DeFi – Decentralized Finance what is and how it works

What is DeFi and how it works

When you think of savings, getting loans, and lending, what place do you perform these services? Banks – operating traditional finance services. However, performing these services on blockchains through a centralized exchange is centralized finance (CeFi).

But for DeFi, it involves both blockchain and decentralized exchange to eliminate paperwork and intermediaries between parties using smart contracts.

Financial services on public blockchains come under the term ‘decentralized finance.’

These services include the ones you perform at banks, including borrowing, interest earning, lending, derivatives trading, insurance buying, assets trading, and others.

The significant difference is that third parties like banks, and numerous paperwork are exempted in decentralized finance, making the financial service faster and more seamless.

Therefore, DeFi is a peer-to-peer financial system in the cryptocurrency ecosystem that uses blockchains to eliminate intermediaries and trust mechanisms.

Unlike in a traditional system where you trust banks or stock exchanges to receive or send funds, DeFi uses smart contracts to settle trades, ensuring transparency and fairness.

Blockchain is the foundation of DeFi as every party holds a copy of the transaction; this ensures no single entity controls the transaction.

 

Centralized vs. Decentralized Finance

Centralized and decentralized finance offers virtually the same service, albeit in different ways. Hence, the difference between the two.
Centralized finance
Traditional services and decentralized services are closely related, and the terms are loosely interchanged.

However, traditional financial service uses fiat currency, while centralized finance uses cryptocurrency.

Both have central control serving as the intermediary.

Centralized finance uses Bitcoin, Ethereum, USDT, and others to service loans and interest through a centralized platform.

A person or group manages these platforms under the regulation of a financial company.

Therefore, every transaction under centralized finance must comply with the law. Also, you must have total trust in the people managing the platform.

 

Decentralized finance

Unlike traditional finance, emerging technologies substitute intermediaries to conduct financial transactions.

Peer-to-peer financial networks coupled with security protocols, advanced connectivity, hardware, and software empower Defi.

Thus, you can trade, lend, borrow, and perform other services through software that records financial action in distributed databases.

These databases are accessible in multiple locations, and transaction verification happens through a consensus mechanism.

Therefore, decentralized finance reduces reliance on banks by letting anyone participate in financial transactions, irrespective of location and personality.

In addition, DeFi gives users control of their money through wallets and personalized trading services.

 

How DeFi work

DeFi’s primary purpose is to provide financial services that people enjoy in a traditional and centralized system better by using decentralized technology.

These services include loans, interest, deposits, payments, and others.

Therefore, DeFi utilizes blockchain technology and smart contracts to deliver financial services better.

Blockchain is a public ledger technology that chronologically records all transactions in a financial platform.

On the other hand, smart contracts, executable codes that store cryptocurrencies and interact with the blockchain, are the building block of DeFi contracts.

These contracts must be self-executional or automatic to enable DeFi functions.

After the contract’s conditions are completed, smart contracts self-execute the instructions.

 

The use of DeFi

  • Lending: you can lend out crypto and earn interest and rewards every time – not month
  • Loan: getting a loan is easier in DeFi because you don’t need to fill out paperwork.
  • Trading: DeFi lets you buy and sell crypto assets without any form of brokerage
  • Savings: you can put your crypto into saving account alternatives to earn better interest rates than banks.
  • Derivatives market: involves making predictions on the price of some crypto assets – similar to stock options or future contracts.

 

Importance of DeFi

  • Peer-to-peer (P2P) financial transactions are one of the significant benefits of DeFi.
  • P2P is a situation where two parties agree to exchange crypto assets without a third party’s involvement.
  • For example, P2P can be used in loan needs where the algorithm matches peers who concur on the lender’s terms for issuing loans.
  • Accessibility: DeFi allows anyone with access to the internet to access a DeFi platform and perform transactions without geographic restriction.
  • Low fees and high-interest rates: there is a permissibility to negotiate interest rates and lend money via the DeFi network.
  • Security and transparency: smart contracts offer security and protect the interests of all participants in a transaction.
  • Equally, records of transactions printed on a blockchain are available for review by anyone without them revealing their identity.
  • Autonomy: without relying on financial institutions, DeFi platforms are not subjected to adversity or bankruptcy due to DeFi protocols.

 

Current and future examples of DeFi

Ethereum platform

This platform allows you to send crypto assets anywhere globally seamlessly. On this platform, you can save, earn interest in crypto, trade, insurance, borrow, lend, and manage funds.

DeFi currency exchange

DEXs are peer-to-peer platforms that enable traders to exchange different cryptocurrencies. These exchange platforms also facilitate direct trading between peers while maintaining anonymity. Traders also control their wallets and access thousands of crypto with their private keys.

DeFi stablecoins

Stablecoins are tied to gold or US dollars to eliminate crypto volatility. These coins are more suited for daily transactions than other cryptos and quickly transfer beyond the border, making transactions swifter. Also, you can earn interest with stablecoins.

Defi lending

Defi lending is rapidly growing as a way to lend and earn interest from digital assets. Lenders can pool their assets with others through smart contracts for borrowers with digital assets as collateral to secure loans. For instance, you can use XRP as collateral to borrow Bitcoin without selling the collateral.. Sometimes, you can borrow an amount higher than the collateral you provided.

Wrapped Bitcoins (WBTC)

WBTC is a way to transfer bitcoin to the Ethereum network to use in the Ethereum DeFi mechanism directly. You also earn interest on bitcoin when you lend out WBTC through the Ethereum network.

Prediction market

People can gamble on the results of future events like games, election results, prices of assets, etc. This DeFi service provides the same service as traditional service without intermediaries.

Risks for DeFi for investors

Although DeFi is revolutionary, there are some setbacks, which include

  • Complexity: Defi is not straightforward as going to the local bank. Equally, it is challenging for beginners to navigate because of numerous application and investment opportunities in DeFi. For instance, you may need to move funds from Coinbase to MetaMask to access some DeFi platforms.
  • Scams: Numerous fraudsters are there to corn you of your money through yields that may outpace those offered by centralized institutions. As they say, some high yields might be too good to be true.
  • Theft: Apart from scams, crypto coins may be stolen due to vulnerable codes in many dApps. However, the core team of the DeFi project may decide to compensate you or not.
  • Cost: Using smart contracts requires a gas fee, like compensation, to run the software. Therefore, multiple steps in trading DeFi may accumulate costs that may be off-putting.
  • Volatility: Crypto assets are volatile, but yield farming may mitigate the volatility. However, fluctuations in the price may result in a loss greater than a year’s entire gains.
  • Fluctuating yield: As with volatility, DeFi participants must deal with fluctuating yields that can fall beyond the support a platform gives
  • Dying projects: Core teams pursuing a DeFi project may leave the project to die, but the protocol will still be running without further updates.

 

Pros of DeFi

  • Decentralized applications let individuals transfer funds without border restrictions.
  • High yield on investment
  • High level of security

Cons

  • Complex for people to understand
  • High risks of frauds and scams
  • Highly volatile

 

Some major DeFi platforms

Aave

Aave is one of the most popular lending protocols, using AAVE tokens to secure the protocols and for users to participate in the governance. You can also stake AAVE tokens through the Safety Module to earn rewards.

 

yEarn

yEarn is an automated liquidity aggregator providing a vast array of yield farming. YFI is the native and governance token of the protocol, which users could stake to claim a pro-rata share of the protocol fees.

 

MakerDAO – Dai

MakerDAO enables the generation of Dai, the world’s first unbiased currency and leading decentralized stablecoin.

 

Synthetix

This protocol is one of the prominent derivative protocols with SNX native tokens. The token allows users to stake 750% of the value of a new derivative that would be minted – Synths. This helps users in earning native inflation apart from the trading fees.

 

Opyn

Opyn is a capital efficient DeFi options protocol that allows users to buy, sell, and create options on ERC20s.

DeFi users and products rely on Opyn’s smart constracts

Opyn is building DeFi-native derivatives and options infrastructure in DeFi

 

Compound

The Compound is a top lending protocol with COMP native token, which users earn by lending assets or participating in the governance of some decisions.

 

Uniswap

Uniswap is one of the most prominent DeFi protocols and probably the number decentralized exchange in the DeFi space. You can earn a UNI token by offering liquidity in a particular pool.

 

TokenSets

Asset management for a DeFi world.

Bring your crypto strategies to life with Set’s leading portfolio management tools.

 

Vesper

Vesper is a platform for easy-to-use #DeFi products. More than fifty audits, 20 strategies, 40.
Vesper Finance is the Ultimate DeFi Platform for Crypto Beginners.

 

Ribbon

The Ribbon Protocol uses derivatives like options to generate sustainable, risk-adjusted yield. Users just deposit their assets, and let the smart contracts do the rest.

 

Conclusion

Financial services on public blockchains come under the term ‘decentralized finance.’

These services include the ones you perform at banks, including borrowing, interest earning, lending, derivatives trading, insurance buying, assets trading, and others.

The significant difference is that third parties like banks, and numerous paperwork are exempted in decentralized finance, making the financial service faster and more seamless.

 

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we’re all gonna make it!

Contact us we have experts to help you how to setup your DeFi operations and how to run it!

 

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