What is DeFi?
The premise of cryptocurrency is that it will make money and payments available to everyone, no matter where they are on the globe.
The Decentralized Finance (DeFi) movement goes a step farther in fulfilling that promise. Consider a worldwide, open alternative to every financial service you use today – savings, loans, trading, insurance, and more — available to anybody with a smartphone and an internet connection anywhere in the globe.
On smart contract blockchains like Ethereum, this is now feasible. Smart contracts are blockchain-based programs that may run automatically if certain criteria are fulfilled. Developers may use smart contracts to provide much more complex functionality than just sending and receiving money. These applications are now known as decentralized apps, or dapps.
A dapp is an app that is developed and managed by a decentralized entity or business rather than by a single, centralized organization or corporation.
DeFi apps use crypto to replicate conventional financial institutions such as banks and exchanges. The Ethereum blockchain is used by the majority of them.
To begin, it’s essential to note that DeFi is a relatively new concept that is just now gaining traction. As a result, DeFi (short for decentralized finance) lacks a precise definition. Rather, it’s an effort to explain what a certain kind of cryptocurrency is currently trying to do.
DeFi cryptocurrencies tend to share certain similarities.
Most DeFi projects are software protocols that operate on top of another cryptocurrency – most often Ethereum or Cosmos – and utilize that protocol’s crypto asset (along with their own and perhaps others) to automate financial services.
DeFi lending allows users to lend out bitcoin and earn interest in the same way that a conventional bank would with fiat money. Borrowing and lending are two of the most popular DeFi use cases, but there are also many more sophisticated possibilities, such as being a liquidity provider for a decentralized market.
Projects such as, DAI, may also include a “governance token,” a crypto asset that allows users to influence project development or earn money from the service (DAI’s governance token is MKR).
DeFi coins’ proponents claim that this implies they may be used as “capital assets,” akin to stocks and bonds. So, although Bitcoin may be used as a pure form of money or a store of wealth, these new crypto assets are designed to provide users exposure to the value of the service they are receiving.
How Does DeFi Work?
DeFi’s components are similar to those of current financial ecosystems in that they need stable currencies and a diverse range of use cases.
Stablecoins and services such as crypto exchanges and loan services are examples of DeFi components. Smart contracts offer the foundation for DeFi applications to operate since they encapsulate the conditions and actions required for these services to function.
A software stack contains all of the components of a decentralized financial system. The components of each layer are designed to fulfill a particular role in the construction of a DeFi system.
How is DeFi used?
As the number of DeFi protocols grows, it’s important to understand the many types of issues these initiatives are trying to address.
The goal of this section is to categorize prominent projects into several categories, which may be useful for creating and diversifying your crypto portfolio.
Borrowing and lending
Users may become lenders or borrowers in a fully decentralized and permissionless manner while keeping full custody of their currencies using DeFi lending.
Smart contracts executed on open blockchains, namely Ethereum, underpin DeFi lending. This is also why, unlike CeFi lending, DeFi lending is available to everyone without the need to provide personal information or trust someone else with your money.
In DeFi, there are two lending protocols that have gained the most traction: Aave and Compound. Both protocols operate by establishing money markets for certain tokens like ETH, stable currencies such as DAI and USDC, and other tokens such as LINK or wrapped BTC.
Users who wish to become lenders deposit their tokens in a specific money market and begin earning interest based on the current supply APY.
The tokens are transferred to a smart contract and made accessible for borrowing by other users. The smart contract issues additional tokens that reflect the given tokens plus interest in exchange for the supplied tokens. These tokens, known as cTokens in Compound and aTokens in Aave, may be exchanged for the underlying tokens. Later in this essay, we’ll go through their mechanics in more detail.
It’s also worth noting that under DeFi, almost all of the loans are now overcollateralized. This implies that if a user wants to borrow money, they must provide tokens as collateral worth greater than the amount of money they wish to borrow.
You may be thinking at this point, “What’s the purpose of accepting a loan if you have to provide tokens worth more than the loan amount?” Why wouldn’t someone just sell their tokens, to begin with?
This is due to a number of factors. Users mostly do not wish to sell their tokens, but they do need money to pay unforeseen costs. Other motivations include avoiding or deferring capital gains taxes on their tokens, or borrowing money to enhance their leverage in a particular position.
Any peer-to-peer trading may theoretically be considered a decentralized exchange (see, for instance, Atomic Swaps). However, the decentralized exchanges that most refer to within the crypto world are platforms that mimics the operations of centralized exchanges.
The main distinction is that their backend is built on the Ethereum blockchain. Nobody holds your money, and you don’t have to trust the exchange nearly as much as you would with centralized offers.
In some respects, DEXs are similar to their centralized counterparts, but in others, they are very different. Let’s start by pointing out that consumers may choose from a variety of decentralized exchanges. Orders are performed on-chain (through smart contracts), and users do not lose control of their money at any time.
Although cross-chain DEXs have been developed, the most popular ones focus on assets on a single blockchain (such as Ethereum or Binance Chain).
Buyers and sellers of derivatives contracts exchange contracts based on the asset’s anticipated future worth. Cryptocurrencies, future event outcomes, and real-world stocks and bonds are all examples of these assets.
Users may exchange real-world assets like stocks, currencies, and precious metals in the form of tokens on Ethereum using protocols like Synthetix.
Users bet on the result of events on other protocols, such as Augur or Gnosis. Augur allows users to generate and trade “shares” that represent a part of the value of events such as elections or sporting results.
Finally, protocols like dYdX enable users to exchange margin tokens, giving traders the ability to leverage short or long bets in a variety of marketplaces.
What are the Risks of DeFi?
DeFi is a new phenomenon that comes with a slew of dangers. Decentralized finance is a new concept that hasn’t been put to the test by long-term or widespread usage. Furthermore, national authorities are scrutinizing the mechanisms they are putting in place with an eye toward regulation.
Other dangers associated with DeFi include:
There are no consumer safeguards in place. In the lack of laws and restrictions, DeFi has flourished. However, if a transaction goes wrong, users may have limited redress. For example, if a bank fails, the Federal Deposit Insurance Corporation (FDIC) reimburses deposit account holders up to $250,000 per account, per institution under centralized finance.
Furthermore, banks are obliged by law to keep a certain amount of capital as reserves in order to ensure stability and to be able to withdraw funds from your account at any moment. In DeFi, there are no such safeguards.
Hackers pose a danger. While a blockchain is virtually difficult to change, other elements of DeFi are vulnerable to hacking, which may result in money theft or loss. All of the possible use cases for decentralized finance depend on software systems that are susceptible to hackers.
Assets are used as collateral to obtain a loan. When you obtain a mortgage, for example, the house you’re purchasing serves as collateral. Almost all DeFi lending transactions demand collateral equal to, if not more than, 100 percent of the loan’s value. Many kinds of DeFi loans are severely limited due to these restrictions.
With collateralization, there is always a risk of liquidation. For example, if a user trades with leverage and collateralized certain assets, those assets could be liquidated (i.e. lost forever) if their trade goes south.