DeFi: Its Use Cases, Pros and Cons, and Why It Is a Better Option Than CeFi

DeFi, or decentralized finance, is a term covering financial services that are provided on public blockchains. DeFi allows users to do practically everything that banks (centralized finance, CeFi) do:

• get loans

• lend funds

• earn interests

• trade assets and derivatives, and so on.

Banks control the user’s assets and charge commissions for every action that a user performs. If a bank decides to freeze a user’s account, it can do it.

In DeFi, there is no centralized body to control users’ funds. The user is the only one who is responsible for whatever he does. 

Here are the main differences between DeFi and CeFi.

What Can You Do With DeFi?

You can perform all the operations that banks provide to their users.

Send Money

With DeFi, you can send money just like you are sending an email. The recipient will get the funds as soon as a transaction is confirmed on a blockchain. 

Borrow Money

Borrowing with DeFi can happen in two ways:

- Peer-to-peer - when you borrow money from other users.

- Borrowing from a pool - other users provide funds (liquidity) in a pool, and you borrow from there.

To understand the last benefit, you may need to know better what a liquidity pool is. Decentralized finance platforms do not get any funds from banks or other financial institutions.

Instead, they use the funds that users provide. 

How does it work?

If you have free tokens, for example, Dai, and want to earn from them, you may lock them in a liquidity pool. They are locked in a DeFi platform’s special wallet.

In return, you receive other tokens, which are called liquidity pool tokens (LP tokens, LPTs). LPTs show how many tokens you have locked in a pool. 

Traders use tokens from a liquidity pool to trade. They pay fees for using the liquidity. From these fees, you get your % depending on how many tokens you have locked.

For example, if your contribution is 2% of the liquidity pool’s volume, you get 2% of fees paid by traders. 

When you apply for a loan with a bank, you need to provide piles of documents. Borrowing with DeFi is anonymous. You don’t disclose your identity and other personal or financial information.

However, to borrow from a DeFi platform, you need to provide collateral. It can be different crypto or even NFTs.

Global Availability

To use services provided by a bank, you need to be a resident of the country where the bank operates. The services provided by DeFi are accessible at any point in the world to anybody.

If you have a device that connects to the internet, and a cryptocurrency wallet, you can use DeFi.

Profitable for Taxes

If you have cryptocurrency, for example, Ethereum, and need more funds, you can borrow them on a DeFi platform and leave your Ethereum as collateral. This is an event that is not taxed. 

But without access to DeFi, you would need to sell your Ethereum to get funds that you can spend (for example, fiat money).

This is a taxable event. This is how DeFi can be used to access funds without having to sell your crypto and pay taxes for it.

Benefits for Lending

For example, you have some crypto, say, Dai, in your wallet. Instead of just keeping it there, you can earn by lending it to other users.

You lock your tokens in a liquidity pool of a lending platform, and other users can borrow them. In return, they pay interest. You get your share from the interests paid to the platform.

Normally, your rewards accrue every second, so you can constantly see the balance of your wallet grow.

Trading

With DeFi, you can access many options for advanced trading:

• Perpetuals

• Margin trading

• Limit orders, and others.

The market never closes, the liquidity level is high, and the opportunities are endless.

Are There Any Cons?

Yes, there are. 

The first concern is the high volatility level. Cryptocurrency prices fluctuate drastically. If the token price drops, a user may lose a lot. 

For example, if you lock 2 ETH in a liquidity pool, and the ETH price is $1,500, the total value of locked funds is $3,000. But after two days, the ETH price drops to $1,000.

Now, your 2 ETH are worth $2,000 instead of $3,000. You’ve lost $1,000 on the price fluctuation.

However, if the token price surges, the user benefits, too. 

Another problem is the number of scams. The technology is still young and not regulated. And this is why it is important to research the project carefully before investing in it. 

Another issue is the absence of regulation. While cryptocurrency is all about decentralization, it doesn’t mean that the blockchain world is unordered.

While the technology is advancing and its adoption level is growing, it is still far from the time when all the network participants will use it ethically.