Beginners Guide to Understanding Decentralized Finance (DeFi)

Beginners Guide to Understanding Decentralized Finance (DeFi)

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April 22, 2021 by DanCurranJr
What is DeFi and How Does it Work? In practice, DeFi is a network of DApps (decentralized applications) and smart contracts built on Ethereum blockchain that focuses on financial applications such as loans, derivatives, exchanges, trading, and more. DeFi focuses on the concept of “Lego” money. That is, the idea is for anyone to be able

What is DeFi and How Does it Work?

In practice, DeFi is a network of DApps (decentralized applications) and smart contracts built on Ethereum blockchain that focuses on financial applications such as loans, derivatives, exchanges, trading, and more. DeFi focuses on the concept of “Lego” money. That is, the idea is for anyone to be able to create, modify, and match, connect, or build on top of any DeFi product permissionless.

DeFi protocols are modular, so they can interact with each other (similar to Lego constructors) to build an increasingly dense system of interacting parts. Anyone who can write a smart contract is able to create DeFi applications. For example, Insta DApp builds a DeFi product by simply building a better user interface on top of existing DeFi products. But in fact, the feature of open interdependence may also be DeFi’s biggest weakness.

If a key component like DAI (stablecoin, pegged to the USD and backed by Ether) becomes vulnerable or damaged, the entire ecosystem built around DAI may collapse.

Currently, the three biggest functionalities of DeFi are:

Creation of Monetary Banking Services

DeFi DApps allow you to create stablecoins (a cryptocurrency whose value is pegged to the US dollar). One such project for stablecoin is Maker. In it, each stablecoin (called DAI) is pegged to the US dollar and backed by collateral in the form of a cryptocurrency. Stablecoins offer the ability to program cryptocurrencies without reducing of volatility that you see with “traditional” cryptocurrencies like Bitcoin or Ethereum.

Maker is more than just a stablecoin project, as it seeks to be a decentralized reserve bank. People who hold the MKR token can vote on important decisions such as the Stability Fee (similar to how the FOMC votes on the Fed Funds rate).

Providing Peer-to-Peer Lending and Borrowing Platforms

Open Lending Protocols are a digital money lending platform built on a blockchain. Borrowing and lending platforms are probably DeFi’s most popular and fast-growing sector. Thanks to the current widespread use of DAI, other peer-to-peer protocols such as Dharma, and liquidity pool designs such as Compound Finance in recent years. 

Like a bank, consumers deposit their money, and when someone else borrows the digital assets, they earn interest. However, instead of intermediaries, here the smart contracts dictate the terms of the loan, connect lenders and borrowers, and distribute the interest. And while you may think that lending to a stranger sounds risky, most loans made in DeFi are backed by more collateral than borrowed value. This reduces the risk for lenders.

BlockFi and Voyager have become common decentralized lending protocols recently. 

Enabling Financial Instruments Such as DEX, Tokenization Platforms, Predictions Markets, and Derivatives.

Another type of popular DeFi application is the so-called decentralized exchange or abbreviated to DEX. DEXes are cryptocurrency exchanges that use the power of smart contracts to enforce the trading rules and execute trades securely. When trading on a DEX there is no exchange operator, no registration, no identity verification, or withdrawal fees.

DeFi’s derivative markets trade almost any asset on the blockchain using synthetic pricing. For example, synthetic price feeds create derivative tokens for stocks, futures, and even Bitcoin using smart contracts. Similarly, prediction markets are another popular type of derivative market in DeFi. Prediction markets essentially allow consumers to bet on the outcome of any event.

Tokenized assets and asset management is another fast-growing sector of DeFi. Asset management protocols allow investors to invest their money in the hands of the smart contract. Other asset management protocols, such as Set Protocol, employ automated strategies such as periodic rebalancing or following technical indicators.

How To Use DeFi?

Anyone can use DeFi products by going to the website of the respective application and connecting with a MetaMask wallet or something similar. You can also use most of the DApps on your desktop. Most DeFi DApps do not require users to provide any personal information or registration. But ETH is needed to pay for transactions on the Ethereum network. 

Users can take out a loan or earn interest on stablecoins using MakerDAO’s Oasis app and Compound. Tokens and cryptocurrencies can be exchanged with or without registration in Kyber, Uniswap, and others. You can even buy tokens that automatically place trades for you using Set Protocol.

On the other side, Synthetix is a platform that allows you to create and exchange synthetic versions of assets such as gold, silver, cryptos, and traditional currencies like the Euro. The synthetic assets are secured by additional collateral locked into the Synthetix contracts.

Is DeFI Secure?

Secure handling of cryptocurrencies and finance instruments requires specialized knowledge. There is a risk factor involved. It is the user’s responsibility to keep their key and holdings secret, use a hardware wallet, and multi-factor authentication.

As a DeFi user, you should know the changing terms of services between different DeFi products, wallets, exchanges, and crypto projects. Some DeFi products can add new dimensions that are paired with DAOs. These are decentralized autonomous organizations that can manage the protocol or platform.

Decentralized applications are still in an experimental phase.

Influence of DeFi on the Traditional Financial System 

DeFi has many benefits for consumers to which traditional banks will either have to adapt, accept them or lose a lot. Nowadays, even the central banks are also studying the role of digital blockchain-based currency in their economies.

One of the biggest advantages is that consumers can earn anywhere between a 7-10% interest rate on their cryptocurrency. This is an extremely attractive option, especially in the current negative interest rates on bank deposits and increased QE. Keeping your euros, dollars, or yen in a bank account will cost you a loss of money over time.

Decentralized finance brings many others benefits compared to traditional financial services. With the use of distributed systems and smart contracts, the implementation of a financial application or product becomes much easier and more secure. For example, many DApps are being developed on top of the Ethereum blockchain, which provides reduced operating costs and lower entry barriers.

A payment system in which anyone could send money to anyone else on the planet was just the beginning of the crypto revolution.

Is DeFi the Future?

The DeFi system cannot be censored or shut down by governments or large corporations. On the contrary, it improves confidentiality and security because there is no centralized single data source whose hacking would allow a security breach to occur.

Unlike traditional banks, Defi eliminates all the types of intermediaries that would usually be involved through the use of smart contracts. A decentralized system also eliminates all high costs, and these benefits are passed on to the end-user. The user has full control over their money without a reliable third party.

DeFi will have a huge impact on the traditional financial system and the way we manage our wealth in the future. Traditional finance may feel threatened at the moment, but it is also impossible to ignore these compelling technology, cost savings, and legacy system improvements. All of these advantages make DeFi an inevitable next step in the financial world.

Where Are the Risks?

There is always some risk with any high-return product, and DeFi also has its fair share. 

The Legal Environment

So far, the legal financial system has been deeply intertwined in many countries around the world. As a result, any attempt to remove the financial system away from this interconnected setup should create a number of legal challenges. And they will have to be addressed in order to achieve large-scale adoption of DeFi.

Lack of Interoperability Between Blockchains

In the world of DeFi applications, where no permissions are required, the lack of interoperability between chains can be a significant obstacle. This means that an application built on one blockchain, say, Ethereum, could not easily transact with an application built on a different blockchain, such as Bitcoin. However, there are already some bridging chains and protocols that allow it. For example, there are some sidechains and layer 2 solutions that trying to scale Ethereum off-chain. Also other blockchains like Polkadot and Cosmos building their ecosystems to be interoperable.  

Transaction Speed 

Ethereum networks can process 25 transactions per second, but these numbers pale compared to Visa’s 24 000 transactions per second. Overcoming speed will be a crucial challenge for DeFi if it wants to gain even greater use. To fill the gap between theory and practice, DeFi will have to overcome some other major obstacles such as non-intuitive user interfaces and affordability, capital inefficiency, hidden risks, and regulation to some extent. 

In Conclusion…

Decentralized finance could be the next significant disruption to the financial system. By using blockchain technology, this new wave of applications and services will help reduce transaction costs and improve financial services, security while providing consumers with a seamless experience from anywhere in the world.

People no longer have to participate in a system that doesn’t work for them. The cycle can be interrupted by removing the central participants. And that’s exactly what comes in the form of DeFi with C2C lending, high-interest accounts, and staking as a form of return.

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