DeFi: The Ultimate Beginner’s Guide to Decentralized Finance
At the heart of cryptocurrency, lies the incredible history of technological advancements that dates back to the 1980s. Even with Bitcoin’s spectacular performance, its financial adoption seemed slow, especially due to its volatile nature. And then came DeFi. It became the latest buzzword. But what it actually meant, was a question asked by many! Decentralized finance, although related to Bitcoin, is not the same. Let’s take a deeper dive to understand better.
What is DeFi?
DeFi (pronounced dee-fye) is short for ‘decentralized finance’. It refers to all the financial services provided on public blockchains, essentially Ethereum. Just like banks, you can borrow, lend, earn interest, and more with DeFi, but when compared to banks, DeFi is faster and doesn’t require paperwork or a third party. The markets are open round-the-clock with DeFi, and there is no centralized authority to stop payments or deny you access to anything, at any given point in time.
‘DeFi’ – Who Coined the Term, When & Where
One can argue that the term ‘DeFi’ has been around ever since the grand launch of ‘Bitcoin’. However, the term got coined during a telegram discussion amongst the Ethereum engineers and entrepreneur including Brendan Forster (Co-Founder and COO- Dharma Labs), Blake Henderson (Product Manager- 0x Labs), and Inje Yeo (Co-Founder & CPO- Set Protocol) in August 2018. They were attempting to come up with a name for their movement of these new types of financial services that would be automated and built on a blockchain with a capability of displacing established banks. Many names were proposed including Open Horizon, Lattice Network, Decentralized Finance Developers. Blake Henderson stated that DeFi worked well as it “comes out as DEFY.” And that’s how ‘DeFi’ came into existence.
How Does DeFi Work?
DeFi aims to deliver all the financial services that are already available such as loans, interests, payments using decentralized technology. It employs the same blockchain technology as cryptocurrencies. Simply put, blockchain is a distributed ledger or database. They are specifically known for their role when it comes to cryptocurrencies. Transactions are recorded in blocks on the blockchain and subsequently validated by other users. Imagine sending money to a friend and that transaction gets timestamped permanently in a digital ledger.
In layman’s terms, DeFi transforms the existing financial industry by changing the ‘how’ rather than modifying the ‘what’. To achieve it, DeFi employs smart contracts and blockchain. Smart contracts are executable codes that interact with the blockchain based on rules. These smart contracts enable DeFi by executing transactions among the participants whenever a predefined condition is met. Through DeFi, smart contracts replace various trusted intermediaries such as banks and brokerage firms.
How Does DeFi Differ From CeFi?
CeFi, as you might have guessed by now, stands for Centralized Finance. The fundamental concept behind CeFi is to provide the benefits of DeFi as well as the conventional financial services. Before DeFi came into existence, CeFi was all the rage. Centralized Finance allows you to borrow money, buy & trade cryptocurrencies and earn incentives through a crypto debit card and more! Examples of CeFi companies include crypto giants like Binance and Coinbase. Users need to create accounts on these platforms to utilize it. They can perform every functionality via this platform itself.
Now that you have a grasp about DeFi and CeFi, let’s take a look at how they differ from each other. When it comes to CeFi, the exchanges are responsible for protecting the assets of any given user, but in case of DeFi, the smart contracts guarantee that transactions are carried out in a secure way and successfully. In layman’s terms, with DeFi, the users are in full control of their valuable assets whereas, with CeFi, the centralized exchanges can set limits on the user and even block them from performing trading. There are many such differences, but the major one is the fact that DeFi is trutless, meaning the users need not trust each other in order to perform transactions, while CeFi is not!
Use Cases of DeFi
At this point, you might be wondering how and where people are using DeFi. Well, we have got you covered. Let’s check out some of the prominent use cases of decentralized finance.
To become a reality, the Metaverse requires various components such as NFTs(that serve as identities), on-chain credit scoring, and DeFi. These components come together to generate a virtual environment in which you can reside digitally. For the Metaverse to work effectively, a trustless financial system is required. This is where DeFi enters the picture. Decentralized finance offers the crypto-decentralized framework required by the Metaverse to house its currencies and economy, allowing users to earn, spend, borrow, lend, or invest without the need for a central authority.
DEXs, or decentralized exchanges, are decentralized counterparts of centralized exchanges (CEXs). Dex’s applications range from asset trading to derivatives trading and are not confined just to cryptocurrency trading. The danger of hacking is negligible since the assets are not held or managed by the decentralized exchange.
Stable coins are backed by valuables such as gold, fiat currency, or many other cryptocurrencies, and they assist in reducing volatility in the cryptocurrency market. Stable coins are used in the DeFi ecosystem for lending, borrowing, payment transfers, and other purposes.
Users trade value on prediction-based platforms by forecasting the result of future events. Such transactions are automated using DeFi platforms. These projects are decentralized and peer-to-peer, yet they also allow worldwide access. DeFi projects allow users to wager on events such as gaming and sports.
The most advantageous effect of DeFi is total control and ownership of one’s assets. Several DeFi initiatives enable users to manage their assets, such as purchasing, selling, lending, and even earning income. On the DeFi platform, there is no need to share any personal data or sensitive information, like one would with their bank or credit card company. Users can keep such private and sensitive data and information on their personal devices using DeFi initiatives such as D-Wallet.
Insurance is one of the largest financial industries that has already proven to be a key DeFi use case. The present insurance system is clogged by mountains of paperwork, outdated audit systems, and archaic insurance claim procedures. All of the present system’s shortcomings can be resolved with the effective adoption of smart contracts.
Lending & Borrowing
Borrowing and lending protocol is an important DeFi use case. The DeFi ecosystem is better suited for peer-to-peer (P2P) borrowing and lending initiatives. Several DeFi projects concentrating on this specific use case have already hit the market. These initiatives have their own interest-based borrowing and lending mechanisms.
DAOs (Decentralized Autonomous Organizations) are the DeFi equivalent of centralized financial institutions, making them one of the cornerstones of decentralized finance use cases. Centralized financial entities play a significant role in the conventional system. These companies function as administrative entities that conduct key financial operations such as fundraising, asset management, governance implementation, and so on.
Major DeFi Protocols
DeFi protocols are basically self-governing programs that have been created to resolve specific issues in the conventional banking sector. More than half of the world’s population lacks access to a bank account, which DeFi protocols aim to alter. Let’s check out some of the most notable DeFi protocols that have gained popularity in the DeFi ecosystem.
AAVE is a popular and well-known lending protocol in the DeFi ecosystem. It uses the native token AAVE for protocol security while also allowing users to participate in protocol governance. Users can earn AAVE rewards by staking AAVE tokens using the Safety Module.
It is a collection of Ethereum blockchain protocols that let users maximize their revenues on crypto assets through loan and trading services.one of the emerging decentralized finance (DeFi) projects, delivers its services entirely through code, eliminating the need for a middleman such as a bank. To do this, it has created a system of automatic rewards based on its YFI cryptocurrency.
Synthetix (SNX) is a protocol for issuing synthetic assets on Ethereum. Synthetic commodities such as gold and silver, synthetic cryptocurrencies, synthetic inverse cryptocurrencies, synthetic cryptocurrency indexes, and synthetic fiat currencies are all supported by Synthetix. The platform introduces non-blockchain assets into the crypto environment, resulting in a more developed financial sector.
A list of DeFi protocols would be incomplete without including Compound, the primary lending protocol. COMP is the protocol’s native token, which users can earn by lending or borrowing assets. COMP is incredibly beneficial for the governance of major protocol choices due to the flexibility of voting and delegation via the Compound Governance Dashboard.
Uniswap is another notable inclusion among the most popular DeFi protocols in use today. It is now one of the most crucial decentralized exchanges in the DeFi space. Users can earn the native token ‘UNI’ by providing liquidity to specific pools. In September 2020, Uniswap introduced a scheme called “Universal Basic Income,” which gave 15% of its supply to past consumers.
The Kyber Network is another intriguing example amongst leading decentralized exchanges, with the ability to capture value via native tokens. Kyber Network Crystal (KNC) is the native token on the Kyber Network. Users can use their KNC tokens to get the right to vote and delegate on critical choices such as the implementation of essential governance mechanisms.
Sushiswap is an Automated Market Maker (AMM) and a lending protocol that uses the ‘SUSHI’ governance token. Liquidity providers can earn the SUSHI token by providing liquidity to certain pairs on Sushiswap. Users can stake SUSHI tokens by utilizing the Omaske bar to earn protocol fees and issue protocols.
The Future of DeFi
DeFi’s future seems bright, from cutting out the middleman to converting basketball video into digital assets with monetary worth. That’s why people like Dan Simerman, the head of financial relations at the IOTA Foundation, a DeFi research and DeFi Development Company , view DeFi’s promise and potential as far-reaching. DeFi is rapidly changing and expanding to replicate the traditional financial services ecosystem, whether through decentralized exchanges, lending and borrowing of various asset kinds, or insurance products. This new type of decentralized financial technology will eventually influence the future of centralized finance companies, with DeFi perhaps perceived as a cheaper, faster, and more relevant alternative.
Are you on the lookout for DeFi-powered solutions? Reach out to one of the leading DeFi Platform development companies – Clarisco Solutions, today!