Decentralized Finance a.k.a DeFi
As we know it today, the financial system has evolved over decades as a result of technological breakthroughs. We no longer visited bank branches for cash deposits/ withdrawals. We also transitioned from cash-based payments to digital payments. Those early morning crowds at the stock exchanges were replaced by digital traffic. The increasing acceptance of the internet has only accelerated the ascent of money.
We then had a fintech revolution. Startups noted for their tech-first strategies, such as PayPal, Robinhood, and others, provided customers with smooth access to financial systems. On the other hand, we had a completely contrasting experience of clunky banking user interfaces.
Despite decades of progress, the financial system is riddled with flaws. Stocks and other financial instruments take days to settle. The whole financial infrastructure consists of siloed systems created with proprietary technology and algorithms that each corporation must develop from the ground up. Despite progress, billions of people remain unbanked across the world. Furthermore, the financial system’s backbone hasn’t changed much since the debut of the mainframe computer. Now, this is where decentralized finance enters the picture, trying to solve the puzzle.
So, What is DeFi?
DeFi is essentially a peer-to-peer network that is not governed by any centralized entities, such as a bank. In the DeFi space, you will interact with your peers via a smart contract in a safe setting provided by blockchain technology. Smart contracts function similarly to traditional contracts. It is a computer program running on the blockchain that is interoperable, self-executing, and permissionless.
DeFi services, such as decentralized exchanges and lending protocols, enable anybody with an internet connection to access financial services, and they are mainly owned and governed by the users themselves. This concept democratizes money and decreases the opportunity disparities that afflict the present financial system. The majority of DeFi apps are developed on Ethereum, the world’s second-biggest cryptocurrency platform.
Let’s tear down DeFi with a basic example:
You wish to pay a shopkeeper for the groceries you purchased; the shopkeeper requests that you pay with your debit card, so you swipe your debit card through the POS machine. In this case, the money transfer procedure requires several intermediaries, including your bank, the shopkeeper’s bank, a payment network such as Visa or Mastercard, and the payment gateway provider.
A decentralized form of the same transaction would include your digital wallet communicating directly with the shopkeeper’s digital wallet with the help of a smart contract. Here the smart contract replaces the intermediaries.
The most simple form of DeFi is peer-to-peer payment; however, with the usage of smart contracts, DeFi projects have expanded into even more complex fields such as lending & borrowing, margin trading, stablecoins, decentralized exchanges, derivatives, insurance, and prediction markets. These protocols operate on the principles of non-custodial, which means you have complete control over your funds, and decentralized, which means no one entity controls or owns the network.
MakerDAO, a platform that emerged in 2015 and allowed users to utilize cryptocurrencies as collateral for loans, is frequently credited with DeFi’s inception. Until recently, the market has been propelled by a libertarian viewpoint and a drive for investors to profit.
Here, we have a few most commonly used DeFi applications:
- Lending Platforms
Decentralized lending platforms, according to proponents, are democratizing the loan ecosystem. Smart contracts are used by these platforms to replace intermediaries such as banks that manage loans in the middle. Due to the volatile nature of the crypto economy, borrowers must provide collateral that is more valuable than the loan amount. Aave, Compound, and Maker are three prominent DeFi lending protocols. If someone needed to borrow an asset in the early days of Defi, they had to locate someone on the platform willing to lend it at a price and terms they agreed on. However, since then, the procedure has changed.
Protocols such as Aave, for example, avoid peer-to-peer lending entirely in favor of pool-to-peer lending (liquidity pools)
This is how it works: The digital assets can be deposited into the liquidity pool (a collection of digital assets) by the user. By depositing in liquidity pools, a user can become a liquidity provider (LP). The user receives fresh aTokens for putting into the pool ( Here “a” means Aave). A user who deposits ETH, for example, will receive aETH in return. The holder of aETH tokens will receive interest on those aETH tokens. The interest generated will be determined by the lending and borrowing for each asset pool. Example — If a user deposits into a pool with excess liquidity, the interest earned will be lower; however, if the user deposits into a pool with less liquidity, the interest earned will be higher.
2. Decentralized Exchanges (DEXs)
Decentralized exchanges are exchanges that allow users to connect directly to trade cryptocurrencies without entrusting their money to an intermediary. DEXs are classified into two types: those that use a liquidity pool and those that use an order book. Uniswap, Kyber, Balancer, and Bancor are a few examples of liquidity pool-based systems. Order book-based ones include Loopring and IDEX. On the other side, there are these centralized exchanges such as Binance, Coinbase, WazirX, and others.
3. Prediction Markets
Participants in a prediction market can place wagers on the outcomes of future occurrences. The purpose of DeFi versions of prediction markets is to provide the same functionality as regular prediction markets while using blockchain technology to remove intermediaries. Augur, Gnosis, and FTX are some of the most prominent DeFi prediction markets.
4. Stablecoins
Cryptocurrencies have created a new financial world, but it has been met with widespread criticism. The price volatility of the assets is one of the major criticisms. Stablecoins come into play here. Stablecoins are a type of cryptocurrency that is backed by fiat currency, gold, or other assets and has the same value as the asset to which it is pegged. There are several uses for stablecoins. Stablecoins are used mainly as a store of value and as a means of exchange as most digital assets.
Concluding..
Like you may have observed, DeFi is an exciting field full of prospects. Though it has the potential to change the world of finance the focus so far has been on speculation, leverage, and yield creation. There are additional problems to be addressed, like security issues with smart contracts, the volatility of the crypto ecosystem, and the public policy challenges. Defi, like the internet, is open, permissionless, and allows for collaborative work. It can build an open, transparent, and irreversible financial system that is accessible to everyone yet controlled by none. Although the success of DeFi is dependent on its ability to fulfil its promises of decentralisation, openness, and non-custodial, it compels the discussion towards a resilient, and open financial system.
This is an introduction post on DeFi; however, we will be concentrating on each protocol in the DeFi ecosystem independently in the following weeks.
