DeFi or Decentralized Finance is one of the hottest topics in the crypto world. By understanding the concept of DeFi, you will be one step ahead in terms of technological knowledge. In this guide to DeFi, we will take you to a closer look at what DeFi is and how it works.
05 October, 2020 | AtoZ Markets – We all know that traditional financial markets are centralized. In the traditional markets, Central authorities issue the regular currency to drive the economy for every trade like the government and banks. Therefore, the authority holds power to manage and regulate the supply of such currencies. Moreover, we pass the control of our assets to various financial organizations like banks to get higher returns. There are some problems regarding centralized currency systems.
What if the Bank prints more money to overcome a financial crisis?
Did you know the Venezuelan government printed huge amounts of money during the oil price drop and resulted in inflation exceeding 1,000,000%? What if your government does such things with the residences? How will you fight inflation?
Let’s unlock the answer!!
In terms of investing, you may put your trust in financial advisors to advise you on mutual funds, and share the market to give you a better return. The return would be higher, but there might be an additional market risk that may put your investment unsecured.
The point to note is that your money in any investment is somehow at risk as long as it is handled by a third party. The centralization of finance underpins the global economy. However, it is not an open system. Therefore, the solution is to decentralize the currency system.
What is Decentralized Finance (DeFi)?
DeFi is brief for Decentralized Finance. Decentralized Finance includes digital assets, smart contracts, protocols, and Dapps. In terms of liability and amount of development, Ethereum is the first choice for the DeFi application. However, that doesn’t mean it’s the sole blockchain platform.
You can think of DeFi as an open financial ecosystem. In this system, you can build various small financial tools and services within a decentralized manner. Since these are blockchain specific applications, you can combine them, modify, and integrate consistently with your needs.
What Decentralized Finance (DeFi) Offers?
DeFi is offering you take control over your own assets. Many new-age banks and fintech firms promise to supply more control to the users. However, you still trust them to manage your funds. On the other hand, the target of DeFi is to offer you full control of your assets using decentralization and blockchain technology. Additionally, many developers of monetary apps are adopting these open-source protocols to make transactions through decentralized exchanges.
The fact that each one protocol is open-source, and it allows anyone to create new financial products. Developers across the world can collaborate with one another to make new products with faster innovation and a secure network.
Anyone can store, trade, and invest their assets in blockchain securely. Therefore, it earns a way higher return than from the normal economic system. Since there are no intermediaries handling your asset, you’ve got complete control over your investments.
Difference between DeFi and Traditional Centralized Finance
What differentiates DeFi apps (Dapps) from their traditional banks or financial institutes?
- Within DeFi, no institute or business manages the core operation. Instead, the rules are written in code or a smart contract. After deploying the smart contract to the blockchain, DeFi Dapps can run themselves without any human intervention.
- The code or smart contract is transparent on the blockchain. Therefore, anyone can see and audit the process. This builds a different kind of trust with users as anyone can understand the contract’s functionality. Moreover, all transaction activities are available for anyone to view.
- Dapps were created for global perspectives. Therefore, whether you’re in Texas or China, you can access the same DeFi services and networks.
- “Permissionless” to create, “permissionless” to participate. Anyone can create DeFi apps, and anyone can use them. There are no gatekeepers or accounts with lengthy forms with a lot of information. Therefore, users can interact directly with smart contracts through their crypto wallets.
- Dapps have Flexible user experience. So you can use a third-party interface, or you can build your own.
- Moreover, you can build new DeFi applications or compose by combining other DeFi products like Lego pieces. Some of the examples are- stablecoins and decentralized exchanges.
The DeFi Ecosystem and Its Products
There are many products on the DeFi. These are known as open finance since it’s an ecosystem where blockchains with conventional financial structures.
Let’s go through some of the DeFi products.
Open Lending Protocols
This is a digital money lending platform built on a blockchain. Open Lending Protocols is most popular among other open finance sectors in recent years.
Just like a bank, users deposit their money in the open landing protocol. Therefore, they earn interest when someone else borrows the digital assets. Instead of third parties, the smart contracts dictate the loan terms and distribute the interest. Due to the transparency of the blockchain, the lender earns higher returns with minimizing risks.
A perfect example of an open landing protocol is the Ethereum blockchain. Moreover, there are other advantages of open landing protocol as mentioned below-
- It has an integration with digital asset borrowing and landing
- Collateralization of digital assets to save from defaulting the loan
- Instant settlement of transactions with secured lending methods
- No credit checks
MakerDAO is the most prevalent decentralized lending protocol. We can observe it as the firm has proposed multiple stability fee raises to maintain parity with its Dai-USD price peg.
Other examples of such protocols are Dharma and BlockFi. These allow users to borrow and lend digital assets.
Unlike cryptocurrencies with a lot of volatility, stablecoins are blockchain-issued tokens that hold a specific value. This happens by pegging it with fiat currencies like the US dollar. Moreover, Stablecoin assists collateral in accommodating the price variation. There are several types of stablecoins. Let’s have a look at a glimpse of these.
- Fiat-Collateralized stablecoins are the most popular. These coins store their value in fiat currencies like the US dollar or Euro. Therefore, these are supposed to be redeemable at a 1:1 ratio with other pegged currency.
- Crypto-Collateralized stablecoins are backed by crypto assets. They basically rely on trustless issuance. These also maintain 1:1 peg against assets through various methods like over-collateralization and incentives.
- Non-Collateralized stablecoins are neither centralized nor over-collateralized with cryptocurrencies. This system supplies more tokens with increased demand. However, the price of each token is lowered, and vice versa to maintain a stable peg.
Exchange and Open Marketplaces
Decentralized exchanges have peer-to-peer transactions of digital assets between two parties on the blockchain. The whole process does not require sign-ups, identity verifications, or withdrawal fees.
In recent years, some decentralized exchanges (DEXs) and P2P marketplaces have been introduced. These are in the early stage of adoption. Therefore, these do not have a substantial volume due to the small number and non-friendly User Interfaces.
Like Centralized exchanges, DEXs also employ some highly innovative methods like atomic swap or non-custodial methods. By using these users can exchange one asset for another with a minimal settlement of risk and time. Although many DEXs are decentralized and non-custodial, it is better to do your own research while using them.
Issuance and Invest Management Platforms
There are many platforms within this sector. A major portion of issuance platforms is the security token market. This platform includes exchanges like ZERO from Overstock, which acts as an issuance medium.
For example, Polymath and Harbor are two such security token issuance platforms. These platforms provide the necessary framework, and resources to launch tokenized securities on a blockchain. They have their token contracts for securities like ST-20 and R-Token. These tokens allow them to automate compliance and customize trade parameters. Additionally, they integrate with various service providers like custodians, broker-dealers and legal entities to assist them.
Conclusion- What is the Future of DeFi?
As we know, money and finance are the same forms since the dawn of human civilization. However, Cryptocurrencies are the latest digital avatar. Therefore, in upcoming years, we may see every financial service to rebuild themselves for the crypto ecosystem.
The first generation of DeFi relies heavily on collateral as a safeguard. Despite the present identity and credit systems, a decentralized identity may have both universal and privacy-preserving.
In the future, we may expect crypto wallets to be the portal to all your digital asset activity. Imagine a dashboard that shows what assets you own with how much you have locked up in loans, pools, and insurance contracts.
Cryptocurrencies are bringing money online. Therefore, we are watching a quantum leap in what is possible when it comes to the functionality of currency.
The Decentralized Finance (DeFi) system will be the first to catch up with today’s financial services industry. However, over time, it’s hard to predict what innovations may come to build financial services to make it more secure and trustable.
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