FN 101 - Decentralized Finance
The world of DeFi (Decentralized Finance) is constantly expanding, as new blockchains are introduced and new dapps (decentralized apps) are built on top of them. This introductory course for DeFi will cover the following:
  • Defining Decentralization
  • Smart Contracts
  • Types of Applications
  • Understanding DeFi Risks

Suggested Prior Reading:

None.

Introduction

Decentralization is simply the action of transferring authority from one place to many. In the world of blockchains and cryptocurrencies, this means that there is no one central authority controlling transactions. This is in stark contrast to the world of centralized finance, where banks control your money, investments and transactions at all times. The decentralized nature of blockchains transfer such authority to code and validators in the network. The more people you have validating the network, the more decentralized and secure the network is.
The centralized financial system is built on trust. Trust in the financial institution or bank you give your money to, trust in whoever you are trading assets with, trust in whatever company you are investing in, etc. Even banks need to trust whoever they are giving a loan to through flimsy collateral deals, credit and background checks, and so on. Decentralized finance does away with trust and creates a trustless financial system where one does not need to know or trust the other person they are transacting with. This is because all transactions are controlled by smart contracts.

Smart Contracts

Smart contracts are essentially programs written on the blockchain. They can accomplish a plethora of use-cases that ultimately create the backbone of a fully decentralized financial system. A blockchain without smart contracts can still be decentralized and useful as a transaction system; Bitcoin, for example. However, DeFi has grown to be much more than that. Some applications of smart contracts in DeFi include the following:
  • Tokenized Assets
  • Decentralized Exchanges
  • Lending Platforms
  • Stablecoins
  • Decentralized Autonomous Organizations
  • Non-Fungible Tokens
  • No-Loss Lotteries
  • Prediction Markets
The list above includes some of the functions that DeFi can execute more efficiently than traditional financial institutions. Moreover, some of these functions are simply too difficult to accomplish in a centralized environment.
To find out more about each individual application, check out the other courses available at Snowball's DeFi University! We will most likely have covered the subject in varying levels of complexity.
Since smart contracts are deployed and ran on their respective blockchain, transactions performed with or by them are encrypted and extremely secure. Furthermore, since all contracts are digital and automated, there is no paperwork to file or human errors to account for. This means transactions are faster, more efficient and more accurate than their traditional finance counterparts.
All smart contract code is fully transparent and publicly available on the blockchain. This allows for the trustless mechanisms present in DeFi, since you do not need to trust a third party; simply read the contract code and verify its functionality yourself. However, in order to facilitate this verification process, there are many organizations that conduct smart contract audits. These audits can help spot any errors or vulnerabilities in the code and ensure that a smart contract's functionality is legitimate for anyone who does not have smart contract or development experience.

DeFi Risks

As with any financial activity, we must look at the risks involved when using decentralized applications. These can be summarized into three categories:
  • Smart Contract Risk
  • Asset Exposure
  • Scams

Smart Contract Risk

The inherent risk of smart contracts is that at some point, a developer or a team of developers must write and deploy each contract. This means that there could be unintentional errors or vulnerabilities in the code that allow an exploiter or hacker to utilize the contract in unintended ways. This is why many DeFi projects (including Snowball) use code that has been used in other contracts (hopefully for a long period of time) and that has been audited, battle-tested and is trusted for its robustness and safety.

Asset Exposure

Cryptocurrencies are volatile. While you can minimize this risk by utilizing stablecoins (which are pegged to currencies such as the US dollar), any other tokenized assets can drastically increase or decrease in price based on normal market fluctuations, as well any event that affects supply and demand. Intuitively, if you are holding a token and its price drops significantly, you will incur that loss.

Scams

The scamming industry is a multi-billion dollar industry (source) in the world of traditional finance. Naturally, some of this would extend to the world of decentralized finance. The anonymity provided by blockchains is somewhat helpful in that sense, but the fact that every transaction is easily traceable has made it very difficult for scammers to cash out their returns. Regardless of the context or technology involved, scammers will always find a way to scam, and it is important to watch out for them.
To learn more about how to avoid common scams in DeFi, check out the EX 151 course on 'Spotting Scams'.

Closing Thoughts

Decentralized finance is a new technology that comes with revolutionary tools and capabilities unknown to the world of traditional finance. The ecosystems that are being built around this technology are still maturing and contain many risks to watch out for. Nonetheless, we hope that these courses can help others to explore the incredible new opportunities available to them in DeFi.