In 2020, DeFi is the main trend in the blockchain industry. For the year, the amount of funds blocked in DeFi increased by $10 billion. Why is DeFi so attractive to investors, and why is it worth investing in? Find out in this article.
What is DeFi
DeFi is a branch of the blockchain industry that includes applications that work independently and provide financial services. The main purpose of DeFi is to simplify classical financial instruments, such as lending, money transfers, trading on exchanges, and insurance. The advantages of decentralized finance are that they eliminate intermediaries that are present in traditional finance. The absence of intermediaries increases the speed of operations and reduces transaction fees due to automation.
DeFi in 2020
By November 2020, the total value of funds locked in smart contracts was over $11 billion. For comparison, on January 1, 2020, $675 million was locked in DeFi.
Most DeFi protocols run on the Ethereum blockchain and use the ERC20 token standard. DeFi is one of the reasons for the growth of Ethereum in 2020. The value of the ETH cryptocurrency increased from $130 on January 1, 2020 to $386 by November 2020. And the number of addresses in the Ethereum network has increased by 25% over the past year.
In September, the decentralised exchange Uniswap issued the UNI governance token in order to attract liquidity. As a result, Uniswap ranked first among other DeFi projects in terms of the volume of locked assets. Also, Uniswap is in the top 5 in terms of trading volumes among all cryptocurrency exchanges, including centralised ones. At the end of September, the amount of funds locked in the protocol exceeded the $2 billion mark, and by November it reached $2.7 billion. The reason for this success lies in the way the UNI token is distributed. 15% of the issue occurred with the help of airdrop-distribution of coins to users who perform certain actions. In the case of Uniswap, the tokens passed into the wallets of all users of this exchange who managed to make transactions before September 1. The total issue volume is 1 billion tokens. This number of tokens will be distributed over 4 years. The price of the UNI token rose to $6.59 shortly after its introduction, but then fell and is in the range of $2-3.
Another example of DeFi’s success in 2020 is the YFI governance token of the Yearn Finance project. The cost of the token at the start of sales in July 2020 was about $90. By mid-September, the token was worth $40,000, meaning, it surpassed the value of Bitcoin. Subsequently, its price began to decline and by November it is about $10,000.
DeFi development prospects
The main difference between decentralized applications and traditional services is the absence of a single central authority that manages all processes. For example, in the financial system, such bodies can be banks, commercial and state organizations. The functions of a centralized organization are performed by blockchain and smart contracts.
The blockchain provides DeFi with a certain level of trust. Protocols and smart contracts are automatic. The source code of the application is publicly available and any investor who knows the programming language can study it. The system is transparent, and blockchain encryption protocols provide protection against data forgery.
The decentralization of protocols forced developers to come up with a mechanism for attracting the liquidity needed for projects to work. As a result, users were able to lock their assets in smart contracts of DeFi protocols and earn a percentage of profitability. In some projects, users receive not only a percentage of profitability, but also governance tokens, which also have a value. Using projects such as Uniswap, Compound, and Yearn Finance, the community saw that people like the idea of being rewarded for providing capital. It turned out to be a convenient investment tool.
Users are also attracted to the ease of access. Banks usually have high requirements, they refuse people with an unfavourable credit history and low income. When working with DeFi, these factors do not matter. Loans are secured by collateral. Therefore, the protocols will not suffer from the fact that someone does not pay off their loan. Also, users, with rare exceptions, do not need to register and pass verification to use DeFi projects. Exceptions include a few DeFi projects, such as the Nexus Mutual smart contract insurance platform. In order to use it, you need to pass KYC verification.
Risks associated with investing in DeFi
The market for decentralised finance is relatively young — the first DeFi project MakerDAO appeared in 2016. And the active growth of the segment began only in 2020. Therefore, it is becoming increasingly difficult to predict the future of DeFi. Now, at the time of active growth of the direction, there are more and more projects and tokens of these projects. As of November 2020, there are already more than 200 DeFi applications. Many of them simply copy existing ones in order to make money on the trend. With this diversity, it is becoming increasingly difficult to choose a DeFi project. Tokens of already popular projects can fall in value, like YFI and UNI. Other projects stop working as soon as they attract the first users, such as YAM Finance.
Decentralization of DeFi projects gives investors not only advantages, but also risks. Thus, the reliability of the protocol and the safety of funds locked in it depend entirely on the program code. There are still risks of hacking by fraudsters or losing funds due to an error in the code. Due to the absence of a central governing body, it is not possible to quickly fix the error or stop hacking. Any changes to the protocol code are made exclusively by voting among the owners of governance tokens. At the same time, even projects that have passed serious technical audits and have a high reputation among the community cannot provide 100% guarantees of the safety of your funds.
Also keep in mind that some projects, such as SushiSwap, are anonymous. If in the case of fraud on the part of ordinary organisations, you can bring them to justice, then in the case of anonymous DeFi projects it is more difficult to do this.
DeFi is an ecosystem of applications that copy the functionality of traditional financial instruments. These applications use blockchain technology to work. In 2020, the amount of funds blocked in DeFi projects increased from $600 million to $11 billion.
DeFi projects are interesting to investors for several reasons:
● DeFi has prospects due to the elimination of intermediaries and the use of blockchain technology;
● Ease of use;
● The opportunity to earn an interest rate for freezing assets in smart contracts;
● The ability to earn governance tokens that have their own value.
Investing in DeFi has its own risks:
● Because DeFi is a trend, the number of such projects becomes too large and many of them are not trustworthy;
● Blockchain technology does not guarantee protection against hacking;
● The process of making changes to DeFi projects requires voting, which can be critical if a vulnerability is found in the project code;
● Some DeFi projects are created by anonymous developers, which makes it more difficult to hold them accountable in case of fraud.