What is DeFi?
Decentralized Finance (DeFi) is a collective term for peer-to-peer financial services on a public blockchain. Simply put, it is a blockchain-based form of finance that does not rely on central finance intermediaries such as brokerages, exchanges or banks meaning, all middlemen or intermediaries are eliminated! Cool, right?
DeFi’s anti-intermediary goal is achieved through the power of smart contracts on blockchains which are programmed to do specific things without errors. DeFi aims to offer universal, open substitutes for any financial service now offered. These comprise the capacity
💰To request insurance
💰To take out loans
According to DeFi Pulse, as of November 2021, the total value locked in DeFi contracts exceeded $107 billion.
Wondering how DeFi came about?
Interestingly, DeFi’s takeoff began in 2018 on a Telegram chat. A group of software developers were trying to give a term to their innovation of financial services that would be built on a blockchain. Their main aim was to outstrip traditional banks.
The genesis of DeFi is Bitcoin which establishes the framework for ‘digital cash’ and the launch of Ethereum in 2015. Generally, users engage with DeFi via decentralized apps (dApps), most of which run primarily on the Ethereum blockchain. dApps function just like normal apps. What sets them apart is that dApps are run on a peer-to-peer network like a blockchain hence no single body has control of the network.
Some of the top DeFi projects are Aave, PancakeSwap, Uniswap, and ColonyLabs. Since 2020, DeFi has been growing at an astounding rate.
Let’s take a look at how DeFi is democratizing finance by replacing centralized traditional institutions.
DeFi Lending and Borrowing
DeFi protocols enable users to borrow or lend money between unknown participants and without any intermediaries or middlemen such as financial institutions or a bank that comes with a lot of interest rates on borrowing and is a strenuous process.
These protocols are highly inclusive as users from any part of the globe or timezone and with any amount can interact with them. Borrowing money from decentralized providers comes in two main forms;
– Peer to peer; meaning a borrower will borrow directly from a specific lender
– Pool-based; lenders provide funds(liquidity) to a pool from which borrowers can borrow.
Examples of DeFi lending platforms are Aave, Compound and Oasis. They organize lenders and borrowers and set interest rates automatically following demand and supply.
Decentralized Exchanges and Open Marketplaces
DeFi plays a huge role in the exchange industry. With the emergence of decentralized exchanges (DEXs), users can trade or swap tokens easily without a third party acting as an intermediary in a transaction. DEXs are composed of smart contracts that enable direct trades between the participants’ wallets. DEXs may also offer lower trading fees than centralized exchanges. Other open marketplaces specialize in the exchange of non-fungible tokens (NFTs). Platforms like OpenSea and Rarible make it easier to find, acquire, and sell a variety of crypto assets, from NFTs in games like Cryptokitties to virtual land plots in the game Decentraland. All these are powered by DeFi. 🔌
There is also decentralized insurance, which is still in its infancy. It aims to make insurance cheaper, faster and more transparent as compared to the traditional financial system. Coverage is more affordable and pay-outs are a lot quicker. The data used to decide on your claim is completely transparent. An important purpose of insurance is to resolve risks and bring security for market participants. An example of decentralized insurance is Nexus Mutual, which offers insurances that cover issues in smart contracts. 🔐
Staking is the process of putting your crypto assets into a Smart Contract, thereby making you a stakeholder. Some smart contracts use a proof of stake system, which means that if tokens are staked on a smart contract, it acquires greater credibility. As an incentive for assisting a smart contract in gaining credibility, you get paid with the same currency, in DeFi’s instance Ethereum.
This is similar to putting your money in a bank’s fixed deposit. It is also similar to buying bonds from companies or the government. The other catch with staking is that it’s the same as getting paid in dividends when investing in stocks. Easy way to make money! 💰
Liquidity pools are smart contracts that include locked crypto tokens provided by the platform’s users. They are self-executing and do not require any middlemen to function. They’re backed up by other pieces of code, such as automated market makers (AMMs), which use mathematical algorithms to keep liquidity pools balanced.
Liquidity pools are used to facilitate decentralized trading, lending, and many more functions of DeFi. Users called liquidity providers (LP) contribute to liquidity pools. In exchange for providing their funds, they earn trading fees from the trades that happen in their pool, which is proportional to their share of the total liquidity.
Liquidity provision comes with some risks. “Impermanent Loss” poses the main threat to your stake. Impermanent loss occurs when the price of a pooled token fluctuates significantly, making a fair trade impossible.
DeFi Yield Farming
— By locking crypto assets into lending protocols such as Aave, users start earning interest on these assets. Similar to how we store money in normal banks’ savings accounts and earn a percentage each year, yield farming gives the same benefits in DeFi. Yield farming in DeFi entails putting your crypto to work and earning more rather than leaving it idle.
How does it work?
Liquidity providers provide coins or tokens to a liquidity pool. Once their tokens are locked into a liquidity fund they are awarded a fee or interest generated from the DeFi platform the liquidity pool is on.
It’s a way to make money by lending your tokens using a dApp. There is no middleman or intermediary in the financing process because smart contracts are used. A marketplace where anyone can lend or borrow tokens is powered by the liquidity pool. Users must pay fees to access these marketplaces, which are used to compensate liquidity providers for staking their tokens in the pool.
In today’s increasingly digital world, it is very obvious that DeFi is making a huge impact in the financial sector. The future of DeFi seems bright and we are excited about DeFi’s future exploits.