what is decentralized finance

What Is Decentralized Finance?

Presently, decentralized finance is the biggest trend in the crypto space: everyone is using the word ‘DeFi’, but what is Defi? At Finvesting, we’ll try to explain what DeFi is to you as simply as possible. Consider this as the ultimate guide to DeFi.

Bitcoin is a cryptocurrency created to streamline the process of making payments to anyone in the world, but value transfer is just a part of the entire financial system. We use a variety of services that revolve around money, for instance, loans, savings plans, insurance, mortgages, mutual funds among others.

As it stands, the world’s financial institutions are inherently centralized, meaning that a few central authorities control the entire global financial landscape. The centralized character of our existing system has several flaws like fraud, corruption, and mismanagement.

Thankfully, these issues can be properly addressed, if the financial system is decentralized through blockchain technology.

This is where decentralized finance steps in with a viable solution: DeFi is an open financial movement that aims to create an open, permissionless, trustless, and transparent financial system and promises to remove third parties such as exchanges, brokerages, or banks altogether.

By eliminating these intermediaries, DeFi will streamline financial processes and workflows in terms of speed, cost, and accessibility.

Properties of Decentralized Finance (DeFi)

To understand what is DeFi, we should know that decentralized finance does not focus on reinventing, rather it points towards revolutionizing the existing financial landscape by removing its flaws. These three properties of DeFi do exactly this:

Interoperability

Different blockchains can communicate with each other or see, access, and share information without needing the intervention of a mediator such as an exchange. This free-progression of data would help grow your span and impact independent of which blockchain framework you use. This also includes the transfer of real-world assets into blockchain ecosystems.

Composability

Commonly known as money legos, this functionality offers users the ability to interact with complex financial products which integrate various DeFi applications or dApps. We can use the example of lego bricks to illustrate this.

Legos are bricks that one uses to build up projects, but then, later on, one can integrate these very projects to build a completely different structure, since the lego bricks can be rearranged easily. In the case of DeFi, existing applications can be combined and something completely new can be created.

DeFi uses composability to meet the unique use case requirements of various protocols and their users. Considered a quirk, in the beginning, it’s now become one of the key features of decentralized finance.

Programmability

Cryptocurrencies can be programmed to automate processes, actions, and routines. Thus, we can thus build exchanges, insurance companies, lending services, and several other kinds of financial decentralized applications. Now, to create a decentralized financial system, we need to develop or use existing infrastructure to run decentralized services.

We use Ethereum as the primary platform to write decentralized finance programs or applications also known as dApps. This is because of the ecosystem that has been created around Ethereum in DeFi due to the flexibility that the platform offers. Widespread popularity has made it the standard for decentralized finance solutions.

Although other platforms like Bitcoin can be used to make decentralized finance products, making an app on Bitcoin is super complex when compared to Ethereum which offers ease of use and elasticity. The more programmability on offer, the more sophisticated and better applications become a possibility.

These automated programs are called ‘smart contracts’ which act as unbiased automated intermediaries that exchange value only when certain conditions are met. This happens in a decentralized manner, meaning that we can determine certain rules regarding how a service would work, but once we deploy those rules, we cannot change them. For example, you can create a smart contract to send money to your friend only when his wallet balance drops below $100.

It’s rare for a decentralized finance product to utilize all three properties of decentralized finance, and most solutions generally rely upon programmability through smart contracts.

Key Use Cases of Decentralized Finance (DeFi)

Although the premise of DeFi is the same as traditional finance, DeFi has some interesting use cases. We’ll take a look at the most vital ones now.

1.   Lending and Borrowing

DeFi lending allows you to earn interest on your static crypto assets by loaning them to people, you can also borrow by depositing crypto assets as collateral without having to involve a third-party like banks.

You can use crypto assets to take loans without having to give details or waiting for long periods, unlike traditional banks which take into account a lot of factors before handing out loans along with higher interest rates to earn when loaning out money. This is one of the strongest and most popular applications of DeFi and cryptocurrency since its inception.

DeFi lending assumes a similar job as any customary bank giving credit to an individual or business but faster and without asking questions. In any case, it has considerably more to bring to the table contrasted with its customary loaning arrangements. Listed below are some intriguing highlights which give DeFi lending and borrowing an edge over traditional banking systems.

  • Dynamic: Traditional loaning arrangements receive a fixed financing cost model for advances. Interestingly, most well known DeFi loaning conventions nowadays offer variable interest rates that automatically change with the economic state on the protocol.
  • Trustless and secure: Since there are no humans involved with the lending and borrowing process, the whole process is trustless as the information is stored in the blockchain transparently which cannot be modified by either the lender or the borrower. Most of these protocols are heavily scrutinized by top security firms in the world guaranteeing the safety of the money stored in them.
  • Hassle-free: Since all of these activities are carried out by smart contracts, you don’t have to worry about doing anything. Passive income becomes truly passive as the interests are collected (on a daily or hourly basis) automatically and you don’t have to do anything.

The borrowing activity in DeFi is over-collateralized, meaning that you exchange an asset, in this case, a cryptocurrency with money that is locked up in a smart contract called the collateralized debt position or CDP. But the money received in turn is less than the true value of the collateral. This is to make sure that if the value of the collateral falls, the crypto that is deposited can be liquidated to make up for the devaluation.

2.   Decentralized Exchanges (DEXes)

Decentralized Exchanges (DEXes) are options in contrast to centralized crypto exchanges. These permit the trade of crypto to happen in a decentralized or permissionless way, and the clients don’t need to surrender custody of their coins to a third-party.

Decentralized exchanges are inline with the crypto revolution’s original aim i.e. decentralization all the way, decentralized exchanges don’t require you to verify your identity and it does away with trading fees as well. Some of the popular DEXes are Bancor,  IDEX, Binance DEX, Uniswap, SushiSwap, etc.

3.   Stablecoins

To truly understand what DeFi is, you should be aware of stablecoins and the role they play in the growth of the sector. Cryptocurrencies are known for their volatility and, for this reason, a lot of people hesitate to invest in the crypto market. To counteract the volatility of cryptocurrencies, stablecoins were created.

The name itself suggests the meaning i.e. coins that are stable and this is made possible since a stablecoins’ value is often pegged to tangible, real-world assets like fiat currencies or other precious metals like gold. With this feature, stablecoins aim to bridge the gap between crypto and fiat currencies and offer the best of both worlds to users. It’s hard to imagine DeFi without stablecoins.

There are three kinds of stablecoins, namely:

  • Fiat-collateralized Stablecoins

Fiat-collateralized stablecoins keep fiat cash reserves, similar to the U.S. dollar, as collateral to give out a reasonable number of crypto coins. Different types of collaterals can incorporate valuable metals like gold or silver, or commodities like oil, yet the majority of the present-day fiat-collateralized stablecoins use US Dollar reserves.

These reserves are taken care of by independent custodians or overseers and it is made sure that they adhere to necessary compliances. Tether (USDT) and TrueUSD are two popular cryptocurrencies pegged to the value of a US dollar.

  • Crypto-collateralized Stablecoins

These coins use cryptocurrencies as collateral reserves, but because of the highly volatile nature of crypto, these coins are “overcollateralized” meaning that a higher value of crypto reserves is maintained to issue a lower value in stablecoins.

For example, if you deposit $1000 worth of Ethereum, you may receive crypto-backed stable coins worth $500, the stability is also maintained by frequent auditing and monitoring. Maker DAO’s DAI is a coin pegged to the USD and is backed by Ethereum.

  • Non-collateralized Stablecoins

These coins do not use any reserves, but function like a central bank since they use algorithms to maintain a stable price. The supply of the coins depends upon the demand, which is controlled by smart contracts.

There are lots of other uses of DeFi such as insurance, asset management, and derivatives trading.

Popular DeFi Protocols and How You Can Make Money on Them

Several projects have popped up in the DeFi landscape, and lots of them look promising as hundreds of people are using their crypto to make money in a truly passive manner. Projects like Maker, Aave, Compound, Synthetix, QDAO, and others are changing DeFi for good, these protocols provide various services like trading on DEXes, make money with ‘yield farming’ or staking with stablecoins, one can earn interest via lending or take out loans and mortgages.

There are hundreds of DeFi projects available in the market but some offer better returns than others, we will now take a look at the most used DeFi protocols along with top DeFi tokens and break down how you can earn from them:

Aave

Aave is an open, non-custodial protocol where you can earn interest on deposits and borrow assets. It’s now among the leading protocols in the DeFi lending space and even overtook Compound in August of 2020 to become the number-one DeFi lending protocol in terms of TVL.

Aave provides daily interest earnings on your deposited crypto assets that are used to provide liquidity to lending pools, this is known as ‘yield farming’. The connection between the pool’s liquidity and the demand to borrow will decide the interest rates. Along these lines, when the demand for borrowing builds, it diminishes accessible liquidity, loan costs rise, and investors get more returns.

On depositing assets, you’ll receive ‘aTokens’, Aave’s interest-bearing stablecoins pegged 1:1 with the deposited assets. Once the deposited assets are withdrawn, the interest earned is collected and credited to your account automatically.

Aave makes it possible for you to borrow 16 distinct ERC-20 tokens and stablecoins, the interest will emanate and will have to be paid at the end of the borrowing period. Interestingly, you can choose between stable and variable interest rates.

Maker

MakerDAO is an open DeFi protocol that is behind DAI (an Ethereum-backed stablecoin). It allows anyone to generate DAI by locking up their crypto assets in the form of collateral. Currently, the platform supports KNC, ZRX, MANA, wBTC, ETH, USDC-A, USDC-B, BAT, tUSD, etc. and this list is more likely to grow in the future.

Earning on MakerDAO is as simple as making an account and depositing your crypto into it. You can even use the generated DAI to buy goods in the MakerDAO ecosystem without having to spend your crypto assets. Maker became the first project in DeFi to cross $1 billion in terms of total value locked (TVL).

You can earn interest on your crypto using Maker protocol’s Dai Savings Rate (DSR) which allows users to lock in their Crypto holdings as collaterals which can be unlocked at any time just requiring one to pay the Ethereum network fees.

Compound

Compound works similarly to Aave; your collateral is exchanged with Compound tokens (cTokens). For example, if you deposit $100 worth of ETH in Compound, you get cETH worth $100 back. The Compound protocol just like Aave pays users for the liquidity they provide, either through lending or staking.

Curve

It is a decentralized exchange and liquidity pool that allows users to trade stablecoins, currently accepting:  DAI, BUSD, sUSD, TUSD, USDC, USDT along with BTC. Curve has 7 liquidity pools and you can earn CRV tokens (Curve’s native governance tokens) once you deposit your assets, you will receive counterparty liquidity tokens. These rewards can be increased by up to 2.5x by vote locking on CurveDAO.

Synthetix

Synthetix is primarily a decentralized exchange that serves as a platform for trading and issuing synthetic assets. It’s also maintained the incentive system of staking. Synthetix does not require any form of personal identification.

The huge advantage that Synthetix has is that it can create a market for real-world assets like stocks and shares on the Ethereum ecosystem. By depositing crypto assets in the liquidity pool, one mints new synths which are then traded on the exchange, and a part of the trading fees are distributed as rewards to liquidity providers.

We hope that you now understand what DeFi is and how it’s used, so you can get involved in the DeFi ecosystem and probably make some money for yourself.

FAQs

What does the future of DeFi look like?

As of now, there is no specific answer to this question, but the future looks bright for DeFi as it is slowly becoming mainstream. Technological advancement in the underlying infrastructure for DeFi is faster than ever with new innovative ideas popping up daily. 2021 looks like a great year for DeFi seeing the recent developments.

Is DeFi legal?

Yes, almost all DeFi projects or protocols need to abide by financial regulatory measures licenses to function regardless of whether they’re centralized or decentralized. Thanks to DeFi, financial watchdogs (e.g., the SEC) have started to notice the crypto space more than ever.

Is DeFi safe?

Yes, almost every protocol undergoes smart contract audits to ensure the codebase is secure and free from bugs and vulnerabilities. Majority of the popular protocols adopt strict security measures to ensure your crypto assets remain safe. Still, it’s advisable to conduct your due research before investing in any project.

Do I need some kind of cryptocurrency to participate in DeFi?

Yes, you would need cryptocurrency to participate in DeFi. Since Ethereum is the platform of choice, most DeFi projects’ tokens are based on the ERC-20 standard. Hence, it would be better for you to hold some ether for the sake of ease.

Do I need a crypto wallet for DeFi?

Yes, a digital wallet is a prerequisite for you to be able to dabble in the field of DeFi. There are several wallet options available for interacting with DeFi applications — MetaMask, WalletConnect, TrustWallet and Argent being the popular ones.