It is an umbrella terminology for a variety of cryptocurrency financial applications in blockchain, geared toward disrupting traditional intermediaries.
DeFi is simply an acronym for ‘Decentralized Finance’ on blockchain applications.
Being decentralized simply means that; these services have no central financial authority guiding them.
These decentralized financial services are meant to replace current centralized financial system.
DeFi relies greatly on cryptography, blockchain and smart contract, with the later being its main building block.
All DeFi apps are built on Ethereum blockchain, as it uses Solidity as its programming language.
The world traditional financial system is one that is plagued with regulations, of which services ranging from money transfer, lending, insurance to saving plans etc all made it up.
They are centralized, and there’s always a person, team, or company that oversees all the affairs. Thus, they are can be referred to as CeFi (Centralized Finance).
CeFi has risk of fraud, funds mismanagement, embezzlement, etc., which is why DeFi was created.
It’s intended to mitigate all the risks associated with CeFi.
Additionally, DeFi grants its users the privacy they seek; cutting off a lot of fees and charges that would’ve been the case in a CeFi system.
DeFi is the best way to create a whole new financial system, without all the risks and exorbitant fees that goes alongside it.
Decentralized finance examples
DeFi examples are categorized as follows:
- Lending and borrowing
- Margin trading
1. DeFi lending and borrowing
Lending and borrowing works in a different way when it comes to DeFi (Decentralized Financial) system.
One of the biggest platform doing this (as at the time of this post) is Nexo.
The platform is an algorithmic and autonomous interest rate protocol that is built for developers.
It allows its users to supply assets that will be lent out to earn interest, while serving as collateral for borrowing other currencies.
Let me briefly explain how it works:
- A user deposit their cryptocurrency investment and get desired currency in return
- The deposited crypto-asset is then held on the platform until the payback period, which the borrower will have to pay back the borrowed money
- Once the borrower pays back the money with the accrued interest rate, they get back their cryptocurrency investment.
Investing in DeFi project is becoming one of the best and most lucrative investment strategies in the community.
Stablecoin is a cryptocurrency that is pegged to an asset with a stable value, such as gold or fiat money like the US dollar.
An example of a DeFi stablecoin is DAI, a crypto-backed stablecoin that is pegged to the U.S. dollar.
DAI is developed by Maker DAO (Decentralized Autonomous Organization), and also runs on the Maker Protocol.
Users can deposit their ETH as collateral and are able to borrow DAI.
If you want to get your ETH back, you just pay the amount of DAI that you borrowed and your ETH is released.
To account for the volatility in the crypto collateral deposited, DAI is over collateralized.
This simply means that the required amount to be deposited is always higher than DAI’s value.
This is a core part of CeFi that can be reproduced in DeFi.
Insurance is a contract/arrangement in which you (the insured) receive financial protection, or reimbursement against losses from the insurance company (the insurer).
In DeFi, the most popular insurance application is the protection of your deposit and against smart contract failures.
The popular DeFi projects include Nexus Mutual, Etherisc, Opyn, and VouchForMe.
4. Margin trading
Margin trading refers to the practice of using funds borrowed from a broker to increase the position in a certain asset.
The DeFi apps here include dY/dX, Margin DDEX, MCDEX, and Fulcrum.
5. Decentralized exchanges (DEx)
DEx (i.e. Decentralized Exchange) is a crypto exchange that operate in a decentralized manner, and without a holding invested funds with authority wallet.
It allows for cryptos to be exchanged in an open and permission-less way.
DEx can be:
- Liquid Pool based – Binance DEx, Kyber, Uniswap, Bancor, Balancer, Curve, etc
- Order Book based – IDEX, DDEx, LoopRing, etc.
Derivatives are contracts that derive their value from an underlying asset’s market performance.
Now, this underlying entity can either be an asset, index or an interest rate on the invested funds.
Examples are mStable, Idle, Synthetix, Yearn.finance, CHAI.money, etc.
Pros and Cons of DeFi
Let us look into all the advantages and disadvantages of decentralized financial system
|Permission-less||Issues of network fees|
|Stable||Bugs in smart contracts|
|Flexible||Slow transactions because of a congested network|
|Not censored||Corruption flow due to no legality|
Frequently Asked Questions
The future looks very bright for DeFi, as the world is going digital and as a result, world of finance is tilting towards DeFi gradually.
It’s the fastest-growing sector of finance, and users earn a lot of interest from lending platforms.
Most DeFi applications are built on the Ethereum blockchain and are in control of a huge chunk of digital assets.
As I always advice, do not leave cryptocurrencies on an exchange for too long, as you may risk loosing it all due to theft or hacks.