In the last 12 years since Bitcoin came on to the scene, cryptocurrencies have exploded in popularity. They have slowly become integrated into our lives, expanding into a trillion-dollar industry and with that size, it’s no surprise they have caused a wave of worldwide financial disruption.
From the birth of cryptography in the 1980s, the match that would start the flame of cryptocurrencies, to the advancements in technology, we have seen many factors that have shaped our present world.
Specifically, the emergence of decentralized finance or DeFi has brought about a lot of changes in the global financial scene, specifically within the crypto space. While the new trend is an interesting one, it is going to change the way we look at cryptocurrencies moving forward.
In this guide we ask some questions and uncover some truths and dig a little deeper to understand DeFi as well as learn more about it. Buckle (NYSE:BKE) up, it’s going to be a bumpy ride!
DeFi: The Trustless Solution
Banks accept cash deposits, issue interest-bearing loans, and pay some of the income they earn to depositors. That’s an excellent example of banks putting their (and your) money to good use. They usually repeat this profit-generating process again and again, with you getting a piece of the action in the form of interest on your savings or fixed accounts. For the past ten years, however, it has been close to nothing: the average interest rate in the United States is just 0.09%.
But for many others, it doesn’t matter because they’re already unable to fully participate in the financial system. 1.6 billion adults in the world remain unbanked, and even those who are banked have little input in how the financial system functions around them. In some ways, therefore, access remains contemporary finance’s problem child.
Until now, that is. Meet DeFi.
Decentralized finance, sometimes known as “DeFi,” is an open worldwide alternative to the limited, controlled and centuries-old traditional financial system that much of the world is familiar with today. Anyone with a smartphone and internet access can use DeFi to put their money to work on their own terms through services like investment, borrowing, lending, and trading.
DeFi, instead of using banks as middlemen, places smart contracts at the center of a peer-to-peer financial system based on open-source blockchains such as Ethereum. It is a system that enables individuals to invest, borrow money, move money overseas, and basically accomplish everything (related to digital money) without having to leave their homes.
DeFi can be compared to a bank with many businesses but no physical locations. It enables trading, streamlines exchange operations, and pays interest on investments without the need for a physical office or human personnel.
This financial system is based on a decentralized blockchain network. DeFi is inextricably linked to cryptocurrencies and blockchains. When you communicate with a DeFi protocol, you’re just engaging with software and nothing more. Blockchain and other open technologies such as artificial intelligence (AI), machine learning, and smart contracts to name a few, can be used to create a decentralized system.
So, in simple terms, DeFi essentially aims to eliminate the necessity for middlemen or other forms of intermediary or third-party interference in transactions.
For instance, when it comes to opening an account or taking out a bank loan, an individual must go through a long list of procedures (in centralized finance) such as submitting their original IDs, proof of address, Biometric IDs like fingerprints, and so on.
With DeFi, on the other hand, a person is not required to provide any of this information (or meet these KYC requirements) while setting up an account. Instead, once a DeFi app account is created, a user can proceed to trade, and lend without necessarily having to submit any form of ID. More so, all of the onboarding process is completed without any third-party interference.
Furthermore, DeFi has introduced a new concept called Open Banking. Every DeFi user has their own wallet. The DeFi ecosystem’s financial transactions are only possible with this wallet, which gives users access to private crypto keys.
If you are wondering, a DeFi wallet is similar to a physical wallet, except that it contains digital currency and not fiat. You can send cryptocurrencies and make other financial transactions with your DeFi wallet.
Infrastructure-wise, the Ethereum blockchain network underpins the majority of DeFi applications, albeit, there are several other blockchain networks like Solana, Cardano, etc., on which DeFi applications can also be hosted. Ultimately, DeFi brings a level of openness to the financial system that was previously unavailable in centralized finance.
How Did DeFi Start?
In an August 2018 Telegram discussion involving Ethereum engineers and entrepreneurs including Inje Yeo of Set Protocol, Blake Henderson of 0x, and Brendan Forster of Dharma, the name DeFi (short for decentralized finance) was coined.
This group of engineers was debating the name for the growing trend of open financial apps built on Ethereum. Some other name suggestions that came up alongside DeFi include Open Horizon, Lattice (OTC:LTTC) Network, and Open Financial Protocols.
However, following a lengthy chat, DeFi became a preferred choice for many including Henderson, who claimed the acronym worked effectively since it comes out as “DEFY.” One could easily assume that he meant “DEFY” centralized finance.
DeFi Features
DeFi is characterized by many attributes depending on the context or use case. However, some of the prominent features of the emerging innovation include the following;
- Non-Custodial
In addition, users are the only ones who have access and ultimate control over their wallets. DeFi applications are referred to as “non-custodial” since app developers/creators do not have custody of your assets; instead, you do.
- Openness
- Transparent
- Decentralized
On top of this core foundation of decentralization, DeFi systems are designed to be regulated by a community of users (rather than centrally controlled). As a result, end-users have complete control over their financial applications, further allowing them to participate in key decision-making processes that promote development and success, such as proposing network modifications.
How does DeFi work?
Decentralized finance makes use of blockchain technology, which is also used as the underlying infrastructure for cryptocurrencies. Blockchain essentially refers to a distributed and secure database or ledger where transactions are being recorded.
Decentralized applications (dApps), however, are hosted on blockchain in order to facilitate transactions, which are subsequently stored in various blocks on the blockchain. Prior to storage, each transaction is validated by other users who are addressed as validators/miners/nodes. If all of the verifiers agree on a transaction, the block is closed and encrypted, and a new block is generated containing information from the preceding block.
The info in each subsequent block “chain” is interlinked together, explaining the ‘blockchain’ title. There is no way to alter a blockchain because the information in previous blocks cannot be changed without affecting subsequent blocks. The secure nature of a blockchain is provided by this concept, as well as other security protocols.
DeFi Financial Products
One of the basic tenets of DeFi is peer-to-peer (P2P) financial transactions. In a P2P DeFi transaction, two parties agree to trade cryptocurrency for products or services without the involvement of a third party.
To fully understand this, imagine the process of getting a loan in centralized finance. You’d have to apply for one at your bank or another lending institute, which doubles as a liquidity pool for other depositors. On the contrary, DeFi allows both lender and borrower to interact directly.
DeFi peer-to-peer lending does not rule out the possibility of interest and fees. However, because the lender might be located anywhere in the globe, you’ll have a lot more possibilities.
In DeFi, you’d submit your loan requirements into a decentralized financial application (dApp), and an algorithm would match you up with peers that matched your requirements. After that, you’ll have to agree to one of the lender’s terms via smart contracts in order to get your loan.
The transaction is subsequently recorded on the blockchain, and you’ll get your money after the consensus process has verified and approved your loan application. The lender can then begin collecting payments at the agreed-upon intervals from you. When you make a payment using your dApp, it goes through the same blockchain procedure; the money is then transferred to the lender.
Investing strategies on DeFi protocols
The following are some of the most popular and well-used types of decentralized financial tools:
- Decentralized Exchanges
Consider a liquidity pool to be a market for two or more tokens. When someone contributes tokens to the pool, they become eligible to receive trading fees equal to their pool share. When someone else buys from the market, a smart contract determines the exchange price based on the ratio of tokens in the pool, and trading fees are then distributed among liquidity providers.
- Lending & Borrowing
- Asset Management
- Insurance
While exchange hacks are improbable with smart contracts, coding flaws do occur occasionally, or a protocol may simply run out of liquidity. DeFi insurance, like Nexus Mutual’s, can help to limit these risks by acting as a protection or extra shield for individuals’ tokens and transactions.
- Stablecoins
- Decentralized Collaboration
- Yield Farming
Users must pay fees to access these marketplaces, which are intended to compensate liquidity providers for staking their own tokens in the pool. The Ethereum platform is where the majority of yield farming takes place.
As a result, the payouts are in ERC-20 tokens. While lenders can spend the tokens however they like, the majority of them are now speculators searching for arbitrage possibilities by profiting from the token’s market swings.
- Prediction Market
DeFi: The Future Today
The evolution of decentralized finance is still in its early phases. For starters, it is unregulated, which means that infrastructure failures, hacks, and frauds continue to plague the ecosystem.
Current laws are based on the concept of distinct financial jurisdictions, each with its own set of laws and regulations. The potential of DeFi to conduct borderless transactions raises important problems for this form of regulation. Who is in charge of investigating a financial crime that occurs across borders, protocols, and DeFi apps, for example? Who would be in charge of enforcing the rules, and how would they do so?
The open and decentralized nature of the decentralized finance ecosystem may also cause issues with present financial regulation. System stability, energy requirements, carbon footprint, system updates, system maintenance, and hardware failures are among the other problems.
Before DeFi may be used safely, several concerns must be addressed and various degrees of solutions implemented. Where this is achievable, banks and businesses will almost certainly find a way to get into the system, if not to control how you access your money, then at the very least, to profit from it.
DeFi’s allure stems from the lack of a central bank or third-party intervention. You have complete control over your assets. DeFi eliminates the need for middlemen and instead promotes open-source collaboration while maintaining security. Traditional – or centralized – financial instruments are adapting at breakneck pace in the DeFi environment, so it won’t be long now. The goal for DeFi is to create independence from huge banks and governments; DeFi proponents want a system that is not run by Uncle Sam and it seems they may soon have it.
Collateralization in DeFi
Collateralization simply describes a situation where a borrower pledges an asset as a guarantee to the lender that the money will be returned, especially in the event that the borrower defaults on the loan terms.
For instance, the possibility that a borrower will default on a loan or any other type of financial obligation cannot be overruled. Hence, lenders may compel a borrower to put up a valuable asset as collateral, which the lender has the right to seize if the loan is defaulted on.
In conventional finance, real estate, vehicles, art, jewelry, and stocks are typically used when securing a loan. Let’s say you want to borrow $100 from Josh, your neighbor, he then requires you to hand over your car as collateral in case you can’t pay.
In another instance, assume you’re in the market for a new home. You, like most people, don’t have enough money to pay for the home outright, so you take out a mortgage to cover the costs. Luckily there are banks and mortgage houses willing to lend you the money.
In this situation, the lender would demand you use the underlying property as collateral for the loan. In exchange, the lender would provide you with a mortgage. Traditionally, mortgages have been collateralized to the tune of 70% to 90% of the property value. This reflects on your credit score.
In the DeFi space, the above scenario is also applicable. Essentially, collateralized loans are the backbone of open lending protocols in decentralized finance. No one has a credit score or any type of official identity linked with the loan they are taking out since DeFi enables open pseudo-anonymous funding.
As a result, most DeFi lending applications, like mortgages, will need borrowers to put up collateral as a means of holding them accountable for repaying their debt. The major distinction between traditional collateralization and DeFi collateralization (as it now exists) is that collateralizing a loan on MakerDAO or Compound requires the borrower to over-collateralize the loan.
This signifies that the collateral’s worth will be more than the loan’s value in order to obtain the loan. As such, borrowers must put up at least 150% of the loan value as security for MakerDAO; however, this might not be the case all the time as some protocols only require the equivalent of the borrowed amount.
That said, if you wanted to take out a 100 Dai loan on MakerDAO, you would need to put up at least $150 in Ether as security. You may select your collateralization ratio, which determines the liquidated price and the quantity of Dai you’ll receive. The liquidation price is the price of Ether at which your loan’s worth exceeds the minimum collateralization ratio’s value.
Given that the minimum collateralization ratio is 150% and you collateralized your loan with $150 ETH for 100 DAI, any decline in the price of ETH below $150 would result in the 13% liquidation penalty being applied to your loan. With this in mind, most people would collateralize their loans in excess of 200%. This is done to provide investors with some cushioning in the event of market volatility and to avoid the liquidation penalty.
Conclusion
The ultimate goal of decentralized finance is to provide financial services that are not reliant on existing financial and political structures. This would make the financial system more transparent, perhaps avoiding worldwide precedents of censorship and prejudice.
While the notion of decentralization is intriguing, it is not for everyone. It’s vital to identify the use cases that are most suited to the capabilities of blockchains in order to build a relevant stack of open financial products.
If DeFi succeeds, it will hand power over to the open-source community and individual users, rather than large centralized corporations. It will be assessed whether DeFi will result in a more efficient financial system once it is ready for widespread usage. However, the fact remains that DeFi is here and it seems it’s here to stay, but will it achieve this goal? Only time will tell.