While the world is facing major economic crises due to COVID-19, we have witnessed the growth of Decentralized Finance (DeFi). Its immense growth has taken the world by astonishment, now the current market is in a state of going upwards and its hype is constantly mounting.
We have compiled an in-depth guide for folks trying to understand what DeFi is and how it functions. In this guide, we will elaborate on all facts and figures from the scratch so, keep on reading it in order to partake in the most rapidly growing sector.
The advent of cryptocurrency brought the decentralization of money. These currencies are virtual and decentralized, which implies that no central agency has authority over them. Groups or individuals develop them, and a nation or government institution does not regulate them. People use cryptocurrencies as a means of exchange and also trade them for profit.
However, despite the use of cryptocurrencies, they still have their limitation. You don’t need to fret because DeFi is the new kid on the block, and its limitations are beyond cryptocurrencies.
Cryptocurrencies and Decentralized Finance (DeFi)
Bitcoin, Ethereum, Litecoin, and other cryptocurrencies came with a lot of uses, and even though they offer a lot, they still fall short in some ways. cryptocurrencies allow peer to peer financial transaction and trading without the need for a third party or intermediaries.
They are decentralized, and users all around the world have complete control over their transactions and assets. However, it is important to note that cryptocurrencies have not completely decentralized the world’s financial system. Rather it decentralized the storage and issuance of money. Here are the three major problems with cryptocurrencies:
- Some Jurisdictions and nations do not approve of the use of cryptocurrencies
- Centralized organizations manage cryptocurrencies, and many of them lack transparency and accountability
- Anyone can access cryptocurrencies through the centralization of exchanges.
What is Decentralized Finance (DeFi)?
DeFi is an acronym for decentralized finance, and it comprises smart contracts, digital assets, protocols, and DApps built on blockchain technology. Moreover, DeFi runs on the Etherium platform due to its robustness, flexibility, and amount of development. As per the reports about $500 Million worth of digital assets worldwide run on DeFi applications. Ethereum hosts all these applications. Aside from that, users can also earn a massive 5 – 20% interest in the DeFi lending platform.
DeFi is an open financial ecosystem that develops various services and financial tools using its decentralized system. Since the Decentralized Finance (DeFi) system makes applications on the blockchain, they are easy to modify, combine, or integrate according to the user’s needs. In fact, DeFi is a form of smart contract it includes tokenization of systems with popular assets such as:
- Decentralized exchanges.
- Lending and borrowing markets.
- Tokenization of physical assets such as gold and other derivatives.
- A system for betting markets, payment networks, and insurance.
- Used for prediction and so much more.
Decentralized Finance Outshines Traditional Financial System
Many modern age banks and financial institutions come with the promise of better control for users. Many financial application developers are also building their apps through open-source protocols to enable decentralized means of exchange.
However, the system is still the same, and these financial institutions control people’s cash as they deem fit. This is not the case with Decentralized Finance (DeFi), it offers users the ability to own and control their assets in a streamlined approach. Its objective is to give users the ability to manage and control their assets through immutable blockchain technology.
It uses open-source protocols that allow people to build robust financial products on blockchain technology through Ethereum. It also allows for the seamless collaboration of developers to create innovative and leading products worldwide. Furthermore, it uses a secure network, which makes it hard for anyone to compromise.
Reason Behind the DeFi Development
DeFi was developed to help resolve the issues with the centralized, traditional finance sector. In the traditional financial system, the Central government of nations issues paper currencies that we use for trading and these currencies drive the economy.
This gives financial institutions a monopolistic power to regulate the flow and supply of such hard currencies. This centralized financial system brings about risk because regulatory bodies consist of humans and humans are prone to errors.
We have seen cases of inflation as a result of the overprinting of currencies. For example, in 2017, the Central government of Venezuela made a costly error of excess printing. It was a poor financial decision that led to sky-high inflation of 100 000%. It really disrupted the economic balance of the country and brought about unprecedented suffering to the masses.
In other instances, banks and financial institutions would often use your money for loans and get high profit while giving you just a fraction of it. Sometimes you could also invest your money in risky schemes that would result in a loss.
Another major point to note is that people do not often have an adequate say on how financial institutions handle their money. These issues and many others arise just because of the traditional financial system around the world. DeFi is here to stay, and it has come to solve the current financial market’s problems.
DeFi Accessibility and Profitability
Anyone from any part of the world can easily invest, trade, and store assets on the DeFi blockchain. You can also earn a much higher return when you give out loans in DeFi than in the traditional financial sector.
There is no need to pay commission, there are no central bodies or intermediaries to handle your assets, therefore, you have 100% control over all your investments.
It provides an ecosystem of financial applications, and it’s like a movement that creates a permissionless, open-source, and transparent financial system. Users of the system communicate with each other through P2P applications known as DApps.
Main Advantages of DeFi
Like we said earlier, traditional financial systems rely on institutions and government agencies to act as intermediaries. The court provides arbitration in the conventional financial system. However, DeFi applications do not need any central body, intermediaries, and agencies. It automatically resolves every dispute, and users have complete control over their assets and transactions.
The absence of intermediaries makes the transaction cost very low, and it creates a more frictionless financial system for everyone. Even though DeFi applications are deployed on the blockchain technology, it eliminates single points of errors and failures.
The public blockchain notes all entries and transactional data and spread across thousands of nodes, which automatically excludes censorship and potential shutdown of service. Applications on DeFi can be built in advance, making the deployment of apps much more robust, less difficult, and more secure.
People all around the world are not able to access traditional financial systems, but accessing the financial system is made so much easier through Decentralized Finance. Furthermore, because the typical traditional financial systems rely on profit, their service is not available in most remote locations or low-income areas. Anyone can access DeFi just with an internet-connected mobile device, making low-income earners benefit from its broad range of services
Core Benefits of DeFi
- Ease of access.
- Runs on a modular framework.
- Built on Public blockchain.
- Worldwide availability.
- Decentralized and not governed by any authority.
- No intermediaries or central governing bodies.
Why Do You Need DeFi?
DeFi provides systems for numerous interesting financial activities that you cannot achieve in a centralized financial system. A good example is in Flash loans, a unique loan that the borrower must take out and payback within a single transaction. Flash Loans allow people to borrow funds instantaneously and pay back the loan.
Below are the most relevant uses of Decentralized Finance (DeFi).
Stablecoin as Monetary Banking Services
DeFi develops financial applications; therefore, its use for monetary banking services is inevitable. You can use it for the issuance of mortgages, insurance, and stablecoins.
Stablecoins’ demand has been on a dramatic rise due to the growing use of blockchain technology. Stablecoins are a type of crypto assets that are tied to a real-world asset. However, they can be transferred between individuals with relative ease.
As you have known, cryptocurrencies are volatile, and the prices can fluctuate rapidly, but this is not the case with stable coins. They are stable and you can use them as digital cash. Another advantage of a stable coin is that it is not monitored or governed by any central authority.
Trading with stablecoins is also beneficial because it is less expensive to carry out transactions with. Since it eliminates intermediaries, the process of getting a mortgage with a stable coin is less time consuming and inexpensive.
Furthermore, it uses smart contracts for executive contracts and deals. Leal fees and other costs are eliminated, and blockchain technology provides adequate insurance for both parties, which results in lower premiums but with the same or better quality of service.
What are Stablecoins?
Stablecoins hold a specific value, unlike other currencies and digital assets that have no specific value. It is usually paged with fiat currency such as the US dollar, but sometimes it also associates with other assets such as gold. The stable coin has three broad classifications, which are as following:
The Crypto-collateralized stablecoins are backed by crypto assets and serve as collateral. They use various methods to maintain their peg against other assets, and they rely on a trustless issuance. It is completely transparent and accessible when a stablecoin debt is clear. The collateral would be held by the smart contract until the stable debt is paid off in the crypto-collateralized system. The stable system would automatically close the smart contract and sell off the collateral in the event where collateral falls below a certain level. The major problem with this system is collateral volatility because some collateral can rapidly lose value. But the smart contract would actively watch the value of the collateral and liquidate it.
The Fiat-Collateralized is the most popular type of stablecoin, and they store value in fiat currencies such as the Euro or the US dollar. They are redeemable with the currency at a ratio of 1:1. They are regulatory compliant, regularly audited, and they provide great opportunities for mass adoption.
This is because active measures are always undertaken to maintain the peg. Its current circulation is backed by reserving a fiat currency in the bank to maintain the circulation supply of the token. Finally, it is important to note that organizations behind the Fiat-Collateralized stable coin generate revenue from the interest of deposit funds from users.
The non-collateralized stable coins are neither over- collateralized nor centralized with crypto assets. It uses the latest algorithm to supply more tokens with increasing demand while decreasing the price of each token. In other times it supplies lesser token with low demand while increasing the price of each token. It uses this system to efficiently maintain a stable peg.
The risk with the Non-collateralized system is that it is sometimes difficult to maintain the stability of the token while contracting the supply of money. And also, the stablecoin would not be able to maintain its peg if there is lesser demand. Therefore participants invest with the belief that the demand would increase.
DeFi for Borrowing and Lending
You can use DeFi for open decentralized lending and borrowing, as it has a lot of advantages. Lending and borrowing on DeFi using blockchain technology drastically reduces counterparty risk.
It makes transactions faster and available to more people all around the world. It uses open lending protocols, that have become the most popular types of applications in the world today. Moreover, it operates through DeFi ecosystem, and it is decentralized.
It provides a unique system for instant transaction settlement. Also, it requires zero credit check but provides the ability to collateralize digital assets and a lot more.
DeFi services are built on the immutable blockchain technology. As such, they drastically minimize the level of trust between parties. They also provide assurance of cryptographic verification methods for the transactions.
DeFi Open Lending Protocol
DeFi provides an open lending protocol built on blockchain technology for users all around the world. Today, open lending protocols have become the most popular lending system out there. It clearly outshines other systems such as compound finance, Dharma, and so much more.
The open lending system works similarly to the traditional banking system where users deposit money while another borrows it and pays interest. Comparatively, DeFi implements digital assets to carry out lending and borrowing, and the lenders earn an interest.
It does not use intermediaries instead, it uses smart contracts to dictate the loan amount and the loan terms automatically connect lenders with borrowers, determines interest, and enforces the contracts. The lender typically earns more interest because no middle man involvement and the system is transparent. Furthermore, lending on DeFi greatly minimizes the risks of lending.
Thanks to Ethereum, that allows for a public blockchain in executing the lending protocol. The DeFi lending protocol offers a lot of advantages over traditional crediting and financial lending services. Here are the following advantages:
- Seamless integration with digital borrowing/lending assets.
- Instant settlement of transactions and provision of the efficient and secured lending system.
- Provides efficient collateralization of digital assets in the event of a default.
- Cost reduction through an automated system, standardization, and interoperability.
- Enables everyone to tap into financial services.
What are Smart Contracts and Tokens?
DeFi runs on Ethereum blockchain technology, and smart contracts are what make Etherium programmable money. They are scripts and applications that run on the Ethereum network seamlessly, they are capable of managing and creating digital assets. Moreover, they execute automatically according to the terms of the contract.
Smart contracts enable parties to build irreversible and strong agreements without the need for an intermediary or a middle man. And for DApps, they are P2P applications on DeFi, and it uses the smart contract to executive agreements between parties.
You use smart contracts for lending, trading, payments, borrowing, collectibles, and so much more. Smart contracts on DeFi can also allow you to create digital assets known as tokens. Tokens represent digital assets such as tokenized physical assets like gold and other currencies.
Role of Smart Contract in DeFi?
Both future and existing financial applications use smart contracts. A smart contract, by default, utilizes lesser legal terminologies, less ambiguous for the transacting parties. It also uses automate computer codes to enforce contract terms between the parties. The codes are automated in the smart contract, it can enforce those terms. This method allows for reliable execution and automation of enormous business processes without the need for manual supervision and enforcement.
DeFi smart contracts are relatively cheaper, faster, more secure and drastically reduce the risk for the transacting parties. Furthermore, confidential and valuable information is tied down in the smart contract, which implies no third party would have access to confidential information.
DeFi Brings Decentralization to Marketplaces
DeFi provides crucial applications for decentralized exchanges such as DEXes. It allows users to trade on digital assets without the need for any intermediary for the exchange.
DApps for exchanges are extremely difficult to access, but DeFi comes with a state of the art system and allows for financial innovation. It enables traders to carry out transactions through their wallets and uses smart contracts as the binding agreement between them. Also, they require lesser maintenance work than a centralized system. As such, they command lower transaction fees, faster processing, and enable decentralization in the marketplaces.
You can also use blockchain technology to allow or issue the ownership of a range of traditional financial instruments. DeFi apps work equivocally to eliminate custodians/single points of failures in transactions.
Furthermore, DeFi provides tokenized securities through blockchain technology and also provides customizable parameters. Other DeFi projects do allow the creation of synthetic assets, derivatives, prediction markets, and so much more.
Difference between Decentralized Finance and an Open Banking System?
Open banking uses application programming interfaces (API) to gain access to financial data. These third-party financial service providers are granted secure access to enable the networking of accounts and data between banking and nonbanking institutions.
They render financial services and products to people in a regular financial system. However, DeFi brings a new and innovative financial system that is independent of the current financial infrastructure around the world. Due to its open system architecture, DeFi is an Open Finance System.
DeFi allows the management of financial institutions/instruments and brings about new and innovative ways of interacting with them. While open banking systems allow the management of traditional financial institutions by unifying and gathering information from several institutions.
Furthermore, a central body controls the open banking system, but in DeFi sector, there is no regulatory body to monitor.
Difference Between DeFi DApps and Open Banking Apps
Dapps do not require anyone to manage them. Nobody governs the DApps as they are fully decentralized. The rules of the applications are written through computer codes and smart contracts.
They deploy smart contracts on the blockchain technology, and the apps run themselves without human intervention. Although there are standby developers that fix bugs, maintain the apps, and also make additions.
This is not the same with open banking apps. As a financial system owns and governs them, they are prone to manipulation. Transactions are not private and third parties can gain access.
Here are the major advantages of DApps.
DApps codes are transparent, and there are no hidden agendas to them. It runs on blockchain technology; therefore, anyone can audit the transactions on them. This brings a handsome level of trust for the applications. Just because it’s an open-source application, anyone that has the technical expertise can find and correct bugs on DApps. Every transaction on the application is also viewable by anyone without exposing the transacting parties’ identity (It doesn’t note your identity) hence, you can remain anonymous.
DApps provide a global system for everyone. Your location doesn’t matter, and you can access it from any part of the world with a mobile device and an internet connection. Traditional financial institutions are not available in certain low-income communities, which can bring about issues for people in remote locations.
You do not need any form of permission to use DApps. Anyone from any part of the world can create DeFi apps, and anyone can use it irrespective of location, gender, age, or affiliation. There are no central governors and no gatekeepers. Users can easily interact with one another through their wallets.
Perfect User experience
With DApps, you can use third-party user interfaces to access and use the applications. You can easily change your interface if you do not like the default DApp user interface. Moreover, you can also build your user interface if you have the technical ability to do so, or pay an expert to create an interface for you. This system ensures a seamless user experience for people all around the world.
Developers can build DApps by either combining older applications or building a brand new one from scratch. For example, you can amalgamate predictable markets and stablecoins to form a new DeFi product. Due to this unique feature, DeFi has become one of the fastest-growing and the hottest topic in the crypto world.
Risk Factor in Decentralized Finance (DeFi)
There is always a risk with any high-profit returning product, and DeFi is not an exception. It still involves a risk factor with cryptocurrencies, wallets, and financial systems because they require specialized knowledge and cutting edge technological solutions.
Therefore there is a risk factor with Decentralized Finance (DeFi). Every user has the responsibility of keeping their holding and keys secretly. You can securely keep your details using a multi-factor authentication system and hardware.
Without adequate security measures, an account is vulnerable, and hackers can transfer funds to another account. Hackers can take advantage of code vulnerability and gain access to your wallet, you must take adequate measures to protect your details.
Cryptocurrencies came with its unique use cases, but DeFi takes those promise a step further. It enables transactions from all around the world no matter where and who. DeFi is the most talked about technology in the crypto space. Even though its market share is comparatively small than the traditional financial sector, it has gained a lot of traction lately because it provides solutions to the problems associated with the traditional financial system.
With more financial DApps and projects, DeFi has brought a revolutionary and decentralized financial reality to the financial market. You can easily access from any location around the world, there is no regulatory body governing it, and it requires no policing / regulation.
Decentralized Finance (DeFi) provides an open and global alternative to every financial service. It automates tradings, savings, insurance, loans, and so much more. DeFi uses immutable blockchain technology and smart contract to facilitate the transaction. It also presents a massive opportunity for investors all around the world to make hue profit from loans.