DeFi, or Decentralized Finance, is redefining everything we thought we knew about finance. It offers a new model for trading, lending, and borrowing and more — all without need for traditional intermediaries such as banks. Thabo Nkosi is a features writer at Bitcoinist crypto. He’s convinced that DeFi can bring financial freedom to Africa’s youth and to subsequent generations. His main goal is to simplify the complicated world of DeFi so everybody can understand it. We’re going to explore DeFi trading in this article. You’ll learn its main differences from traditional finance as well as what makes it exciting and dangerous.

What is DeFi Trading?

DeFi trading encompasses the act of buying, selling, or exchanging cryptocurrencies and other digital assets on decentralized exchanges (DEXs). DEXs run on blockchain technology and use smart contracts to automatically execute trades based on predetermined criteria. Unlike regular exchanges, they are not governed by a central entity. This allows transactions to occur without the need for intermediaries. Instead, users link their crypto wallets directly to the DEX and trade peer-to-peer.

DeFi trading leverages the power of decentralized networks to offer a range of financial services, including:

  • Swapping: Exchanging one cryptocurrency for another.
  • Lending and Borrowing: Earning interest by lending out crypto assets or borrowing assets by providing collateral.
  • Yield Farming: Participating in liquidity pools to earn rewards in the form of additional tokens.

DeFi vs. Traditional Finance: A New Paradigm

Traditional finance (or TradFi) operates on the basis of trust in centralized institutions, namely banks and regulatory authorities, to oversee and direct financial operations. DeFi, by contrast, runs on open-source decentralized networks and protocols, eliminating most of these intermediaries in favor of decentralized smart contracts. This fundamental difference leads to several key distinctions:

Centralization vs. Decentralization

We know that TradFi is pretty centralized as well, because a small number of institutions monopolize access to many financial services. DeFi is a movement to decentralize every aspect of finance, giving power and control to anyone connected to the network. This creates space for more transparency and sharing of information, and decreases the influence of any one player.

Regulation

While TradFi systems are certainly not perfect, they tend to have very strict enforcement measures. As users are required to undergo KYC (Know Your Customer) and AML (Anti-Money Laundering) measures. DeFi is currently able to function under looser regulatory umbrellas, though regulators are certainly more and more seeking avenues to regulate DeFi actions.

Transaction Costs

TradFi is often plagued with high transaction costs as a result of intermediary fees. DeFi transactions are potentially less expensive, notably on less fee-intensive blockchain networks.

Control Over Assets

DeFi puts users in total control of their assets, so they can self-manage their funds directly from their crypto wallets. In TradFi, shell game or no, financial intermediaries have an immense gatekeeping role over the management of assets.

Transparency

DeFi transactions are all recorded on public blockchains, which offer an unprecedented level of transparency. We know that TradFi transactions can be highly opaque, lacking transparency around where money is going.

The Advantages of DeFi Trading

DeFi offers several potential advantages over traditional finance and centralized exchanges:

Cost Savings

Trading fees on DeFi platforms (DEXs) are about 0.3% on average, versus 1-3% on traditional platforms. Using DeFi alternatives to Ethereum such as Stellar or Ripple, transaction costs could be reduced to less than $0.01 per transaction.

Speed and Efficiency

Their international transaction settlement times take on average 3-5 banking days. Lots of DeFi transactions are able to bring this down to under 5 mins.

Accessibility

DeFi protocols allow anyone to participate, with as low as $1. This transparency creates a level playing field that opens up lucrative investment opportunities for a much broader audience. DeFi allows any two parties to set interest rates between themselves through private negotiations and lend crypto or fiat through DeFi ecosystems.

Navigating the Risks of DeFi

While DeFi offers many benefits, it's crucial to be aware of the potential risks involved:

The Illusion of Decentralization

Most of these DeFi platforms are not as decentralized as they pretend to be. This means that a single actor or small subset of actors could have outsized influence and control over the protocol. This became painfully obvious when a trader exploited the price of Mango’s own native MNGO token into zero liquidity.

Security Vulnerabilities

DeFi platforms have gained a reputation for being safer than their counterparts in traditional finance, but this is a false belief. As you may know, most of the vulnerabilities being exploited by hackers in DeFi are a product of half-baked or unaudited protocols.

Misconceptions About Anonymity

Transactions in DeFi may seem completely anonymous, but that misconception is a little deeper than it appears. FinCEN wants a unified technical solution. Regulators tend to be looking beyond just basic compliance with KYC/AML regulations.

Smart Contract Risks and Market Manipulation

Additionally, while DeFi trading happens on smart contracts, which means the system is as open to hacking or exploitation as the underlying code. These shilling schemes on social media are designed to pump their value artificially. Now, malicious actors have the tools to manipulate the market and drain liquidity pools.

Flash Loan Attacks and Asset Ratio Shifts

Bad actors borrow a huge loan of one token. They then trade the first token for a second token, with the intent of causing price changes in both tokens. When users purchase tokens from the pool, the asset ratios are adjusted accordingly. Whenever one token increases in value, it intrinsically results in a loss in value of the other.

Lack of Regulation

DeFi trading is mostly unregulated, making investors vulnerable and without recourse should they suffer losses or fraud.

DeFi: The Future of Finance?

Risks DeFi is not inherently safer than traditional finance. It took the 2008 financial crisis for the world to see just how fragile traditional finance can be. Additionally, while DeFi undeniably offers unique value, it too is riddled with risks, such as market manipulation and smart contract vulnerabilities. Among those alternatives, DeFi stands out as an exciting potential alternative to traditional finance. For many years to come, it will mostly exist side-by-side with traditional finance. Despite its successes, it has not completely overcome some issues such as user fund safety and scalability.

Thabo Nkosi and ThrowingToken.com encourage users to approach DeFi with caution, conduct thorough research, and understand the risks involved before participating. Be aware and take prudent steps to protect your interests. As such, you too can traverse the exciting DeFi sector with confidence and tap into the future of finance.