined financial environment through an Internet connection that involves less costly administration.
There are a number of reasons why so many people are interested in and bullish on decentralized finance.
DeFi technology is empowering, the barriers to entry are very low, it is decentralized, yet globally accessible, permission-less/frictionless, growing rapidly in acceptance and popularity, and its capabilities are game-changing.
For example, there is a high number of people in the world that are “un-banked” – those without access to traditional banking systems in the form of a bank account in order to verify their savings or assets.
DeFi and cryptocurrency in particular have been talked about as a global solution for the unbanked. It can also be uniquely valuable in the practice of sending money overseas to family members or others
DeFi assets are not able to be controlled by a central bank.
What can you do with DeFi?
There is an ever-growing list of things you can do with DeFi. Here are just a few:
Send money across the globe
Access stable currencies
Buy insurance
Trade tokens
Start a cryptocurrency savings account
Borrow funds with and without collateral
Fund ideas and business concepts
Buy or Invest in Real Estate
Buy or purchase Fine Art
Decentralized finance assets can carry data and functionality on the blockchain, providing smart contracts for how to digitally handle transactions and more.
The applications of DeFi are limitless, and we are now just in the early stages of learning all that Defi can do.
What are examples of DeFi-enabled assets and application components?
Cryptocurrency
Cryptocurrency is a certain type of DeFi asset that is used as virtual money.
One of the basic ways to understand some of the most popular cryptocurrencies is that they are created through a process called “mining”. This is not physical mining, but instead, it's the creation of blocks of data through computing processes, through which the coins are created. Then that blockchain ledger provides a verified chain of custody for each of these assets.
Here are three of the most common types of cryptocurrency assets:
Coins
Cryptocurrency coins may or may not be decentralized. However, the first cryptocurrency, Bitcoin, is inherently decentralized and provides an excellent example of a decentralized blockchain asset. It is verified by its holders in a peer-to-peer system and responds to market pressures accordingly.
Stablecoins
Stablecoins are a particular type of cryptocurrency that is pegged to a fiat currency (i.e., physical currency) such as the dollar.
So while Stablecoins are decentralized cryptocurrency they tend to provide greater stability.
One question is how regulators are going to treat stablecoins moving into the future, as some have suggested they should be regulated like securities.
Tokens
Some types of cryptocurrencies are essentially utility tokens that are held for some specific purpose besides just monetary value. Many of these tokens are tied to particular platforms where they help accomplish tasks. That in itself makes them different from stablecoins and other cryptocurrencies.
Cryptocurrency Wallets
A cryptocurrency wallet is a virtual/digital wallet to hold the information that comprises DeFi assets.
Wallets can be fully virtual in the form of software resources that can be manipulated by operating systems. Additionally or alternatively, people can use hardware wallets which are actual physical devices with USB ports and other gear attached.
What are DeFi Applications?
Decentralized Finance applications are simply tools or resources that use a decentralized finance system to offer value and smart contract handling for information and transactional functions.
Cryptocurrencies and tokens are available through DeFi platform exchanges and other kinds of DeFi applications, for example….
Liquidity and Staking
As DeFi assets become more popular, people are looking at how to create liquidity through broad exchange aggregators and work through decentralized lending platforms to gain value.
They’re also innovating the lending and borrowing process through something called staking, where an individual will pledge DeFi assets in order to get competitive interest from them. The interest that can be obtained with staking is generally much higher than the interest rates that can be obtained by putting dollars into a bank or even a specialized money market account.
Trading
Various exchanges have sprung up to accommodate cryptocurrency and decentralized finance asset trading. Many of them will have a large footprint as aggregators, and the ability to offer many different trading pairs so that users can turn their value into all sorts of fiat or crypto formats, or pursue strategies like arbitrage (buying and selling crypto strategically for value gains).
What are the Tax Implications of DeFi?
Different countries tax cryptocurrency in different ways. Tax regulators are looking to capture gains from cryptocurrency sales on annual tax filings. The IRS, for example, now requires those who sell cryptocurrency to report the cost basis and associated information for tax purposes. However, tax laws related to DeFi currency transactions are still evolving.
Conclusion
DeFi presents itself as an exciting new frontier for investors. Using the power of decentralized finance, investors and depositors will be able to manage their capital, leverage it in new ways, and participate in a new system that changes how we think about money and investing.
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*Disclaimer: EquityBrix is not an investment adviser. This information is for educational purposes only and does not constitute investment or tax advice. It’s important to be informed and to make your own investment decisions or do so in consultation with a professional financial advisor. Under no circumstances should this material be used or considered as an offer to sell or a solicitation of any offer to buy an interest in any investment. Any such offer or solicitation will be made only by means of a written online prospectus relating to the particular investment.
FAQs
What is DeFi in the simplest terms?
At its core, DeFi just refers to assets and activities that use a decentralized peer-to-peer system.
What is considered DeFi?
Any asset or activity that does not use a central administrator could be called DeFi. DeFi systems typically run on the blockchain or some other decentralized platform.
What is a DeFi in cryptocurrency?
It's important to recognize that not all cryptocurrencies are decentralized. A decentralized cryptocurrency will be part of a blockchain network that is validated by peer-to-peer holders and not a centralized system.
What is DeFi and why do we need it?
DeFi is important to the financial world for the reasons discussed above: access to capital by the unbanked, free and fast transactions, and various types of data handling.
*Disclaimer: EquitySlice is not an investment adviser. This information is for educational purposes only and does not constitute investment or tax advice. It’s important to be informed and to make your own investment decisions or do so in consultation with a professional financial advisor. Under no circumstances should this material be used or considered as an offer to sell or a solicitation of any offer to buy an interest in any investment. Any such offer or solicitation will be made only by means of a written online prospectus relating to the particular investment.
