The basics of decentralized finance

Headlines mentioning cryptocurrencies, blockchain technology, and peer-to-peer finance have become common in recent years. Still, not everyone understands how they work, and the decentralized finance (DeFi) sector can seem intimidating. In turn, this limited awareness of DeFi’s building blocks has meant that many people have missed out on DeFi’s significant returns, believing that it is all about exchanging Bitcoin, Ether, stablecoins, and other cryptocurrencies.

As the CEO of AQRU, an incubator specializing in decentralized finance, I’ve met many people who think like this. For this reason, I have put considerable effort into raising awareness about DeFi and explaining that decentralized finance is similar to the traditional financial system in that it offers a wide range of services such as lending, savings and insurance. But unlike its traditional counterpart, these services use peer-to-peer and blockchain technology to eliminate intermediaries and offer investors higher returns.

So, let’s take a closer look at the building blocks of decentralized finance, how the system works, and how it has managed to offer clients higher returns than traditional finance.

How does decentralized finance work?

Decentralized finance is based on blockchain technology, an immutable system that organizes data into blocks that are chained together and stored in hundreds of thousands of nodes or computers owned by other members of the network.

These nodes communicate with each other (peer-to-peer), exchange information to ensure they are all up to date, and validate transactions, usually through proof-of-work or proof-of-stake. The first term is used when a member of the network must solve an arbitrary mathematical puzzle to add a block to the blockchain, while proof-of-stake is when users set aside a cryptocurrency as collateral to give them a chance to be selected to become random as a validator.

To encourage people to keep the system running, those selected as validators receive cryptocurrency as a reward for verifying transactions. Popularly known as mining, this process has not only helped remove key entities like banks from the equation, but has also allowed DeFi to open up more opportunities. In traditional funding, they are only offered to large organizations so that members of the network can make a profit. And by using network validators, DeFi has also been able to reduce the costs that intermediaries charge, so management fees don’t eat up a significant portion of investors’ returns.

Smart Contracts

In decentralized finance, all transactions are performed by smart contracts, which are programs or pieces of code stored on the blockchain that only execute when certain conditions are met.

For example, a smart contract to buy a non-fungible token (NFT) like the popular Bored Ape would automatically trigger once the buyer paid the seller. And if the agreement is broken or the seller blocks the transmission of the NFT, the smart contract would determine that there was a breach of contract and not complete the transaction.

As a result, decentralized finance does not require a central or independent third party to verify compliance with contracts and, in the event of a breach, to determine where the problem originated and how the non-compliant party should compensate the victim.

Challenging traditional finance with decentralized finance

From this explanation, it might appear that by removing intermediaries, DeFi can offer users just a few pence in savings on transaction costs. However, the reality is much more impressive – especially compared to traditional finance – which is why it is time to take a look at how a bank and the exchange work and why the DeFi system is built to give users the upper hand.

When money is deposited into a traditional savings account, the bank invests the assets in its diverse portfolio of holdings for returns that can range from 10% to 20%. However, running a bank is expensive. Once the bank has covered all the costs (and paid its own share), there’s not much left for customers, who typically receive returns of around 0.06% per year on their standard savings accounts. And with UK inflation just hitting a 30-year high, saving in the bank is a very effective way to become poorer in real terms.

Stocks and stocks aren’t much better. While professional traders make investments with average returns of around 10% per year, the reality is that returns for ordinary people are much lower, as the US Securities and Exchanges Commission estimates that 70% of day traders lose money each quarter. Meanwhile, risk-averse investors who focus on the so-called safe investment options may not lose money, but to pay for that “safety,” their returns will tend to be low, so if they’re lucky, they just barely outperform inflation .

This is where the peer-to-peer character of the blockchain comes into its own. For secured loans, for example, smart contracts typically require borrowers to deposit 150% of the loan value and automatically enforce the terms of the contract, eliminating the risk of non-payment. And because the entire process is run by computer code, there are no additional or hidden fees, meaning most if not all of the returns go to the lender.

Another excellent example of how the elimination of intermediaries has allowed decentralized finance to offer investors higher returns is in liquidity mining, where consumers receive returns by placing their assets in a decentralized pool of loans. As in traditional finance, returns depend on the risk of the investment, with newer and riskier coins bringing exceptionally high returns, while trusted tokens like bitcoin, stablecoins, and ether offer healthy returns of more than 10% per year. Regardless of investor profile, the share of revenue going to the user is likely to be significantly higher than traditional funding, as many DeFi platforms only require “gas” to cover blockchain transaction fees.

There is more than higher returns

In addition to ensuring users can access significant returns, the use of smart contracts and blockchain technology has also enabled decentralized finance to offer investors an additional level of security and transparency not currently available in traditional finance.

As smart contracts have been battle tested and improved for years, they can now ensure that both parties deliver exactly what they promised. And when contract terms need to be changed or loopholes filled, the unidirectional nature of the blockchain prevents changes to the contracts being made without the support of both parties. This differs significantly from the letters we often receive from banks outlining their updated terms and conditions, which we can either accept or reject as long as we are willing to switch providers.

When it comes to security, it’s not just about making sure contracts are honored and that no changes are made without our consent, it’s about making sure our assets are safe. As a result, we are now seeing many platforms, like our own AQRU app, that allow users to access the decentralized markets, learning from traditional finance and implementing many of the security solutions that banks use. This has given users confidence that they can earn greater returns through DeFi while efficiently managing risk.

Conclusion

Decentralized finance is an exciting financial ecosystem that, through tight security controls, can allow everyday investors to easily earn high returns and earn income from existing holdings. The blockchain’s immutable ledger allows intermediaries to be freed from financial transactions, greatly improving returns as the only fees incurred are for maintaining the blockchain itself. Innovations in blockchain have made it possible to use smart contracts to create impressive financial products that pose a real challenge to traditional financial institutions.

In inflationary times, DeFi is a means of preserving and generating value without undue risk or time investment. We believe investors should start seriously considering decentralized markets as part of a diversified investment portfolio – the returns could just be too good to pass up.

Philip Blows is CEO of AQRU plc.