What is DeFi and Why is DeFi Popular?

What is DeFi and Why is DeFi Popular?

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If you’ve ever invested in the financial market and are up to date about the latest fiscal trends, you are probably familiar with the concept of DeFi, but what is DeFi and why is DeFi popular?

For the uninitiated, DeFi stands for decentralized finance which is a common umbrella term used for defining a variety of crypto or blockchain-based financial applications that are driven by the goal of moving away from centralized banking systems. And why is DeFi popular? Because it removes the middleman and grants the individual more control and freedom with their finances.

At its very crux, DeFi uses blockchain technology as its primary motivator. As you are probably aware, blockchain is also the iconic technology that later went on to create Bitcoin, a digital currency that simplifies anonymous transactions by not being centralized or controlled by a specific source.

Decentralizing as a financial trend is indeed vital because conventional (read centralized) applications often come with human gatekeepers who end up hindering the natural flow of the transactions. After all, most users cannot control their money directly. DeFi as a concept is distinctive, to say the least since it exemplifies the role of blockchain from a basic transaction operator to more sophisticated and detailed use cases.

Several other digital assets like Bitcoin and the like are often deemed better than the age-old payment systems like those run by giants like Paypal, Alipay, and WeChat Pay. Why? Because they simply do away with any middleman from their online transactions.

Every time you use your credit card for shopping or paying bills at a restaurant, there’s always a financial entity acting as the middleman for you and the said enterprise where you are using the card. Being the middleman in place, these financial entities have more control over your transactions. The worst part, they have the complete authority to pause/cease your transactions.

With Bitcoin, decentralized banking, and blockchain technology in general, these middlemen are moved out of the scenario. When you opt for this mode of banking, you have complete control over how your asset is managed or transacted.

It is worth noting at this stage that digital purchases aren’t just the only kind of transactions that are controlled by financial entities. Other transactions like any form of credit, insurance, funding, investment, and even your loans are under their authority. When you cut these middlemen out you enjoy greater autonomy and that is exactly what DeFi aims to achieve.

Before being popularly known as Decentralized finance, DeFi was also called “Open Finance” primarily due to the degree of transparency it offers during transactions. But what exactly is the future of DeFi? What pros and cons does it come with? Why is it getting incredibly popular among the masses? Well, these are some of the questions we are going to unearth over the course of this article.

What can you do with DeFi?

With decentralized finance, there are many things that you can now do that were otherwise not possible with conventional financial instruments. In case you are wondering what exactly its use cases are, here are some examples below.

  • Lend and even borrow digital currencies without accruing interest on the loan.
  • Set up crowdfunding campaigns on a blockchain where funds can be disbursed to help unbanked communities.
  • Set up micro-lending initiatives where funds can be disbursed directly to a trusted user, saving on middleman fees or worse, theft and loss of funds.
  • Earn passive income by staking your crypto on blockchains such as Dash, Polkadot, and Cardano.
  • Purchase cryptos called stablecoins that can be moved to the same value of a commodity/currency.

Why is DeFi popular?

One of the biggest reasons why DeFi is popular is because it doesn’t involve any third party in financial transactions. Now that you control and oversee every transaction, money management and investments are a lot more hassle-free and safe insha’Allah (God willing).

Popular DeFi tokens

There are a number of popular DeFi tokens such as Aave, yEarn, Uniswap, UMA, and more. However, the main purpose of these DeFi platforms and tokens is that they are used primarily for projects that are based on lending out your crypto to earn interest and/or derivatives, and both of these are seen as prohibited in Islam.

Here is a short list of some popular DeFi tokens:

This is one of the biggest DeFi protocols. Aave is primarily used as a loan platform where lenders can stake their crypto in “lending pools” where borrows are able to use the crypto for loans. Lenders earn interest on their borrowed crypto. As of now, its average supply stands at 16,000,000 units.

This is yet another automated liquidity aggregation tool with a range of financial products. YFI is the primary token and it currently has a supply of 30,000 units. The primary activity on yEarn is for lenders to earn money off of the crypto staked in lending pools. The lenders earn money off of those who borrow from the pool.

With a complete supply of 1,000,000,000 units known as UNI tokens, this is one of the biggest DeFi platforms out there where you can trade Ethereum tokens.

With an average supply of 100,224,817 units, UMA is yet another popular DeFi protocol that makes way for creating synthetic assets without involving any permissions or whatsoever.

Pros and cons of DeFi

As with everything else, DeFi comes with its own set of pros and cons. In this section, we’ll dig a little deeper about them.

Advantages of DeFi

Fully Decentralized
This is probably one of the defining benefits of DeFi. Since online banking and investments run on smart contracts, people using this technology can exchange tokens without involving middlemen.

Automation in Market
DeFi works as an automated market which again leverages a unique mathematical equation for pricing assets. The liquidity, on the other hand, is received from a range of providers who can earn tokens as their primary reward. This also eliminates the need for individuals having to be closely monitoring the trade.

Simplified Lending
DeFi is certainly an excellent alternative for borrowers as it is a way for borrowers to gain access to decent capital. DeFi also allows borrowers to use existing funds as security and qualify for a loan without having to use an Experian score or credit score.

Easy Stakes
Since DeFi is based on proof of stake technology, you get a reward every time you lock assets in the proof of stake network.

Disadvantages of DeFi

Lack of Certainty
In case a blockchain hosting the decentralized finance project encounters an issue, the project in question gets directly affected. This can be an issue because blockchain technology for DeFi is still young and still going through changes and improvements.

Issues with Scalability
With DeFi, transactions might be approved over a longer period. What’s more, in some instances, the transaction may even turn out to be expensive. Blockchain applications can produce a mere 13 transactions each second as opposed to their conventional counterparts that can process thousands of such transactions.

Vulnerability in Smart Contracts
DeFi projects may encounter issues even with the minutest flaw in their base smart contract. Since this may also result in monitory losses, it is deemed as a significant con.

Liquidity Issues
As with many other blockchain-based assets, DeFi also has its fair share of liquidity issues. Liquefying DeFi tokens are certainly more difficult when compared to conventional contracts.

Is DeFi Halal?

DeFi in and of itself is halal and not haram. DeFi, or decentralized finance, is nothing more than people involved in commerce and/or financial operations that are not centralized by a bank, lending institution, or finance company, etc.

DeFi is where people can perform financial operations in a “trustless” environment where a software application can be used to verify identities, contract agreements, and more without the need for human involvement. This is what is meant by a trustless environment. You do not need to put trust in a human to conduct the operation, and this, in general, is not haram.

However, at this time, the world of decentralized finance (DeFi) focuses more on money lending where people take their fiat currency, purchase tokens on a DeFi blockchain, add their tokens to a lending pool for borrowers to access for loans, and then earn interest off of the loan as well as possibly earn money from trading transaction fees.

Making money off of loans or, “renting money”, is not the goal of Islamic finance and is prohibited in Islamic law so this is an area of conflict for Muslims when it comes to DeFi.

Now, there are Islamic scholars who categorize cryptocurrency as either a currency or an asset. For example, some scholars will classify Bitcoin as a currency but classify Ethereum as an asset. If the cryptocurrency is classified as currency, then the rules of riba al buyu apply; therefore, making money off of loaning Bitcoin would be considered haram. This is relatively easy to understand. But what about Ethereum?

Ethereum and the DeFi tokens on the Ethereum blockchain would be classified as assets.

At the time of writing this blog post, the majority of DeFi operations are primarily conducted on the Ethereum blockchain where numerous DeFi tokens, Aave, Uniswap, Sushiswap, yEarn, Maker, etc., are being used for DeFi operations.

Now comes the question, in Islam is it permissible to make money off of an asset? The simple answer is, yes. If you were to own a house and rented out that house to earn an income, then the house would be classified as an asset and it is permissible to make money off of renting the house.

But cryptocurrency is different. DeFi tokens are assets, but the problem is that generally speaking, most DeFi tokens are used to replace, represent, or be a placeholder for money. So, even though we can say that we are making money off of an asset (the DeFi token), the truth is, the DeFi token is truly being used as a substitute for currency; the US Dollar, the UAE Dirham, the Indonesian Rupiah, the Chinese Yuan, the British Pound, etc.

At this time, there has not been an overall Islamic ruling saying that cryptocurrency DeFi tokens are haram, and I highly doubt scholars will say that DeFi tokens are haram. Rather, the scholars will ask, what is the token being used for? And what is the token truly representing in the operation? I believe this is what scholars will focus on.

It is simply for Muslims to understand the basics of Islamic finance and to ask ourselves the question, when I use a DeFi token, what am I using it for? Is it to make money off of loans? Am I truly just renting money? If this is the reason, then I would advise staying away from such operations.

My hope is to eventually see Islamic financial products offered on DeFi blockchains. In time, I would love to see Murabaha (cost-plus financing) products, Islamic REITs (Real Estate Investment Trust), and Sukuk investment options on DeFi.

Is DeFi the future of finance?

Insha’Allah (God willing) I believe DeFi is certainly the future of finance and banking as we know it and given the amount of transparency it comes to offer, Muslims should certainly consider it as a viable financial tool.

Scholars are already studying the Ethereum blockchain and considering the possibilities of how utilizing blockchain for DeFi can be of benefit to the ummah and the world at large. Of course, since the trend is new people are wary of using such a tool, but given the promises it has to offer, I do believe that DeFi is here to stay.

And in the end, Allah knows best.

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