What Is DeFi and Why Everyone In Crypto Is All About Decentralized Finance
How do you explain DeFi?
DeFi or decentralized finance aims to disrupt the traditional financial system by using software protocols instead of relying on intermediaries. An example can be seen in decentralized (DeFi) lending where you can programmatically take out a loan in cryptocurrency and lenders could earn interest on their deposits.
What is DeFi and why do we need it?
Decentralized finance (DeFi) gives everyone the opportunity to borrow, lend, send, transfer, buy, and sell digital currency. It does this through programs called smart contracts that don’t need permission usually required by banks. The benefits of DeFi include control of your money as well as the ability to earn interest at a higher rate compared to traditional banks, a process known as yield farming.
How do you make money with DeFi?
You can make money with decentralized finance (DeFi) by staking the assets you own in DeFi protocols referred to as yield. This allows you to grow your crypto holdings without the risk usually done by trading on the market.
What are DeFi projects?
DeFi projects are software applications that run on top of a blockchain, commonly Ethereum. These projects use their software protocols and smart contracts to further automate and improve financial services.
What is DeFi?
DeFi, otherwise known as decentralized finance, and its users aim to recreate its own version of the financial system without the control of traditional financial institutions such as banks and the government.
This type of disruption is obviously made possible by technology, but how exactly?
In a very basic sense, we can turn to Bitcoin for inspiration when thinking about DeFi. Instead of a central entity such as a bank, a network of computers or nodes confirm transactions on the Bitcoin blockchain.
Many people think of Bitcoin as the new gold standard and use it as a store-of-value investment that helps protect them against inflation.
The Ethereum blockchain is like Bitcoin, but its technology allows other startups to build applications on top. Most of these applications are known as dApps or denaturalized applications. Most of these use cases were pointed out by Vitalik Buterin, the creator of Ethereum, in its whitepaper.
Etherum and its DeFi Applications
Several DeFi applications (dApps) are powered by the Ethereum blockchain protocol aimed to further progress this emerging financial space.
When you program DeFi apps, you pretty much tell it a simple set of rules when it receives money, and then it puts that money to work. These programs, also known as a smart contract, enable trustless interactions, allow transactions to be anonymously executed on the blockchain, and replaces intermediaries like bank tellers.
You can think of a smart contract like you would a vending machine. It simply removes the human interaction involved and relies on the code to do its job. Pretty cool, right?
Decentralized lending platforms
One of the most fundamental aspects of financial services is the ability to borrow and lend money. And DeFi has definitely found a unique path to incentivize both borrowers and lenders to take part.
Decentralized lending happens when you can programmatically take out a loan on the blockchain. Since it’s decentralized, there’s no need to ask your bank for permission to do this and again it relies on smart contracts to carry these transactions out. Some of the most known DeFi lending platforms are Compound and Dharma.
Compound allows users the ability to borrow or lend their crypto. The main benefit of lending your crypto and having your value locked is that you can earn interest which is usually higher than traditional markets. Compound’s interest rates are calculated algorithmically depending on supply and demand of the crypto market.
Like traditional financial services, users who want to take out a loan must put something up as collateral. But because you can’t put your house or any physical assets up as collateral, DeFi lending platforms usually want users to overcollateralize by depositing in more crypto, usually Ethereum (ETH), than what they receive back in stablecoin.
This may not look like a great deal but it is actually incentivized for the borrower as their investment of crypto assets stays exposed to the market even after they borrow. This is a classic example of what takes place with another platform, MakerDAO.
Stablecoins
One of the biggest problems with this emerging financial market is price volatility. As most people know, the price swings that Ethereum experiences day over day lands between 5–10%.
Now imagine if you had to pay back on loan when prices are skyrocketing! That can make it incredibly hard to plan things in the future.
Stablecoins were created to solve this problem and are a fundamental building block of decentralized finance.
Now how did they engineer it to be less volatile compared to other tokens?
By pegging that coin to something tangible like gold or the US dollar. Genius.
So this allows users to transfer value with a reliable price point and it seems to be working. There are more than $15 billion US dollars in stable coin liquidity on the Ethereum blockchain. THAT’S MONEY!
DeFi Trading
Trading cryptocurrencies takes place on decentralized exchanges (DEXs) like Uniswap.
Once again, you don’t have to trust anyone else to hold your crypto assets when using decentralized exchanges because we’re living in the future using a peer-to-peer (P2P) exchange. A P2P exchange refers to the distributed network when computers/nodes communicate and transact with each other. All that’s needed is an internet connection, the parties to agree to deal with each other, and the specific protocol and smart contracts used.
DEX’s are a big part of the future of crypto, yet, there are challenges from regulators who believe that there should be some liability held by DEX’s even though they don’t hold any of the assets that get transacted.
All in all, DeFi is a new and interesting world right before us with some amazing use cases. With a name like that, its hard not to believe in its aim to defy the long-held traditional financial system. Whether you believe in or not, you can be sure that a new frontier is being built to stay by crypto believers.
Are you bullish of DeFi? What are your favorite DeFi apps?
Originally published at https://glenngabriel.com on April 27, 2021.
