Introduction
DeFi Blockchain is a distributed digital ledger that can be used to record transactions and store data in the absence of intermediaries like banks or government agencies. When Bitcoin, the first blockchain project, was released in 2009, it sent shockwaves around the globe. The blockchain technology behind Bitcoin brought decentralized financial transactions to the masses. Now that the people, not monarchs, are in charge of the country, its developers are using DeFi to try to end the banking system’s monopoly on creating and issuing currency.
When you say “DeFi,” what do you mean?
DeFi is an initialism for “Decentralized Finance.” The word was created in 2018 by a group of blockchain developers communicating over the messaging app Telegram. The Ethereum, Yeo Set Protocol, 0x, and Dharma developers were chatting with each other and Brendan Forster from Dharma about building decentralized financial apps on the Ethereum network. These days, virtually everyone uses a bank to keep track of their finances.
The Central Banking Authority is responsible for regulating the banking sector. On the other hand, any country’s currency is subject to oversight and regulation by government financial regulators. Alterations to currency can only be made by the government. DeFi, on the other hand, is a decentralized financial management paradigm that frees all users from reliance on the state’s monopolized financial network.
To begin, let’s define the DeFi Ecosystem.
The participants in a DeFi ecosystem are able to conduct financial transactions and carry out other necessary tasks independently of one another or any governing body. Financing networks free from the suspicion of manipulation were notoriously difficult to establish before to the advent of blockchain technology. With Bitcoin’s blockchain, however, users could make monetary transactions without worrying about their information being tampered with. The DeFi ecosystem includes cryptocurrency trading markets, cryptocurrency storage wallets, and P2P transaction networks.
The government ensures that there is no fraud by keeping records of all financial transactions. When a financial transaction is conducted over a blockchain network, however, the details of the exchange are recorded in a distributed digital ledger that is kept on a large number of computers all over the world. The data recorded on a blockchain network is extremely difficult to alter or modify. The DeFi ecosystem includes everything related to the recording and verification of blockchain and cryptocurrency transactions.
I need to know the fundamentals of DeFi, what makes it tick.
Understanding the differences between DeFi and TeFi (Traditional Finance) networks can be difficult at first. Many bitcoin trading services are centralized, which is important to keep in mind. Here are a few telltale signs that the reader is dealing with DeFi:
Free Banking
Fiat currencies from one region cannot be used by a citizen of another region without first being exchanged. The major advantage of DeFi, though, is that people of all different nationalities and locations may all use the same currency. It would be accurate to argue that there are no barriers or prejudice in the DeFi environment. Users can often buy digital assets from blockchain and cryptocurrency companies with their local fiat currencies.
Decentralized
Because they are permissioned or private networks, blockchains like Hyperledger can be centralized. While Bitcoin and Ethereum are examples of centralized blockchains, a DeFi blockchain is completely decentralized. These blockchains are not managed by a central authority or private company because they are open source. Their ownership and operational status is transparent to the public.
Non-Custodial
If a financial system is non-custodial, then its participants can make transactions without going through a single trusted authority. Everyone who owns cryptocurrencies should also have a digital wallet account. However, non-custodial wallets are the best option for those who want complete autonomy over their financial records, transactions, and personal information. If a person’s digital wallet is non-custodial, then nobody besides themselves is the legal owner of the funds stored inside.
Transparency
The DeFi ecosystem is characterized by public blockchains. The blockchain records every single transaction that occurs on a DeFi network and makes it available to anyone who wants to view it. By providing a duplicate of every transaction to every user, DeFi ensures that the historical record of monetary dealings remains unaltered.
The data stored on the world’s millions of servers is immune to hacking attempts. Concurrently, this means that all participants in the DeFi network may see and verify every transaction activity, independent of their share size.
Multiplying
DeFi endeavors are focused on giving power to the average guy. For this reason, the most prominent blockchains are public, open-source networks. Any programmer, wherever in the globe, can take the blockchain’s source code and modify it for their own purposes. Blockchain technology that has been designated as open-sourced is not protected by patent or other intellectual property rights. This is the fundamental driving force behind the exponential growth and proliferation of blockchains.
There are many benefits to using DeFi.
The majority of workers today choose to deposit their paychecks into a bank account, which is the safest way to handle financial matters. As a result, it is natural to wonder why one should consider utilizing a decentralized finance network rather than a bank that operates within the framework of the centralized financial machinery. Why has the DeFi ecosystem become so widespread in the previous decade? Here are a few of the most compelling reasons:
Accuracy Confidence Interval
There are considerable delays in the centralized banking system, according to several economists and seasoned financial market watchers. Mismanagement of the centralized banking system has been blamed by some experts for problems including inflation, recession, and economic disaster. That’s why many see blockchains and DeFi as a breath of fresh air compared to TPIs and centralized financial institutions. An optimistic view holds that DeFi can be used to enhance existing financial infrastructure.
Quick and Irreversible
DeFi is a financial transactions network that is rapid and irreversible. Before the launch of DeFi, a person had to wait for days or months to get a loan application accepted by a bank. Meanwhile, like the safety of conventional banking, transactions on the DeFi network are unidirectional and irrevocable. In addition, traders using DeFi can do so from any location and at any time.
Power of the System
Multiple global economic collapses have shown that a system dependent on a centralized banking network is incredibly vulnerable. Banks fail and the money supply is cut off amid catastrophic events like war or pandemics like the coronavirus infection. However, with DeFi everyone can maintain performing all sorts of financial tasks including money exchange, lending, purchasing, and others independent of Central banking and government faults.
Permissionless
DeFi is a permissionless financial zone. If there is no need for authorisation from a central bank or private financial institution, then anybody can make a financial transaction or perform a financial function inside the ecosystem. DeFi depends on automation protocols like smart contracts and it allows the users to keep using the financial options as long as they met all the prerequisites for a transaction. There is no need to provide any form of documents or wait for a bank to approve your application in DeFi.
Immutability
PoW and fully decentralized financial networks make it difficult for hackers or other threat actors to manipulate or change transaction data. The security protocols on DeFi blockchains like Bitcoin and Ethereum are many times stronger than the centralized financial networks like SWIFT. Therefore, the users can keep conducting new financial transactions without worrying about any unauthorized alterations in the data.
One of the most significant benefits of DeFi networks is their open nature. Inside a DeFi ecosystem, all community members have equal status. Because of this, any member of the community can look up any transaction record they’d want. A financial transaction can be traced, cross-checked, and further information extracted without any specific permission or permission from the monetary institution involved.
What can’t be done with DeFi
DeFi is typically presented as the next logical step in financial infrastructure development. However, it’s worth noting that DeFi has a few nits to pick as well. Here are just a few of DeFi’s current headaches:
Scalability
The lack of scalability is a common problem with DeFi solutions. It takes a long time for each new block to be verified in a blockchain that uses proof-of-work. On the other hand, when trading volume grows, a blockchain network may experience problems including rising transaction costs and slow verification times. However, enhancements have been developed to expand the size of blocks so that more transactions can be processed in a given time period. An further approach worth noting is the implementation of second layers on blockchains to improve their scalability.
Liquidity
DeFi platforms also have to contend with a lack of liquidity on the platform. Some networks allow the bitcoin holders to build a Liquidity pool by encouraging them with yield income. However, users may not spend their committed cryptocurrency from the pool. Over-collateralization is a problem on DeFi as a result of the platform’s low liquidity.
Inadequate Coverage
Bank failure and economic downturns plagued early financial institutions. However, modern banks have Bancassurance to back them up, so customers can be certain that their savings are safe in their bank accounts. Meanwhile, DeFi lacks the resources to provide its account holders with any form of insurance protection, putting them at increased financial risk and leaving them vulnerable in the event that the DeFi business entity should fail.
Threats to DeFi’s Security
It took centuries for the established financial systems to develop to their current state. However, the DeFi system has only been in existence for slightly over a decade at this point. As a result, the DeFi network faces significant challenges and dangers. Some of the most significant security dangers of DeFi are as follows, and anyone considering engaging in cryptocurrency trading should be aware of them:
Estimate of Liquidity
When an asset is highly liquid, it can be swiftly converted into cash or traded for another type of asset. The lack of liquidity in the DeFi industry is nothing new. As a result, most DeFi systems feature several separate sources of funding. However, it might be difficult for a token or cryptocurrency to gain significant support in its early stages.
As a result, there is evidence that some DeFi ecosystems inflate or fabricate their liquidity pool numbers in order to lure additional traders with false guarantees. In addition, a liquidity pool determines a token’s value not using external oracles but rather based on the token’s weight in the pool.
This value difference presents an opportunity for hackers to conduct pool duration off-balance DeFi or Flash loan assaults. Thus, the pool’s computations may be inaccurate, opening the door for hackers to siphon off funds.
Attacks from the Front
One form of hacking attempt is known as a frontrunning assault, and its goal is to steal cryptocurrency or alter the digital ledger before it has been confirmed. As a result of the Miner Extractable Value, an attacker can generate a new version of the same transaction with increased gas prices.
Therefore, attackers can make money while miners chase the fake transaction with a bigger reward. When automated bots launch an attack, it’s usually miners that feel the wrath rather than regular internet users.
Access to Confidential Information
In the DeFi market, a bitcoin trader cannot do business without a digital wallet account. Manufacturers typically provide both a private and public key to ensure the security of the digital wallet. Entering your private key and public key together serves as your password for the digital wallet.
There is minimal likelihood of a person remembering a private key in the same way they would a standard password, however, due to the fact that private keys are a string of data. Many customers experience the permanent loss of their DeFi reserves due to the loss of their private key.
Money Scams
Financial fraud and Ponzi schemes have had a lasting impact on DeFi. In other circumstances, “whales” with large amounts of a DeFi token drive up the price through speculation.
Known as a Rug Pull, this scam occurs when large holders of tokens (whales) sell all of their tokens at once, causing a dramatic drop in price. Meanwhile, there are Ponzi schemes in DeFi where untrustworthy developers propose a new token and try to make money by bringing new blood into the sector, before eventually withdrawing their investments or disappearing.
Control Failure
The use of privilege functions is one of the technical highlights of smart contracts. With PFs, the smart contract’s developer can make modifications or retrieve the functions without involving the smart contract’s host. It is also possible for a smart contract’s inventor to take complete ownership of the users’ DeFi funds at any point. This allows scammers to take money from individuals who are unaware they are victims.
However, hackers can steal cryptocurrency by seizing control of access and privilege functions and using them for their own ends.
5.1% Assault
The term “51% Attack” refers to a hypothetical situation in which mining pools form a cartel and take control of 51% of the hashrate contribution on the blockchain. The mining cartel controls such a large portion of the hashrate that it can alter the blockchain’s transaction history and double spend cryptocurrency without being detected. Even decentralized blockchains like Bitcoin aren’t immune to attacks on the 51% threshold.
How Can I Prevent Potential Security Issues Using DeFi?
Without the interference of the traditional banking system, DeFi is able to function as an independent financial network thanks to the use of smart contracts. Smart contracts, on the other hand, are just strings of code. Mistakes in the coding of a smart contract can occur at any time during development.
However, there are situations where updates might actually weaken the security of a smart contract. While this is happening, hackers are always researching new ways to compromise a smart contract. DeFi networks with a dedicated security team and an in-depth technical examination are, nonetheless, more likely to be secure than their rivals.
Conclusion
Threats to both money and technology exist inside the DeFi ecosystem. At the same time, it has numerous benefits that the TeFi system lacks. Investors in cryptocurrencies would be wise to think through the DeFi’s drawbacks in advance, so they can devise workarounds and contingency plans.
