Understanding Crypto – What is DeFi and why use it?

Decentralised Finance or DeFi, as it is often abbreviated, is a financial system which is not managed by governments nor central banks, nor traditional financial service providers.

By Chris Davies

It is finance that takes place in a virtual world, with checks and balances confirmed by algorithms completed by millions of users and is therefore decentralised. It uses blockchain technology to record these transactions.

The core components of DeFi

1. Blockchain technology enables secure and transparent record-keeping.
2. Smart technology is a distributed ledger technology that enables secure and transparent contracts. They are self-executing programs that run on a blockchain and automate the execution of financial transactions.
3. Decentralised applications (dApps) are software applications built on top of a blockchain network that allow users to interact with the blockchain and access DeFi services.

Examples of DeFi services

DeFi services allow users to trade assets, borrow and lend funds, and manage their investments without the need for a central authority. Some examples are:

• decentralised exchanges (DEXs) eg uniswap
• lending and borrowing platforms
• stablecoins eg USDC,  and asset management protocols.

Benefits of using DeFi

DeFi has the potential to democratise finance and provide more accessible and inclusive financial services to people all over the world.

1. Decentralisation: DeFi eliminates the need for intermediaries such as banks or other financial institutions, giving users complete control over their funds and removing the risk of a central point of failure.
2. Accessibility: DeFi is open to anyone with an internet connection and a compatible wallet, allowing people from all over the world to access financial services, even if they cannot access traditional banking services.
3. Transparency: The blockchain technology underlying DeFi ensures that all transactions are recorded on a public ledger. The system is thereby transparent and auditable.
4. Lower fees: DeFi transactions often have lower fees than traditional financial services, because there are no intermediaries taking a cut.
5. Programmability: DeFi services are built on smart contracts, which allow for the creation of complex financial products and the automation of processes.
6. Innovation: DeFi is an open ecosystem that encourages innovation and experimentation, leading to the development of new financial services and products.

Disadvantages of using DeFi

While DeFi has the potential to revolutionise finance, it is not without risks and potential drawbacks. It is important for users to understand these risks and make informed decisions when using DeFi services.

1. Complexity: DeFi is a relatively new and complex technology. Users may need to invest time and effort to understand how it works and how to use it effectively.
2. Volatility: Many DeFi assets, such as cryptocurrencies, can be highly volatile and subject to large price swings. Significant gains but also significant losses are likely for investors.
3. Security: Although DeFi uses blockchain technology to ensure the security of transactions, there have been instances of hacks and exploits on DeFi platforms, leading to the loss of funds for investors.
4. Regulation: DeFi operates outside of traditional financial systems, which can make it difficult for regulators to monitor and oversee the industry, creating legal and regulatory risks for both users and service providers. That said, many governments and central banks are taking an interest in DeFi and are proposing regulating where they can.
5. Lack of customer support: DeFi services are typically decentralised and there is no central authority to turn to for customer support. It can be challenging to say the least, for users to resolve issues or disputes.
6. Blockchain can be incredibly energy.

We look after many clients who invest in crypto assets in the Decentralised Finance world, and understand their requirements for crypto tax reporting. If our crypto tax specialists can help you at any point in your crypto journey, please do get in touch.