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What Is Decentralized Finance (DeFi)?

Wondering about what does DeFi means? DeFi is a financial application built on blockchain technologies. Continue reading this article for more information on DeFi.

Today, cryptocurrencies have exploded into a trillion-dollar industry, causing a wave of global financial disruption.

At the heart of cryptocurrencies is a remarkable history of innovation dating back to the 1980s, when advances in cryptography were made. Since then, a series of events have shaped the crypto space, with the most notable being the first cryptocurrency, Bitcoin.

Despite its meteoric rise over the last 12 years, financial services for Bitcoin have been slow to emerge, owing primarily to the currency’s inherent lack of stability and adoption. Because of its significant price volatility, mainstream institutions will not accept a Bitcoin loan — making Bitcoin a poor asset for accurately planning any investment.

Things move quickly in the crypto world, and decentralized finance (DeFi) is a current trend — it’s an exciting place to be, without a doubt. If you’re still not familiar with DeFi, let’s delve a little deeper and learn more about it.

Decentralized finance (DeFi) explained

Decentralized finance (DeFi) is an umbrella term for various public blockchain applications and projects to disrupt the traditional finance world. DeFi is defined as financial applications built on blockchain technologies, typically using smart contracts, and is inspired by blockchain technology. Smart contracts are automated enforceable agreements that can be accessed by anyone with an internet connection and do not require intermediaries to execute.

DeFi refers to applications and peer-to-peer protocols built on decentralized blockchain networks that do not require access rights for simple lending, borrowing, or trading of financial tools. The Ethereum network is used to create most DeFi applications today, but many alternative public networks are emerging that provide superior speed, scalability, security, and lower costs.

Why is DeFi important?

DeFi expands on Bitcoin’s basic premise — digital money — to create an entire digital alternative to Wall Street without all associated costs (think office towers, trading floors, banker salaries). This can create more open, accessible, and fair financial markets that anyone with an internet connection can access.

What are the benefits?

  • Open: You are not required to apply for anything or “open” an account. You simply gain access by creating a wallet.
  • Pseudonymous: You do not need to provide your name, email address, or any other personal information if you are a pseudonym.
  • Flexible: You can move your assets anywhere, at any time, without asking permission, waiting for lengthy transfers to complete, or paying exorbitant fees.
  • Fast: Interest rates and rewards are frequently updated (as often as every 15 seconds) and significantly higher than traditional Wall Street.
  • Transparent: All parties involved can see the entire set of transactions (private corporations rarely grant that kind of transparency)

How does it work?

Users typically interact with DeFi through software known as dapps (“decentralized apps”), the majority of which are currently running on the Ethereum blockchain. In contrast to a traditional bank, there is no application to complete or account to open.

Here are some of the current ways people are interacting with DeFi:

  • Lending: Lend your cryptocurrency and earn interest and rewards every minute, not just once a month.
  • Obtaining a loan: Get a loan instantly without having to fill out paperwork, including extremely short-term “flash loans” that traditional financial institutions do not provide.
  • Trading: Conduct peer-to-peer trades of specific crypto assets, just as you would if you were buying and selling stocks without the use of a brokerage.
  • Investing in the future: Put some of your cryptocurrency in a savings account alternative to earn higher interest rates than you typically get from a bank.
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  • Buying derivatives: Make long or short bets on certain assets. Consider these to be the cryptocurrency equivalent of stock options or futures contracts.

What are the downsides?

  • Due to fluctuating transaction rates, active trading on the Ethereum blockchain can become costly.
  • Your investment may experience high volatility depending on which dapps you use and how you use them – this is, after all, new technology.
  • For tax purposes, you must keep your records. Regulations can differ from one region to the next.

How did DeFi get its start?

Initially, humans bartered for goods and services. However, as humans evolved, so did economies: we invented currency to facilitate the exchange of goods and services. As a result, coins aided in introducing innovations and developing higher economic levels. Progress, however, comes at a cost.

Historically, central governments have issued currencies that underpin our economies, giving them more power as more people came to trust them. However, trust has been broken occasionally, leading people to question the centralized authorities’ ability to manage the money. DeFi was created to create a financial system that is open to all and reduces the need to trust and rely on a central authority.

DeFi began in 2009 with the launch of Bitcoin, the first peer-to-peer digital currency built on top of the blockchain network. Thanks to Bitcoin, the idea of ushering transformation into the traditional financial world through blockchains became an essential next step in decentralizing legacy financial systems. This was made possible by the 2015 launch of Ethereum and, more specifically, smart contracts. The Ethereum network is a second-generation blockchain that was the first to fully realize the potential of this technology in the financial industry. It encouraged businesses and enterprises to create and deploy DeFi-related projects, forming the DeFi ecosystem.

DeFi provided many opportunities to create a transparent and robust financial system controlled by a single entity. However, the turning point for financial applications began in 2017, with projects enabling more functionalities than just money transfer.

Challenges within centralized finance

Financial markets can enable great ideas and drive societal prosperity. Nonetheless, power is centralized in these markets. When people invest in the current financial system, they give up their assets to intermediaries like banks and financial institutions, which keeps risk and control at the center of these systems.

Historically, bankers and institutions have failed to recognize market risks, evidenced by the 2008 financial crisis. Without a doubt, when central authorities control money, risk accumulates at the center, endangering the entire system.

Bitcoin and other early cryptocurrencies, designed to give individuals total control over their assets, were decentralized in issuance and storage. Access to a broader range of financial instruments remained difficult until the advent of smart contracts, which enabled DeFi.

DeFi protocols and how they work

DeFi has evolved into a fully functional ecosystem of working applications and protocols that value millions of users. DeFi ecosystems currently hold assets worth more than $30 billion, making it one of the fastest-growing segments in the public blockchain space.

Here’s an overview of the most popular DeFi use cases and protocols available in the market today.

DeFi lending and borrowing

By enabling lending and borrowing, DeFi shifted finance in a new direction. Decentralized lending, also known as ‘Open Finance,’ provided crypto holders with lending opportunities to earn annual yields. Individuals could borrow money at a fixed interest rate thanks to decentralized borrowing. The goal of lending and borrowing is to meet the cryptocurrency community’s needs while also serving financial service use cases.

Top DeFi lending and borrowing platform: Compound Finance

Compound Finance, which debuted in 2018, is the brainchild of Rober Leshner. The project is an Ethereum-based lending protocol that allows users to earn interest by lending out assets or borrowing against collateral. The Compound protocol enables this by generating liquidity for cryptocurrencies via interest rates determined by computer algorithms.

Compound users earn interest by depositing cryptocurrencies. The following is a list of cryptocurrencies that can be deposited on the protocol and the expected Annual Percentage Yield (APY). Users can use cryptocurrencies as collateral for loans once they are available on the Compound platform.

$COMP, the governance token for Compound protocol, is used by its holders to suggest and implement development changes. Changes include:

  • Select which digital assets to support.
  • Adding modifications to how $COMP tokens are distributed.
  • Adjusting collateralization factors to the platform.

Decentralized exchanges

Decentralized Exchanges (DEx) are one of the most critical functions of DeFi, with the most capital locked in comparison to other DeFi protocols. DExs enables users to exchange or swap tokens for other assets without the need for a centralized intermediary or custodian. Traditional exchanges (centralized exchanges) provide similar options, but the investments available are subject to the will and costs of that exchange. Another disadvantage of CExs that DExs address is the additional cost of each transaction.

Top decentralized exchange: Uniswap

UniSwap, which was founded in 2018 by Hayden Adams, is the largest automated token exchange by trading volume on the Ethereum blockchain. The project was launched after receiving funding from several venture capital firms, including the Ethereum Foundation. UniSwap uses smart contracts to automate cryptocurrency transactions.

UniSwap currently provides three functions: token swapping, liquidity addition, and liquidity removal.

Token exchange

  • To use this service, users must first create an account on Metamask.
  • After creating a Metamask account, users can choose which tokens they own to exchange for another type of cryptocurrency.

Increasing liquidity

  • Users deposit an equivalent value of tokens into the token’s associated exchange contract to provide liquidity.
  • You can add liquidity tokens to a “pool” on the UniSwap interface when you have liquidity tokens.
  • Users who offer liquidity on UniSwap earn exchange fees based on the value of the tokens provided for liquidity.

Removing liquidity

  1. You can remove the liquidity on UniSwap by merely choosing the ‘Remove Liquidity’ option from a drop-down menu.

$UNI is UniSwap’s governance token, which means token holders have a say in the protocol’s development and treasury. The token was released in September 2020 and was given to anyone who used Uniswap.

Stablecoins

Stablecoins are a viable solution to the volatility issues plaguing cryptocurrencies, assisting DeFi in gaining prominence. Stablecoins’ value is tied to a relatively stable asset, such as gold or the US dollar, to keep its price consistent. Stablecoins became useful during risk-off periods in the crypto space, providing investors and traders haven. Because of their stability, they are dependable collateral as assets Stablecoins  are also crucial in liquidity pools, which are an essential part of the DeFi ecosystem and DExs.

MakerDAO

MakerDao, founded in 2015 by Rune Christensen, is a company developing technology for savings, borrowing, lending, and a stable cryptocurrency on the Ethereum blockchain. The project was one of the first to implement DeFi protocols. Instead of holding an ICO, the project privately sold $MKR tokens over time to fund development. Maker’s stablecoin, $DAI, was launched in 2018 and has gained significant traction.

  • The protocol is as follows:
  • A user can create a Collateralized Debt Position by sending or depositing $ETH to a smart contract on Maker’s protocol (CDP). This will allow you to take $DAI at a fixed collateralization rate.
  • Assume the price of $ETH falls in the future. In that case, a user’s CDP will be closed automatically to ensure that the network has enough capital locked against the borrowed tokens. This can be avoided by depositing more $ETH or withdrawing less DAI in the first place.
  • $ETH can be reclaimed by paying the original amount plus a small fee.

To function, the project requires two types of tokens: $DAI and $MKR.

By encrypting a cryptocurrency in the Maker protocol, $DAI is created. $DAI is used in the same way as any other stablecoin: it can be traded against other digital assets or used to make purchases.

In contrast to $DAI, MakerDAO’s $MKR token is volatile and not tied to any asset. $MKR tokens are used to vote on proposals affecting how $DAI can be used. Holders of $MKR tokens benefit when the token rises in value; however, they suffer the most significant price drop when the system fails.

Prediction markets

Prediction markets are platforms where individuals can predict the outcome of future events ranging from sports betting or politics to stock price predictions and more. DeFi allows for participation in these markets. Decentralized prediction markets have long been touted as a possibility via smart contracts.

Top prediction market: Augur

Augur is a decentralized prediction market platform that uses the masses’ collective prediction. August, a DeFi platform, uses Ethereum to tap into the “Wisdom of the Crowd” to generate real-time predictive data. Augur’s first version was released in 2015, and its main net was launched in 2018.

Augur provides you with two primary actions:

  1. Market creation: By spending some Ethereum, users can create an Augur market. Users must set taker and maker fees when making a market, which should be low enough to encourage people to bid but high enough to cover the Ethereum cost.
  2. Trading Events Shares: Users can buy or sell shares that represent the probability of a market event occurring. Traders can profit by purchasing positions at a low cost and selling them when the price rises. People who correctly predict an event will be rewarded when the market closes.

$REP is an ERC-20 token that can be used to create a prediction market, purchase participation tokens, or dispute an outcome on the Augur platform. As the name implies, $REP represents token holders’ market reputation. Users stake their reputation for any action that necessitates the use of tokens.

Asset management

DeFi also provides asset management as a service. It aims to make investing more efficient, less expensive, and accessible. Asset Management benefits from aspects of the DeFi ecosystem such as transparency, composability, and trustlessness.

Transparency promises to make information more accessible and secure, allow for portfolio hyper-customization, and be trustless in allowing access to historically illiquid assets and managing their investments.

Ampleforth used a smart contract to adjust the supply of its tokens daily to match market demand. These smart contracts use Ampleforth’s and Chainlink’s price oracles to obtain real-time Bitfinex and KuCoin Exchange data. These decentralized price feeds assist in determining whether or not the token’s price is within the equilibrium range (0.96-1.06 USD range). If the price of a $AMPL token falls below $0.96, the supply drops. Ampleforth increases supply if it is greater than $1.06.

$AMPL is an ERC-20 token with one US dollar price target. However, Ampleforth allows the tickets to fluctuate alongside the price to achieve an equilibrium range rather than tying it to a fiat currency. In Ampleforth wallets, the price is automatically adjusted. Because the supply of $AMPL tokens is unaffected by inflation or deflation, Ample is an ideal asset for preserving purchasing power against other investments.

How do I make money with DeFi?

The value of Ethereum DeFi projects has been exploding, with many users reportedly making large sums of money. Users can generate “passive income” by loaning out their money and earning interest from the loans using Ethereum-based lending apps, as mentioned above. Yield farming, as previously described, has the potential for even higher returns but at a higher risk. It enables users to use the lending aspect of DeFi to put their crypto assets to work and generate the highest possible returns. However, these systems are frequently complex and opaque.

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Is investing in DeFi safe?

No, it’s dangerous. Many people believe that DeFi is the future of finance and that investing in disruptive technology early on could result in massive gains.

However, it can be difficult for newcomers to distinguish between good and bad projects. There has also been a lot of bad.

Many DeFi applications, such as meme coin YAM, have crashed and burned as DeFi activity and popularity have eased through 2020, sending the market capitalization from $60 million to $0 in 35 minutes. Other DeFi projects, such as Hotdog and Pizza, suffered the same fate, and many investors lost a significant amount of money.

In addition, DeFi bugs are unfortunately still widespread. Smart contracts are robust, but they can’t be changed once the rules are baked into the protocol, which often makes bugs permanent and thus increases risk.

The future of DeFi

We are witnessing a quantum leap in the new functionalities of money due to distributed ledger technology innovation. For the first time in history, a global financial system for a global population is being shaped by itself. Everyone is welcome to participate in the governance of DeFi protocols and have a seat at the table where the world of decentralized finance is actively being created.

The DeFi space is gradually catching up with the traditional financial system. Despite some of the challenges that come with operating on the cutting edge of innovation, the world of decentralized finance is on the rise.

It’s difficult to predict how this space will evolve as the ability to build financial services becomes more democratized. However, when DeFi and fintech intersect and merge, we will reach an inflection point where nascent financial technology will become a component of a new economic system. One realizes the dream of being quick, safe, accessible, and egalitarian.

Conclusion

Decentralized finance is still in its early stages of development. To begin with, it is unregulated, which means that the ecosystem is still riddled with infrastructure mishaps, hacks, and scams.

Current legislation is based on the concept of distinct financial jurisdictions, each with its own set of laws and rules. The ability of DeFi to conduct borderless transactions raises critical issues for this type of regulation. Who, for example, is in charge of investigating a financial crime that occurs across borders, protocols, and DeFi apps? Who would enforce the rules, and how would they be implemented?

System stability, energy requirements, carbon footprint, system upgrades, system maintenance, and hardware failures are also issues to consider.

Many questions must be answered, and advances must be made before DeFi can be used safely. Financial institutions will not give up one of their primary sources of revenue if DeFi succeeds. If DeFi grows, banks and corporations will find ways to get into the system, if not to control how you access your money, then to profit from it.