The term DeFi may need no introduction in the world of cryptocurrencies. Decentralized finance— financial services without the need of an intermediary or a regulatory body— represents the sum of all that cryptocurrencies and the blockchain stand for. Satoshi Nakamoto created Bitcoin to replace traditional money and remove all of its restrictions. With Bitcoin, people could send and receive money at any time of the day, to any location in the world, and pay for goods and services swiftly with little or no delays. Bitcoin represents the earliest form of decentralized finance (DeFi), with several institutions presently accepting it as a mode of payment. Recently, El Salvador became the first country to accept Bitcoin as an official legal tender.
Since interacting with DeFi requires substantial knowledge of how it works, here is everything you need to know about decentralized finance:
DeFi represents the availability of financial services like payments, deposits, withdrawals, lending, borrowing, and saving without regulation by an intermediary or a centralized organization. Although the Bitcoin network remains the earliest form of DeFi available, it could not go beyond supporting payments and storing. However, recent events suggest that Bitcoin will soon begin to support the onboarding of Decentralized Applications (dApps), which is the final piece of it truly becoming decentralized finance.
Developers began to build alternative blockchains to onboard the true potential of decentralized finance to the crypto space. Ethereum was the first of the alternative blockchains created. Ethereum was an upgrade on Bitcoin as it could support decentralized finance. It had the security advantage of Bitcoin and could process transactions faster. Ethereum’s creation signaled the expansion of DeFi in the crypto space.
Today, several other blockchain ledgers support DeFi applications. Analysts have touted Solana as a possible Ethereum killer, and blockchains like Avalanche, Polkadot, Polygon, and Binance Smart Chain also support the deployment of decentralized applications for DeFi.
How does DeFi work?
If you eliminate intermediaries, brokerages, and regulators from financial services, how do you see that there are no defaults and no one cheats the system? The answer is a simple one:
You program the entire operation.
Decentralized finance achieves its potential of decentralization through the use of smart contracts. Bitcoin could not support DeFi fully because no one could write code on it. Ethereum removed that obstruction by being an open-source blockchain on which developers can write all kinds of code and build applications. In DeFi, smart contracts govern and regulate financial activities, so there is no need for human intervention.
Smart contracts opened up the possibility for people to carry out all financial activities on the blockchain. People could borrow cryptocurrency, lend to others, save to earn interest, provide liquidity through deposits and transact in stablecoins.
Stablecoins, in particular, was a whole new concept entirely that attracted users to DeFi. Cryptocurrencies are subject to high volatility. Hence, they could be problematic as people could send a particular coin’s value, and its value would have changed by the time the receiver gets it. Stablecoins were distinct from regular cryptocurrencies as they were pegged to the value of real-world currencies, removing the risk of volatility–hence the name ‘stablecoin.’ The USD Coin (USDC), a stablecoin built on Ethereum, is pegged to the US Dollar at a ratio of 1-1.
Developers called the smart contracts protocols, and they formed the basis of decentralized applications (dApps).
DeFi combines an open-source blockchain, smart governance contracts, and decentralized applications for interaction with smart contracts. The dApps offered features that were alike with traditional financial services in the real world. Some financial products available on DeFi include:
Cryptocurrencies represent an alternative and borderless payment method for goods and services. With the obstruction of brokers, exchange rates, intermediaries, and financial institutions, cryptocurrencies offered a whole new way of sending and receiving money.
Most of the monies deposited in traditional banking institutions provided liquidity for the banks to process transactions daily. In DeFi, users provide liquidity by pooling pairs of cryptocurrencies in a liquidity pool. The liquidity pool function is found chiefly on DApps that support the trading of crypto tokens–decentralized exchanges or DEXs. Based on the amount of liquidity a user provides and the exchange rates between the liquidity pair, the liquidity provider earns impermanent loss or profit. Liquidity providers also earn fees charged on exchange transactions, and sometimes, new tokens (yield farming is a feature that lets users earn new tokens by providing liquidity).
Lending and Borrowing
Another feature of DeFi that you need to know is the lending and borrowing service. In traditional finance, accessing loans is a burdensome task, with so much red tape that people are discouraged from the start. DeFi platforms like Celsius and MakerDao allow users to borrow cryptocurrencies by providing collateral in the form of another cryptocurrency they already own. Other DeFi platforms like Aave offer loans that users can access without collateral called flash loans. These kinds of loans are borrowed and repaid in a single transaction, hence the name. Users can also lend their cryptocurrencies directly or in pools and earn interest proportional to the lent value. The Annual Percentage Returns (APR) determines the interest.
Crypto projects have utilized the crowdfunding feature on some dApps to raise seed funding for development. Crypto launchpads and starter dApps are some DeFi applications that support crowdfunding.
Decentralized exchanges are DeFi applications where cryptocurrencies are exchanged directly for one another. Automatic market makers (smart contracts that do the job of market makers) facilitate the exchanges. DEXs, as decentralized exchanges are called, are an essential feature of DeFi that you need to know about. Some decentralized exchanges, like dYdX, also offer advanced trading features like limit orders and leverage trading.
Interacting with DeFi applications requires attentiveness and technical knowledge. Also, the open-source nature of smart contracts means that if they have bugs, they could be exploited.
Before interacting with any DeFi application, proper research is advised.