DeFi (decentralized finance) is an ecosystem of applications that uses cryptocurrencies to deliver financial services decentralized from a central authority. It is built on decentralized networks, with the Ethereum blockchain being the most popular and best for deploying applications. Lending, insurance, stablecoins, derivatives, and cryptocurrency exchanges are just a few of the services offered in this field of digital technology, which is now undergoing fast development.
You will learn about the attributes and elements of DeFi in this article.
Simply About DeFi
Decentralized finance (DeFi) is an ecosystem of financial applications (projects) developed on various blockchains. The most popular projects are built on the Ethereum, Tron, and Kava networks; however, there are also DeFi systems based on the Bitcoin blockchain, which are based on RSK (Rootstock – smart contracts in the bitcoin network).
The goal of DeFi is to bring the existing financial system to the blockchain, making it accessible and open to the whole world.
In simple words, the task of DeFi is to collect in its projects all the goodies and advantages of the existing financial system (in the form of interest rates on deposits, lending opportunities, insurance, and “legalized” transactions) while replacing various agents and intermediaries with smart contracts. It’s like taking a fertile tree from rotting soil and replanting it to grow it in favorable, protected conditions.
In short, DeFi differs from the existing financial system with the slogan: Efficiency, accessibility, and transparency!
DeFi projects, in turn, provide the opportunity for peer-to-peer lending, when a person from anywhere in the world can take out a loan or deposit existing assets.
The effectiveness of these projects is that they eliminate intermediaries in their routine work. The work of a banker or an insurer in the decentralized finance system is performed by a code, which is also a law that establishes rules and resolves possible disputes.
The guarantor is the blockchain, based on which this or that project is built (mainly Ethereum). And all relationships are built and regulated through smart contracts.
The Difference Between Decentralized and Traditional Finance
DeFi can perform all the same functions as traditional banks but much more efficiently and conveniently. The decentralized finance movement makes it possible to use loans, open interest-bearing accounts, and trade without trusting centralized financial institutions. Services are provided through decentralized apps (dApps), usually deployed on the Ethereum platform. At the same time, it is absolutely unnecessary to be an Ethereum specialist to use them, although this will not hurt for a deeper understanding of the process.
If we compare traditional and decentralized finance according to the main criteria:
- System of payments and transfers. Bank transfers from one country can take several days and involve significant fees. In addition, it is a complete lack of privacy. The cryptocurrencies underlying DeFi do not need intermediaries; transfers are carried out as quickly as possible (on the Ethereum network – from 15 seconds, with a commission of approximately $0.02). The benefits are apparent.
- Availability. Banks impose strict restrictions on who can open an account, much less use financial services such as lending. More than 1.5 billion people worldwide do not have access to banking services, and DeFi is guaranteed to make life easier for them. All you need is the Internet to use them.
- Centralization. Banks are safe enough to hold funds, but not 100%. And the fall of a large bank necessarily entails a large-scale financial crisis. Decentralized organizations manage DeFi protocols, which gives confidence that some people will not be able to make decisions independently.
- Transparency. The average investor has no idea how their bank account funds are used. Concerning Decentralized Finance, the source code of protocols developed based on public blockchains is entirely transparent to all users and open to audits.
DeFi protocols are code, and it always executes precisely as it is programmed, and it is the same for every participant without exception. Any vulnerabilities or flaws in the code are immediately apparent.
The DeFi movement aims to solve traditional finance’s main problems: low transaction speed, control of regulators, high commissions, and limited availability. It can eliminate these differences and provide access to financial transactions to every person without censorship.
Experts have identified the three most important advantages of Decentralized Finances. The first is decentralization, thanks to which control over the ecosystem belongs to all participants at once, transactions are fast and transparent, and there are no intermediaries. The second is management with the help of smart contracts. And the third is open source code, which can be checked and finalized at any time and used to form other services based on them.
How DeFi Is Used
Decentralized Finance has found its way into more than ten main areas – and there is no doubt that this list will continue to grow. Let’s take a closer look at some of them, and you will see why exactly the DeFi principles in them came to the most appropriate place.
The need to use smart contracts arises along with the question, “who should pay first?”.
Previously making a deal with a person whose decency you are not sure of, the only possible way out was to find a third, preferably specially authorized person who, with his powers and a pile of frightening small print, can protect you, naturally for a fee. The work is essentially mechanical.
Blockchain transparency may seem questionable if you are not a developer or programmer. However, if you wish, you can figure it out and see for yourself. In addition, most projects openly place all data, from capitalization and collateral to the list of transactions.
To date, the market volume for DeFi projects is about $8.5 billion, even though at the beginning of the year, this figure fluctuated around $677-$680 million. Among the investors who believed in the potential of DeFi projects: were Coinbase, Y Combinator, Polychain Capital, Paradigm, Dragonfly Capital, Andreessen Horowitz, and others.
Crypto-economy, in particular DeFi projects, is on its way to reforming the entire financial services industry, just as the Internet has transformed new media, opening up and showing freedom of choice and alternatives.
Deposits and Loans (Landing Platforms)
The lending system in DeFi projects is somewhat different from the banking system we are used to. By giving you a loan, the bank bears risks, so it tries to protect itself as much as possible – hence the requirements for credit history, many documents on solvency, etc. In some cases, the need for a guarantee of another, no less solvent person.
Such a lending approach in the crypto industry would hardly be safe and successful, primarily for the platforms themselves. There is no personal user data in cryptocurrencies, so it is almost impossible to determine who owns a particular wallet; at most, you can see a list of all transactions.
Therefore, in Decentralized Finance projects, the lending system is more like a pawnshop, where the loan amount depends directly on the pledged asset. In the decision to give you money or not, the key role is played not by what kind of person you are, how much and in what way you earn, but only by what you can offer in return.
The principle of operation of a pawnshop is as follows: a client can pledge any item (asset) or valuable item and receive a loan based on the value of the goods. The pawnshop can borrow 50% of the value of the item while charging interest for, so to speak, service. When exiting this “deal,” the client takes the pledged goods and pays only the assigned percentage (conditional commission).
The pawnshop always lends amounts below the actual value of the collateral so that the goods can be sold and the loan repaid in the event of a client’s insolvency.
The commission of the Maker DAO project has fluctuated between 1-3% per year since 2017, which is significantly less… than anywhere else. At the same time, you can exit the transaction and repay the debt obligation at any time.
To get a loan in Maker DAO, you pledge crypto (ETH, BAT, USDC, WBTC, TUSD, or another) at the already known ANNUAL percentage, and the platform pays you up to 66% of the value of the pledged assets (for precisely the same reason as a pawnshop). You receive a loan in DAI tokens – a stablecoin that the platform deliberately releases at your request. The release of DAI is regulated by the smart contract CDP (collateralized debt position).
For example, by pledging 10 ETH at the rate of $220 (i.e., $2200 in total), you can get up to 1452 DAI, respectively $1452. You can dispose of the received DAI tokens as you like; at this time, your ETH is securely protected by a smart contract. As soon as you decide to pay off the obligation, you come to the platform and return the borrowed DAI. At the same time, the pledged ETH is automatically unlocked and returned to your address. It is not at all necessary to take the maximum possible amount of DAI, since the higher the percentage of the value of the collateral you take, the greater the responsibility.
When pawning any item in a pawnshop, the likelihood that it will noticeably drop in price over the life of the debt obligation is extremely low and rarely considered. However, such a possibility exists when you pledge cryptocurrency as an asset.
Thus, if the locked asset drops in price, the position may be liquidated with an accompanying penalty. Liquidation occurs when the cryptocurrency you pledged falls in value, which is close to the value of the debt.
That is, if you take 55% DAI when pledging ETH, liquidation will occur when your collateral (ETH) value falls by 35% or more.
It is straightforward to avoid this; it is enough to monitor the rate of the crypto-asset with which you will provide a loan. In case of drawdowns, either pay off the obligation yourself or increase the security by increasing the amount of ETH.
Or, even more accessible, take a smaller percentage of DAI on collateral, then the probability of liquidating your position decreases accordingly.
Another significant project that currently occupies a dominant position in terms of capitalization among DeFi projects is Compound. Something in the style of a cryptocurrency bank, where anyone can lend their coins or borrow the missing funds at the interest calculated by the system. Interest on deposits in stablecoins is always higher; in particular, the interest rate on DAI is 2.24%.
DAI And Stablecoins
One of the earliest and most significant projects in the Decentralized Finance Fi ecosystem is Maker Dao, a DAI stablecoin lending platform secured by crypto assets. These are ETH, BAT, USDC, WBTC, TUSD, and others.
DAI is a stablecoin, a token backed (pegged to a “real” asset) in this case by the US dollar. This is not the first and probably not the last token with a pegged asset; however, it has an entirely different, more credible operation mechanism. Utilization, as well as the emission of DAI tokens, are also specified in the smart contract.
The idea of stablecoins can be seen as a combination of technology and the conditional stability of fiat money (mainly the dollar). A kind of bridge that allows you to pay with a stable, still cryptographically protected coin without leaving the crypto market, without contacting the bank and identifying the person. Stability is ensured by linking to real, familiar assets, the value of which most people are sure.
Stablecoins, in general, is quite a useful thing. Agree that if you pay for a product/service, for example, with bitcoin, there will always be winners and losers. Sending 10 thousand dollars today, tomorrow it could be worth 8 or 12. Not exactly, but it definitely can, which cannot happen with DAI or other stablecoins. In anticipation of the sharp volatility of the market, stablecoins can provide safe storage for those particularly restless. Stablecoins make it possible to “freeze” a cryptocurrency for the duration of its unwanted “ripple” without leaving the market.
DAI can be used on almost all Decentralized Finance platforms.
How to make money on DeFi?
De-Fi projects are expanding opportunities for crypto enthusiasts by offering new models and ways to make money on their crypto assets. Among the new options is the ability of a cryptocurrency to multiply only due to its presence.
Just like a “dollar works for itself” while deposited in a bank, Decentralized Finance landing platforms (such as Dharma and Compound) allow you to earn passive income in DAI stablecoins and other cryptocurrencies.
The topic of decentralized finance is almost endless; we just went over the top and covered the main aspects. Today, hundreds of applications in this area have been created and are successfully operating. Some became very popular in months, like Compound or Uniswap. Large companies have not ignored the potential of DeFi; for example, the Binance exchange saw fit to launch a decentralized Binance DEX platform.
DeFi applications and projects can benefit residents of countries with weak or unstable economies. For example, in Argentina, it was even proposed to give people a salary in DAI in connection with the horrendous inflation of the national currency. Services are also in demand in developed countries, as they offer a more profitable and affordable lending system and open up new opportunities for interest income from investments.