Decentralized Finance (DeFi) Explained – A Beginner’s Guide To DeFi

• What exactly is DeFi?
• Why do we need DeFi?
• What is the future of DeFi?

As we all know, Bitcoin was created in 2009 as an alternative to the existing financial system. It aimed to develop a financial system that is decentralized and not controlled by any centralized authority. 

Although Bitcoin was intended to function as money, many limitations still exist. Bitcoin has unintentionally created new central authorities such as node operators, miners, exchanges, and wallets to control the flow of this cryptocurrency. 

Thus, there was a need to further advance this solution with DeFi. As Bitcoin tries to decentralize money, DeFi aims to decentralize the financial institutions that control that money.

To understand DeFi and its utility in our current ecosystem, we first need to understand the existing financial system, i.e., centralized finance that provides us financial services for over two centuries.

What is Centralized Finance (CeFi)?

Today, our traditional financial system and all of its services are entirely centralized. Banks, insurance companies or stock markets, and other financial institutions have someone in charge that controls and offers financial services.

Because humans control the whole system, the system itself is prone to mismanagement, fraud, and corruption. As a recent example, consider the 2007-08 financial crisis in the US, which resulted from the bankers’ housing market bubble.

The significant problems of a centralized financial system can be listed as follows:

1. There are some nations or sectors of society that do not have access to the banking systems
2. Lack of access to these financial sectors sometimes prevent people from being employed
3. A bank may restrict your account or prohibit you from transferring money to another party
4. There may be hidden transaction charges applied to a particular transaction
5. Your personal details may be shared with other parties and authorities
6. Authorities can regulate the whole financial market for their own interest
7. Because of intermediaries in a specific transaction, transaction costs are high

Now as we know the problem that DeFi is trying to solve, let us understand the types of services that a financial system provides.

What are Financial System Services?

The financial system of any nation consists of banks, investment houses, lenders, finance companies, real estate brokers, and insurance companies.

Thus, financial system services include the following services:

1. Transfer of money from one point to another,
2. The lending of money from one person to another,
3. Saving plans,
4. Investment plans,
5. Insurance plans,
6. Stock market,
7. Money market, and many more.

And more…

Now, as we have an idea about what types of services we are aiming to provide through a decentralized ecosystem, let us dive in and understand DeFi

What is DeFi (Decentralized Finance)

In simple terms, DeFi or Decentralised Finance can be defined as a merger of traditional banking services with blockchain technology. It replaces some components of the traditional financial system with smart contracts on a blockchain. Thus, DeFi offers financial services carried out on a blockchain (the most common blockchain used is Ethereum).

Therefore, DeFi platforms allow people to borrow funds from others, speculate on price movements on a range of assets using derivatives, trade cryptocurrencies, insure against risks, and earn interest in savings-like accounts.

A lot can be done with DeFi. I have listed a few of the functions of DeFi below.

What all can you do with DeFi?

With the wide variety of services that DeFi offers. You can predominantly use it for services such as:

1. Send money to anyone around the globe
2. Have access to stable currencies
3. Borrow funds with collateral
4. Borrow without collateral
5. Start crypto savings
6. Trade tokens
7. Grow your portfolio
8. Fund your ideas
9. Buy insurance
10. Manage your portfolio

Now let us understand the components of DeFi which contribute to developing and maintaining the ecosystem.

Various Components of Defi

To understand the DeFi to its core, we should understand the components which make the DeFi ecosystem. It is similar to the ecosystem of the traditional financial system, good infrastructure, and a stable currency at a broad level. With these two components, decentralized applications (Dapps) have developed many use cases, which we will discuss later in this article.

So, let us understand the infrastructure of DeFi, i.e., the blockchain system on which it is made.

Decentralized infrastructure – Ethereum

Ethereum is the most used infrastructure for the DeFi ecosystem. It is a technology built by its community, and most Decentralised Apps (DApps) that you use today are developed on this platform or Layer 2 solutions of Ethereum like Polygon (Matic). Moreover, it has an in-house token called Ether (ETH).

This means that Ethereum has more usage than Bitcoin, which can merely be used for payments or store of value as of now. 

Ethereum uses a smart contract that replaces the need of a financial institution in the transaction. A smart contract is a code-based agreement and whether the agreement will be honoured or not depends on the fulfilment of certain conditions. The contract will always run as programmed, and no one can alter it when it is live.

A need for trusted authority arises in a transaction to ensure that both the parties do as they had agreed upon. For that, the trusted authority charges a big chunk of the fee. Further, the trusted authority can become corrupt and collude with one of the parties to contract. Therefore, DeFi replaces the smart-contract with that trusted authority. Thus, as mentioned above, you are trusting the smart contract and not any external trusted party.

These days, many other smart contract blockchains have developed that provide almost a similar utility compared to the Ethereum blockchain.

The second essential component of DeFi is stablecoins. Let us attempt to understand what they are.

Stable Currency

Price volatility of assets is one of the key arguments that is used to discredit cryptocurrencies like Bitcoin and Ether. Few solutions have been devised for this problem. 

Stablecoin is one of the most appreciated and widely used solutions among them. Stablecoins are mostly pegged to some other asset which restricts its price fluctuation. It’s a type of synthetic asset that is often pegged to a real-world fiat currency (but can also be pegged to other real-world assets).

The significant advantages of stablecoins are:

• They provide a stable denomination against any crypto asset
• The movement of stablecoins between exchanges is relatively easy

A token is mostly pegged to a real-world asset such as fiat money, any commodity such as gold, or a crypto asset itself to ensure the stability of the stablecoin.

Types of Stablecoins

Based on how a stablecoin is pegged to an asset, stablecoins can be classified as follows:

• Fiat-backed

Fiat-backed stablecoins are the most commonly used category of stablecoins. Here, a crypto coin is pegged to a fiat currency, mainly USD. In other words, an equal amount of fiat currency is held as a reserve at all times and can be used for redemption of the stablecoin. USDT, TUSD, GUSD, PAX, and USDC are the most common examples.

• Crypto-backed

This includes stablecoins which are pegged to cryptocurrencies. As crypto tokens are highly volatile, this peg is required to be overcollateralized, i.e. the cryptocurrency used as collateral to issue the stablecoin should be higher in value than the issued stablecoin. DAI is an example of crypto-backed stablecoin.

• Commodity-backed stablecoins

Stablecoins pegged to a commodity such as gold are covered under this category. DGX is an example of a stablecoin that is backed up by gold.

• Algorithmic stablecoins

These stablecoins are not pegged to any asset. To achieve a certain stable price, required supply is computed with the use of algorithms and smart contracts.

Now as we have the components that make the DeFi ecosystem, we can explore the horizon of DeFi. By simply coding an application that is empowered with smart contracts on a blockchain known as Decentralised Applications (Dapps), we can make various use cases of DeFi.

Let us understand the existing use cases of DeFi.

Use Cases of DeFi

With the power of DApps, the sky’s the limit for what can be done in the DeFi space. Some of the use cases that are currently available are as follows:

Decentralized Exchanges (DEX)

Decentralized Exchanges i.e., DEX for short, are autonomous Decentralised Applications (DApps) that allow a user to buy or sell crypto tokens while having full control of their funds and their private keys.

The is different from how a centralized exchange works, where the exchange acts as a custodian of crypto assets for its users. Therefore, DEXs are aimed at eliminating any trusted authority to supervise and approve a particular crypto trade.

Thus, a DEX helps us as follows:

• Complete control of private keys with the user
• Better security as a hack on the DEX’s blockchain will not impact your assets
• A user achieves personal autonomy over his or her assets

As a DEX does not have any asset at their disposal, the major drawback is that they have liquidity problems compared to a centralized exchange such as Binance, CoinBase, FTX, etc. For example, when there is a buy order of 1 BTC, the DEX does not hold any asset to fulfil the buy order. Unless the DEX has a very big order book, the exchange might fail to fulfil the order. Therefore, many DEX employs a liquidity protocol to maintain a Liquidity pool where an asset hodler (known as liquidity provider) can provide liquidity to the DEX and earn rewards against it. Some of the examples of existing DEX can be MDEX, PancakeSwap, Uniswap, Sushiswap, 1inch Exchange, Binance Dex, etc. 

Now the following use case. Are you a Hodler? If yes, then you can interest by lending your crypto through the lending platforms. 😱😱😱😱

Lending and Borrowing Platforms

DeFi lending platforms allow a user to lend or borrow cryptocurrencies without any intermediary. A lender can list his crypto assets on the platform for lending, and simultaneously, a borrower can borrow these funds. The lender can earn interest on the assets that he has lent on the platform.

Compared to traditional lending, DeFi lending platforms are based on blockchain and lend and borrow money in a trustless manner without intermediary as a trusted authority. Further, as there is no human involvement in lending or borrowing, there is no bias in the treatment of any user.

Benefits of DeFi Lending can be as follows:

• No applicability of federal or state laws
• No partiality in the lending process
• Quick lending process
• Permissionless access to anybody anywhere
• Better transparency
• Immutable transactions
• Self custody
• Interoperability
• Programmability

The most popular DeFi lending platforms are Aave, Maker, Compound, InstaDApp, etc. the relatively new concept popped from the lending function is yield farming.

What is Yield Farming in the Context of DeFi?

Yield Farming is another concept related to crypto lending where a lender tries to maximise his return on capital with the help of various DeFi products.It is also known as Liquidity Mining.

A person generally moves his funds across several protocols to maximize his return on lending. Some of the renowned yield farming platforms are Beefi.Finance, Yearn Finance, etc.

Moving on, do you know that you can get yourself insured against a crypto hack?

Insurance in DeFi

As more apps and protocols launch and more money pour into DeFi, it’s important that DeFi investors can mitigate their risk of losing their funds. 

While the DeFi sector is booming, it has also been a victim of hacks and fraud. This is where insurance projects such as Nexus Mutual (NXM), Etherisc and Cover Protocol come in.

Let us take Nexus Mutual as an example and understand what it offers to its users. It is an Ethereum based platform that has community-driven management and offers insurance products to its users. For instance, the platform offers a “Smart Contract Cover” which safeguards a user against vulnerabilities in a smart contract used on various DeFi platforms. The company has a DAO (Decentralised Autonomous Organisation) structure and is governed through a utility token called NXM.

A DeFi app to save you from a DeFi hack!!

Tokenization

Tokenization is the process of converting some form of asset (physical or otherwise) into a token that can be moved, recorded or stored on the blockchain system. 

Tokenization is termed as the new fuel which can take the DeFi industry to the moon. Till now we were only dealing with crypto assets, but tokenization can dematerialize real-world assets and move them to the blockchain.

Please note that tokenization can be done through a centralized mechanism as well such as FTX exchange and Binance exchange have issued tokenized stocks of Tesla. However, the mix of DeFi and tokenization will take us to a whole new level.

Read: Best Tokenized stocks platforms

For example, suppose if we tokenize land and property on a blockchain. A person would be able to land and building on a DeFi platform. Further, he could apply for a mortgage through the same platform that will govern the ownership right and once mortgage payments are complete, it will transfer the ownership right of the concerned property to the borrower.

Because there would be no intermediaries to this transaction such as property dealers, lawyers, or banks, it would make the whole process cost-effective and faster. Thus, the possibility of what tokenization and DeFi can do together is unimaginable and therefore pose a huge potential and opportunity.

The Organisation for Economic Co-operation and Development (OECD) has published a complete analysis of what tokenization of real-world assets provides in the shape of an opportunity. In the report, OECD has tried to explain the impact of tokenization and has also analyzed the hypothetical situations such as tokenized equity markets, debt markets or real estate markets. You may refer to the report here.

So, as huge as the opportunity DeFi is, it is still in the age of its infancy in comparison with the 200 years old financial system. Thus, there are some limitations which it needs to address.

Limitations of DeFi

The possible limitations of DeFi are as follows:

1. Scalability

This is the most evident problem with the Ethereum blockchain that so many DApps have been created on the platform that it has run out of its maximum capacity of operation. Due to this, a single transaction takes substantial time and a huge cost in the form of a gas fee (network transaction processing fee). Thus, defeating the sole purpose of introducing a blockchain.

2. Problems with smart contracts

Vulnerabilities to a smart contract are the major concern for the future of DeFi projects. A small flaw in the code of smart contracts can lead to a substantial loss of funds.

3. Bad Actors

A bad actor can identify a wrongly written smart contract and exploit its limitations. This can also lead to loss of funds.

What is in the future for DeFi?

I am very excited about the future of DeFi. According to my understanding, the future would be the integration of real-world assets with blockchain with the help of DeFi. In the coming years I am sure that many national economies will embrace DeFi and build their own decentralized economies for good. This will help in the optimization of national resources and will put an end to corruption in any possible domain.

As far as individual aspects are concerned, I understand that a person would be free from the pothole of intermediaries and trusted authorities and would be able to truly own his assets. It would be a fair world for all.

Let me know your thoughts about DeFi space and what you think the future holds for us in this space.