Cryptocurrencies have evolved into a trillion-dollar market, sparking a wave of global financial disruptions. At the heart of this remarkable innovation is bitcoin, the first successful digital peer-to-peer electronic cash system.
Despite bitcoin’s specular growth in the past 14 years, its adoption as a day-to-day medium exchange has been very slow due to its inherent volatility. Mainstream financial institutions won’t accept loans or payments due to this, making it a poor asset to budget or plan any investment accurately.
Since the advent of bitcoin, there have been various developments aimed at making the crypto market more stable and providing financial services to users. Decentralized finance, also known as DeFi, is an exciting space taking conventional financial services and placing them on blockchain technology.
If you’re still unaware of what is DeFi, let’s dig a little deeper into what it is and what you can do with it.
What is DeFi Anyway?
DeFi is an umbrella term used to refer to financial services on the blockchain, more so on the Ethereum blockchain. With DeFi, you can do everything you can with a conventional bank — earn interest on your savings, borrow, lend, get insurance, trade assets or even invest in securities in the form of tokens.
However, unlike traditional financial services, DeFi enables a peer-to-peer ecosystem that allows users to transact directly without a central authority or any governing entities. Moreover, since no third party is involved, DeFi transactions and services are faster, cheaper, and more secure.
Why is DeFi important?
DeFi takes the basic principles of bitcoin and expands on it, creating an entire digital alternative to Wall Street and the financial sector. DeFi is attractive to most retail investors and users because:
- It eliminates third parties, thereby removing the paperwork and fees financial companies charge for using their services.
- DeFi gives users total control of their funds through digital wallets like Metamask and Trust wallet.
- Anyone with an internet connection can access the DeFi space. Users do not need to acquire permission from a government or bank.
- With DeFi, users can transfer funds in minutes, if not seconds.
Comparing DeFi to Centralized Finance (CeFi)
To understand how DeFi works, you should know the critical differences between DeFi and CeFi.
The first and essential aspect of understanding DeFi is looking at how the network governs it. While singular finance institutions and government bodies govern CeFi, smart contracts govern decentralized finance. They deliver the framework needed for working on decentralized financial services.
A smart contract can be defined as a program stored on the blockchain that runs when it meets certain pre-determined conditions included in its code. They are typically used to automate the execution of an agreement so that all participants can be sure of the outcome.
Developers also use smart contracts to develop Decentralized Autonomous Organizations (DAOs). DAOs are organizations or decentralized applications that run autonomously according to the rules set out in the smart contract.
Peer-to-peer (P2P) transactions
In central finance, your funds are held by banks or corporations whose primary task is to facilitate and authorize transactions between different entities.
For example, to use your credit card in your local store, your payment has to be processed by your banks, the credit card issuer and finally, the retail store owner. Moreover, each of these parties will charge you a fee, making CeFi transactions quite expensive.
Since it’s built on top of the blockchain, DeFi facilitates P2P transactions. Crypto funds will directly be deducted from your digital wallet balance and added to the recipient’s wallet balance when transacting. The network achieves this through communication protocols, smart contracts, distributed financial database and a consensus protocol to validate and process the transaction. Additionally, since DeFi transactions are P2P, they are cheaper than their counterpart.
Key components of the DeFi ecosystem
Stablecoins are a vital component of how DeFi works. You can compare them to real-world fiat currencies. However, unlike fiat currencies, they are digital assets. Stablecoins are a type of cryptocurrency pegged on a 1:1 ratio to fiat currencies, in most cases USD, to maintain stability, contrary to most crypto market prices.
Stablecoins achieve stability by ensuring that the value of stablecoins issued by a crypto project, an equivalent amount in assets, is reserved in a financial institution. Through this, stablecoins can maintain their almost 1:1 ratio with fiat currencies.
There are three main types of stablecoins:
Fiat-backed stablecoins – These are stablecoins that are backed by fiat currencies. This means that for every stablecoin issued, an equivalent amount is held in a bank, financial institution or with the U.S treasury. Some examples include Gemini Dollars, Tether, and USDC, among others.
Asset-backed stablecoins are stablecoins backed by real-world assets like gold, oil, or even real estate.
Crypto-backed stablecoins – Are backed by other cryptocurrencies. However, unlike other stablecoins, crypto-backed stablecoins are always over collateralized to withstand crypto price swings. A good example is DAI, MakerDAO’s stablecoin.
Non-collateralized stablecoins – Lastly, these types of stablecoins are not collateralized by any asset. Instead, they have a mechanism that creates (mint) stablecoins on a demand basis, much like how banks print notes when the demand is high. This mechanism is implemented autonomously through smart contracts.
Since stablecoins have a market price close to fiat currencies, they are used to price products by merchants, issue out loans in crypto, and calculate interests earned from crypto and in day-to-day transactions in the crypto space. The design of stablecoins for maintaining stability compared to other cryptocurrencies provides a gateway through which users can access financial services on the blockchain ecosystem in a decentralized and trust-less way.
b. Open ledger protocols
Financial transactions are the heart of any financial ecosystem, and governing authorities play a crucial role in facilitating them. However, in the DeFi ecosystem, transactions are facilitated through open ledger protocols, specifically smart contracts.
Smart contracts are also inherently transparent since they reside on the blockchain. This means that users can leverage Block Explorers like Etherscan to track transactions. This is one of the main features that makes DeFi favourable among retail investors. Unlike your bank account, where you are unaware of what happens in the background, DeFi services allow you to keep track of transactions.
Smart contracts are also crucial in connecting ledgers and balances between two digital wallets, eliminating intermediaries and central authorities. For instance, smart contracts play a vital role in matching lenders and borrowers, interest management, and documenting all the transactions. To facilitate lending and borrowing, the DeFi ecosystem uses liquidity pools. A liquidity pool is a crowdsourced pool of cryptocurrency or tokens locked in a smart contract used to facilitate borrowing and lending. Since smart contracts are transparent, users can track how much a liquidity pool has, the available cryptocurrencies, average interest rates, and who the lenders and borrowers are.
c. Decentralized exchange platforms
Decentralized exchanges or DEX platforms are also critical to the DeFi ecosystem. While crypto exchanges like Binance and Coinbase are considered major players in the crypto space, they are centralized platforms. They are governed by a board of governors who control how the exchange works. As such, this beats the whole point of a DeFi ecosystem.
On the other hand, DEX is governed by the network users themselves through smart contracts. To participate in the governance process, users must purchase and hold tokens native to the DEX. For instance, to take part in the governance of Uniswap, you need to purchase and hold the UNI token.
Additionally, DEXes take away the need for storing digital assets by allowing users to connect their wallets to the exchange. With DEX, you also need to provide personal information to trade your crypto assets. They utilize non-custodial wallets — digital wallets that give you total control of your digital signatures and crypto funds.
d. Platforms for asset management
DeFi brought many new attributes such as derivatives, composability, security tokens and non-fungible tokens. These factors have presented prolific indications for the possibility of including real-world assets in the scope of decentralized asset management.
For instance, the tokenization of real-world assets into NFTs and their placement on the blockchain enable asset managers to efficiently include them in their portfolios. The introduction of security tokens through Initial Coin Offerings allows investors to have private companies’ shares in the blockchain technology. Moreover, real estate properties can also be tokenized and sold to retail investors as smaller tokens.
Such assets generally feature additional growth and income mechanisms for companies. They are also a gateway for retail investors to access investment opportunities that would have otherwise been inaccessible, plus the benefit of decentralization, transparency, and P2P interactions.
Common use case of the DeFi system
1. P2P Borrowing and Lending
Lending and borrowing are by far the most popular of DeFi protocols. As DeFi replaces conventional financial institutions, there will be a gap in the lending and borrowing space.
However, since DeFi is a P2P ecosystem, independent projects develop autonomous solutions that match lenders to borrowers. These projects appeal because they allow users to set their interest rates, store their funds in their wallets, and offer better interest rates than conventional institutions.
Among these projects are Compound, Aave, MakerDAO and Liquidity, to mention a few.
2. Payment solutions
One of the main goals of DeFi is to bank the unbanked. The inherent traits of DeFi that is, decentralized, distributed, permissionless and transparent, make it well suited for solving issues in the current financial system. It’s also cheaper, and anyone with an internet connection can access the DeFi ecosystem.
3. Decentralized organizations
As we mentioned above, most DeFi projects are referred to as DAOs, meaning that they are run by smart contracts and governed by the users instead of a central authority. DAOs give a new meaning to how organizations will be developed and run. Since there are no central authorities, there is less asset manipulation and fewer transaction fees between DAOs or users and DAOs.
Due to the high inflation rates and low-interest rates witnessed in late 2021 and early 2022, conventional saving vehicles are becoming less favourable to investors. As a result, various DeFi projects have taken it upon themselves to offer saving plans using multiple crypto assets and stablecoins.
For instance, Crypto.com allows users to earn up to 14.5% interest on USDC, the stablecoin managed by the Centre Consortium.
5. Derivatives and synthetic assets
As mentioned, smart contracts allow the creation of tokenized derivatives and securities. In recent years, this has become the unique DeFi use case. Instead of spending a lot of money and meeting many standards to get your project public, DeFi provides an efficient and easy way to get your crypto project listed on an exchange through an ICO or an Initial Decentralized Offering (IDO).
6. Compliance and know your transaction
Traditional financial institutions focus on KYC as a tool for implementing anti-money laundering measures. However, in most cases, the KYC requirements often contradict privacy issues. Moreover, users have required their personal information every time they open an account with a new bank.
DeFi, on the other hand, focuses more on Know Your Transaction (KYT). This mechanism suggests that audit or accounting firms concentrate more on your transactions and the wallet address rather than sensitive personal data.
Despite its infancy, DeFi has grown into a $76 billion sector. However, given its youth, the legal details and regulations around it have not yet been fully materialized. Since DeFi revolves around digital assets, governments and financial institutions might fit it into the current financial system or create new laws and guidelines for the space.
However, with big companies like Tesla, Square, Amazon and Google taking an interest in DeFi, investors can be sure that DeFi is here to stay.