DeFi: what exactly is it and what are its implications for investors?

Find out what DeFi is, its benefits and limitations, and how you can adapt your investments to it.

Maria is an experienced investor looking to diversify her portfolio. She has converted some of her assets into cryptocurrencies and invested this capital in interest-bearing stablecoins, a type of cryptocurrency designed to maintain a stable value, usually indexed to the value of the dollar or euro, with a return similar to a fixed-term deposit. João is a small businessman who needs to raise funds quickly. He has used his savings in the form of cryptocurrencies as collateral for a loan and to expand his business.

Maria and João have two things in common. The first is that they are not real, but they could be. The second is that their financial operations are based on a new type of investment. Launched in 2017, DeFi has already led to more than 500 cryptocurrency protocols appearing and underpinning $100 billion in assets. But what does DeFi mean? What are the risks involved? And, most importantly, how can it influence investment decisions?

DeFi: what is it?

DeFi, or "Decentralized Finance”, refers to a new financial paradigm where users can access a range of services – such as exchanging cryptocurrencies, and seeking and offering loans – without an intermediary.

This concept is based on blockchain technology, which records every movement in a theoretically inviolable way. These records prove who moved what asset for whom, and serve as the (only) proof of ownership.

These are the guiding principles of DeFi networks:

1. Decentralisation: There is no central authority. Operations are validated by all the people who make up the network rede.

2. Transparency: All transactions are recorded in a public ledger (blockchain) that is accessible to all, ensuring greater transparency.

3. Immutability: Once recorded, transactions cannot be altered or deleted, ensuring the immutability of the data.

4. Interoperability: DeFi platforms are generally built with protocols that allow them to integrate with other systems and applications. This means that you are not tied to a particular platform or vendor and they can interact with each other.

5. Accessibility: Anyone with access to the internet can participate without the need for extensive permissions or controls.

These transactions are only possible thanks to other underlying technologies. One of these is blockchain, a decentralised network with a digital, inviolable and distributed ledger that stores all transactions made – but there are others.

DApps are applications that operate on these blockchains through second-layer solutions, embedding the logic of the application in smart contracts – digital contracts that define the terms of the application to be used.

In the hypothetical case described above, Maria could lend her cryptocurrencies to João. This transaction could be executed via a smart contract and accessed by both users via a DApp. If João defaults on the loan, the contract terms could require an immediate return of the collateral to Maria, without the need for human intervention.

DApps are an example of the diversity and innovation that exists in the DeFi ecosystem, offering multiple ways to exchange, lend and earn cryptocurrency income without intermediaries. As always, it's important to understand the risks and do your research before engaging with any DeFi platform.

DeFi: Benefits

These are some of the benefits associated with DeFi:

Accessibility

DeFi makes various financial services, such as loans and transactions, more agile and accessible to a wider audience. Any person with an internet connection can use DeFi services. It also brings value to those who do not have a bank account or live in countries with unstable financial systems.

Transparency throughout the entire process

To ensure maximum transparency, all transactions are recorded on the blockchain, which helps to combat fraud and increase trust among participants. It also provides a sense of control over financial data.

Speed and efficiency

Many financial services can be processed quickly directly on the blockchain. You can also use cryptoassets to access services such as borrowing or lending money, receiving interest, trading assets and buying insurance.

DeFi: limitations:

These are some of the limitations associated with DeFi:

Transparency

Blockchain transparency is not always timely. Most protocols do not allow individuals to anonymise their transactions. This is aggravated in financial markets because the lack of anonymity signals to the markets the intention of the transaction (on the part of the investor), which can lead to front-running – other participants who know the direction of the transaction (e.g. a purchase) can anticipate it by making similar transactions (they anticipate the purchase, causing the price to rise before the order is executed).

Scalability

Most protocols are still new and are therefore subject to the same scalability issues as the blockchains on which they operate. As a result, several protocols have attempted to overcome this difficulty by promoting solutions that aggregate and process transactions before they are registered on the blockchain, allowing the number of transactions in each block to scale.

Security

While blockchain security is high, the contracts used to develop DApps can be vulnerable if they are written or applied incorrectly.

An example of this type of failure is the case of DAO (launched in 2016), one of the first venture capital firms to be run entirely by the investors themselves – in other words, without a professional management team.

Hailed as a revolutionary project, it quickly raised $150 million in ether (ETH). Less than three months after launch, the DAO was hacked and investors lost $60 million. The Ethereum blockchain, on which the DAO was built, was later controversially split to recover the stolen funds, which were returned to investors.

In addition, the interdependence between different smart contracts further complicates the attribution of legal liability for failures or exploitation of vulnerabilities. In 2016, for example, a user was able to exploit an error in a smart contract’s code to embezzle some 3.6 million ether, a cryptocurrency, without being held legally responsible. Why? What he did was allowed by the code.

DeFi related investment opportunities

The DeFi universe offers a variety of investment opportunities for investors to take into consideration. At Banco Carregosa you will find several alternative solutions to gain exposure to this type of investment, whether in the form of Crypto FX or ETPs.

Remember, as with any investment, there are risks involved, so make sure you do your research before you invest.

Banco Carregosa, specialised financial advice

DeFi solutions offer innovative benefits, but they also pose serious threats to investors. It's essential to rely on reliable institutions such as Banco Carregosa to make informed and secure investment decisions. You can count on the Banco Carregosa team of experts. Contact us, protect your assets and increase the value of your capital.