DeFi is simply an acronym for “Decentralized Finance”.
It is an umbrella terminology for a variety of cryptocurrency financial applications in blockchain, geared toward disrupting traditional intermediaries.
Being decentralized 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. Currently, all DeFi apps are built on the Ethereum blockchain.
This is because Ethereum uses Solidity as its programming language. This Solidity allows you to put in all the logic needed for the DeFi apps.
Why do we need DeFi?
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 associated with it.
That is why DeFi was created; to mitigate all these risks associated with CeFi.
Additionally, DeFi grants its users the privacy they seek; cutting off a lot of fees and charges that would have been the case in a CeFi system.
DeFi is the best way to create a whole new financial system without all the major risks and exorbitant fees that goes alongside it.
Categories of DeFi
DeFi categories include:
- 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, autonomous interest rate protocol that is built for developers.
It allows its users to supply assets that will be lent out and users earn interest. They can also serve as collateral for borrowing other crypto-assets and 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 cryptocurrency 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 runs on the Maker Protocol.
Here, 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 cryptocurrency exchange that operate in a decentralized manner, and without a holding invested cryptocurrencies with the 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 performance. Now, this underlying entity can either be an asset, index, or an interest rate.
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
- Not censored
- Issues of network fees
- Slow transactions because of a congested network
- Corruption flow due to no legality(stolen funds can be circulated)
- Bugs in smart contracts
Let me answer some of the frequently asked questions I found online, while writing this article to explain this kind of crypto financial system.
Between DeFi and CeFi, which is better?
DeFi is an improved version of CeFi, and talking about which of them is better, it solely depends on the user to decide which to use for more convenience.
How can one make money while using DeFi?
You can make money from DeFi by lending out your crypto-coins for interest. Just create an account with an exchange and buy ETH (Ethereum).
After that, download Trust crypto wallet and withdraw your ETH to it.
Now that you got some DAI in your crypto wallet, you can transfer it to any lending platform (e.g. Nexo) and start earning profits on it.
Though yet to attain mass adoption, 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 is the fastest-growing sector of finance and its 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 all your investment in an instant due to theft or hacks.
If you have money to invest in maintaining high security for your crypto investment, I would recommend you purchase Ledger Nano X, which is also one of the best cryptocurrency hardware wallet in the market.