The word Decentralized Finance or DeFi is now almost synonymous with the word blockchain, as DeFi is one of the largest and the most in-demand skills in the blockchain space.
In this post, we start by getting to know what DeFi is, how DeFi works and the key concepts behind DeFi. This is part 1 of our full DeFi course on the Finxter blog:
🪙 Full DeFi Course: Click the link to access our free full DeFi course that’ll show you the ins and outs of decentralized finance (DeFi).
What is DeFi?
Decentralized Finance, also referred to as “DeFi,” enables customers to access financial services that include lending, borrowing, and trading.
Note: All abbreviations of Decentralized Finance – DeFi, De-Fi, defi or Defi mean the same. We will use these acronyms in all future articles.
These financial services use Decentralized applications (Dapps) in implementing their functionality and they do not rely on centralized finances to execute their operations. The vast majority of these services are being created on the Ethereum blockchain.
To use the DeFi tools, you don’t need to be an Ethereum expert, although it helps to be familiar with how Ethereum or layer-2 blockchains like Polygon operate.
Defi is not a single service or a product, but an assortment of several goods and services that can replace traditional institutions like banking, bonds, insurance, and trading.
It is possible to integrate these services, each having its own functionality, to build one protocol with multiple functions. Thus grouping services like borrowing, lending, staking and many others together to create one multi-functional financial application. As it is workable to assemble these services, DeFi apps are also called “money LEGOS”.
What is DeFi’s Process?
It is common to have collateral be locked in the smart contracts for the DeFi dapps to function.
The Total Value Locked (TVL) is the term used to describe the amount of collateral present or locked in the DeFi dapp services, such as lending, staking, or liquidity pools.
Defi Pulse, an analytics platform, started tracking the TVL in 2019, which was roughly about $275 million and in June 2022, it’s about $40.9 billion.
Because of the rapid growth of the total value locked, it signals the quick expansion of the DeFi ecosystem. The DeFi ecosystem has improved the lives of the people. As the DeFi ecosystem has expanded rapidly, it would be difficult to cover all the components it offers. Hence, we will discuss a few major components that make the DeFi ecosystem function.
DeFi is in its nascent stage and can be considered very experimental and speculative, with various projects being improved upon daily. DeFi may change over time to where it is indistinguishable from what it appears to be at the moment.
Components Making the DeFi
The DeFi ecosystem relies on the below-mentioned critical components or concepts. They are also briefly described to get an overview.
Lending and Borrowing
DeFi lending and borrowing are two separate entities. The centralized or traditional finance systems need users to have bank accounts to use their services, and many users do not have this luxury. For borrowing from these centralized banks, you need a strong credit score and sufficient collateral to exhort banks and believe that one can repay loans.
DeFi lending and borrowing can remove this barrier as they allow anybody to use their digital assets (crypto coins or tokens) as collateral to get loans and later repay loans to get back their digital assets. Lenders can earn interests and other incentives, such as commissions, on the assets they invest in by participating in the lending pools.
To take part in the DeFi lending or borrowing, there is no need for any bank account or credit card and it is super easy.
Stable Coins
They are crypto coins not subjected to inflation and therefore the name is stable.
Cryptocurrencies are highly volatile and in a single trading session, they can even fluctuate by 10%.
Stablecoins are cryptocurrencies that are pegged against fiat currency dollar($) such as USDT(Tether), or crypto-backed, such as DAI, and they help ease the volatility. With USDT, $1 = 1 USDT.
They create stable coins in a decentralized manner through an over-collateralization (dollar $, reserves adequately collateralized) process, run wholly on decentralized ledgers, are overseen by autonomous decentralized organizations (DAO), and have reserves that are open to audit by anyone who so desires.
Stablecoins, though not strictly speaking a financial application, are essential in ensuring that DeFi apps are more widely available by offering a reliable store of value that is immune to market fluctuations.
Derivatives
In the traditional financial systems, derivatives, as the name suggests, derive their value from the performance of another financial asset, where the asset can be a bond, stock, fiat-currency ($), interest rates, etc. They apply the same principle in the DeFi systems, where the asset can be a cryptocurrency.
There are two types of derivatives: Hedging and Speculation.
Hedging is a risk management tactic used to reduce losses. Consider a scenario of a carpenter or furniture maker who wants to protect himself from the unforeseen spike in the price of wood. To accommodate the risk, the furniture maker can purchase a futures contract from his supplier of rubber wood, at a specific future date and time, for a specified quantity of rubber and a predetermined price.
DeFi systems are now getting started with decentralized derivatives. The most famous derivative DeFi systems are Synthetix, dYdX and UMA and they are in their early stages of development or constantly updated.
Decentralized Exchanges (DEX)
We can do trading of cryptocurrencies and tokens on exchanges such as Binance, Coinbase, WazirX, etc.
These exchanges are centralized exchanges, which means they serve as mediators and guardians for the assets exchanged on their platforms. Thus, customers have no complete control of their assets. Additionally, if the exchange gets hacked, which sounds like paranoia, but there have been recent exchange hacks (e.g., 2020 KuCoin hack), putting your assets in danger.
A decentralized exchange (DEX) addresses these problems by allowing users to trade without relinquishing control of their assets. As no money gets stored on DEX, users can be relieved of the fear of the exchanges being hacked, resulting in the loss of their assets.
Lottery
With the rapid changes in the DeFi space, many innovative apps have emerged and the DeFi lottery is one of them.
With the aid of Defi Lottery Platforms, users can take part in a variety of lotteries and learn about the many games that are offered. Users of DeFi lottery systems can play on those platforms to win big money quickly or just for pleasure.
As Defi lottery platforms are decentralized and provide people the option to make significant money without leaving their homes, more and more consumers are switching to them from traditional lotteries conducted on paper.
Some of the salient features of the DeFi lottery systems include reliability, completely autonomous, no government interference, transparent and secure, auditable, player anonymity and mitigate costs as there are no intermediaries like banks, agents or financial organizations that results in higher operating costs as seen in organizing a traditional lottery system.
Insurance
Insurance is a risk management technique where a person gets financial compensation against losses from the insurance provider in case of unforeseen catastrophes.
People get insurance for homes, automobiles, health, and many more.
Is there a DeFi insurance policy?
As a lot of digital money gets stored on smart contracts, these contracts are vulnerable to exploits.
🌎 Learn More: Top 8 Security Exploits on Smart Contracts
It is not possible to ensure if the smart contracts are completely secure and there is always the risk of an attack leading to huge losses, even with smart contract auditing or codebases examined thoroughly.
Considering these risks, it is essential to have insurance, particularly when one is dealing with a substantial amount of money on DeFi platforms.
Fund Management
Fund management is of two types: active and passive.
Active management necessitates regular buying and selling in order to outperform a certain benchmark or index, and passive management duplicates the performance of a certain benchmark or index.
A hopeful development is that several DeFi initiatives have made it possible for passive fund management to occur in a decentralized manner. Customers can easily keep track of how their finances are being managed and understand the costs they will have to pay, thanks to DeFi’s transparency.
Trustless Payment
In the DeFi world or blockchain, trustless refers to a system wherein we do not have to depend on any institution-such as a bank, agents or third party for the payment system to function. The ability to send money between two parties in a decentralized and trustless manner is one of the primary functions of the crypto economy.
More cutting-edge and experimental payment methods are being created and tested because of the growth of DeFi. The development of DeFi and the pace of innovation will undoubtedly lead to new perspectives on how payments work, which will help to address many of the problems with the current financial system.
Conclusion
In this first post on DeFi, we got an idea of what DeFi is, how it works and also discussed the major components of the DeFi system.
As DeFi is changing at a rapid pace, in the upcoming blogs we will uncover more DeFi topics and implement a few smart contracts – Dapps that make the DeFi ecosystem.
Programmer Humor – Blockchain
