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A Guide to DeFi: Decentralized Finance for Newbies

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Cryptocurrencies such as bitcoin were created to make it easy for people, wherever they are in the world, to exchange value with each other. Out of this desire was born a new movement, known within the crypto industry as Decentralized Finance, or DeFi for short. Some even prefer to use the term open finance.

The DeFi movement takes the promise of cryptocurrencies a step further but still builds on the underlying technology powering cryptocurrencies, albeit with a few customizations.

DeFi revolves around applications built on top of the blockchain, a decentralized ledger that publicly keeps track of all transactions on it.

There are now different kinds of blockchains, ranging from public to private. At the heart of DeFi is the desire to automate the majority of tasks in the financial industry, thereby cutting out middlemen. It’s all about control and transparency. But still, let’s get to what decentralized finance is.

What is decentralized finance (DeFi)?

Decentralized finance is an ecosystem of financial applications built on top of decentralized ledgers, better known as blockchains. Because of the way the blockchain is structured and intended to be used, this has numerous ramifications for the financial industry.

Blockchain is a technology created to work without a central authority. And this is what DeFi is all about.

To take the definition of DeFi a little further, decentralized finance is regarded as a system building a transparent, open, and permissionless financial services network that runs without the need for a central authority.

DeFi users interact with each other through decentralized applications (Dapps) running on peer-to-peer (P2P) networks.

The current financial system is selective. It excludes some people while also making it harder for others to access the services. In this instance, DeFi can be considered to be an upgrade of the current financial system, but with a focus on providing financial accessibility to all the people in the world.

The success of DeFi will potentially lead to the creation of new financial markets and products.

Some of the concepts of DeFi may initially sound like an over fetched script from the future. Imagine two people from different parts of the world negotiating a loan deal without the need for a bank or intermediary. It may be too much to imagine now but it is not impossible.

Smart contracts and Dapps in DeFi

A decentralized app (Dapp) is an application built on a P2P decentralized network maintained and controlled by all members on the network rather than a single entity.

The main characteristics of Dapps are:

  • Open-source – the source code should be available for everyone to see. No single entity can lay claim over the source code.
  • Decentralization – everything related to the Dapp should be stored on a decentralized blockchain protocol. This shields the app from the dangers of being controlled by a single authority.
  • Consensus algorithm – they need to have a consensus algorithm.
  • Incentivization – entities responsible for maintaining the blockchain protocol must be rewarded for their work.

Bitcoin is the first true example of decentralized finance. However, it is limited in design and this led to the creation of Ethereum, an alternative blockchain platform with extended capabilities.

At the heart of Ethereum are smart contracts. Smart contracts are pieces of computer code or programs that enforce a contract if pre-determined caveats are met. The contracts are enforced digitally without the need for third parties or middlemen.

Ethereum’s smart contract ability made a go-to-platform during the 2017 initial coin offering (ICO) boom. A number of many competing blockchains have been created to rival Ethereum’s dominance. Even then, Ethereum is still a major driver of the DeFi movement.

Differences between DeFi Dapps and traditional banking apps

What differentiates DeFi’s decentralized applications from traditional banking apps that we are accustomed to?

  1. Dapps, just as their name suggests, are decentralized. This means that they are not managed by a single authority or its employees. Instead, it relies on computer code bundled into smart contracts. Once the smart contracts are running on the blockchain, they operate without the need for human interference. From time to time, developers will be responsible for updating the Dapps or fixing bugs but they don’t interfere with the execution of the digital contracts.
  2. The code for Dapps is transparent and available for anyone to audit it. It builds trust amongst users as the community has the right to understand the conditions written in the contracts or discover hidden bugs. The transactions are public, which means anyone can view them. This can raise privacy questions but the transactions are not directly tied to one’s identity.
  3. DeFi applications do not subscribe to the limitations of geographical boundaries. Dapps are global and work the same way irrespective of which country you are from. For the same Dapp, people in Africa, Asia, Europe, the Middle East, and the Americas all have access to the same services. However, access to these services may be limited by local regulations but all things fair and square, DeFi apps are accessible to everyone with an internet connection.
  4. Dapps are permissionless. You don’t need permission from anyone to create a Dapp, and you certainly don’t need permission to use them. In the legacy finance world, there are gatekeepers and lots of red tape to go through. Dapp users only interact with the smart contracts in their digital wallets. Nothing complicated at all.
  5. Dapps offer flexibility in user experience. If you don’t like a Dapp’s interface, you can build your own or make use of a third-party interface.
  6. Interoperability – DeFi applications can be built by bundling other DeFi products together.

DeFi growth in the crypto sector

DeFi, just like the broader cryptocurrency industry, is still in its nascent technologies. New metrics have been implemented to measure the growth of the DeFi movement. At the moment, “ETH locked in DeFi” is the new method of measuring traction of this financial movement. Whether this is correct or not remains to be seen. But until the new metric is found, this is what we will go with.

According to DeFi Pulse, a service that tracks the growth of the emerging sector, about $237 million was locked in DeFi on Jan. 31, 2019. Within a space of one year, this value has parabolically surged to around $843 million.

defi

The growth of the DeFi movement has become a cornerstone area for Ethereum as more than 100 projects were building decentralized apps in 2019. The growth of Ethereum DeFi has been clear despite Ether’s price taking a beating in 2019.

According to some reports, Ethereum’s price depreciation has been largely due to ICO treasuries being offloaded. This, of course, does not mean that the sell-off has been the only reason behind Ether’s price decline.

DeFi will likely have an impact on Ether price if it starts to attract new people and not those that have been ‘HODLing’ Ether for a couple of years.

Introducing DeFi concepts and use cases

The scope of DeFi use cases is as wide as the financial industry. And could potentially create new financial products as well. Here are some concepts and use cases for the DeFi movement:

Stablecoins

Stablecoins are cryptocurrencies pegged to other assets to ensure their stability. They were designed to curb the volatility associated with cryptocurrencies. They act as a bridge between the crypto industry and the traditional world where fiat currencies and assets such as precious metals have a stable price.

The volatility in crypto is not bad. It is only bad in certain instances. Stablecoins were then created to offer the benefits of cryptocurrencies but without the volatile side effects. The majority of stablecoins are backed by the USD or gold. In theory, a stablecoin can be backed by any fiat currency, asset or commodity.

The stablecoin project Maker is part of the DeFi movement. Each stablecoin, known as Dai, is pegged on par with the USD and backed by crypto collateral. The Maker Oasis Dapp allows you to create your own DAI stablecoin. This is one of the major attributes of the crypto industry; anyone can create a token without any hastles.

But Maker is a lot more than a stablecoin project. It is some sort of a decentralized central bank. Those who hold separate MKR token have the right to vote on important decisions such as the stability fee. In a way, this is akin to how central banks, more specifically, the US’ Federal Reserve votes on the Fed Funds rate.

According to DeFi Pulse, Maker dominates the decentralized finance movement the same way that bitcoin dominates the crypto market. Maker’s dominance (based on the Total USD Value Locked in DeFi) of the DeFi sector sits at 56.81 percent.

Maker DeFi Market dominance

Borrowing and lending

Decentralized lending protocols are some of the most popular applications in the DeFi ecosystem. This is mainly because lending and borrowing in the traditional financial world is not easy, especially for small and new companies.

Here are some of the reasons why lending and borrowing is not easy for small companies or individuals:

  • Lack of track record – startups or individuals without a good track record find it hard to borrow capital from banks. Their credit history does not paint a good picture of their creditworthiness.
  • Lenders want to know whether you have the capacity to repay the loan in the specified times. If your bank balance or business income flow does not reflect this potential, you may not qualify for the loan.

If you’re lucky to borrow money from financial institutions, you’re at the mercy of paying extra fees.

Using open lending protocols built on blockchain technology minimizes reliance on intermediaries, thereby making it cheaper and faster to borrow money.

Decentralized exchanges

In certain terms, the crypto universe is more like the stock market. Cryptocurrencies are bought, sold, and traded on market places known as exchanges. There are different types of exchanges: centralized, decentralized, and non-custodial among others.

Centralized exchanges such as Binance, Coinbase, Huobi, etc. are popular due to their liquidity and user-friendly interfaces. However, they are prone to hacks and exit scams.

This brings us to decentralized exchanges. These exchanges are decentralized and have no single entity controlling them. They facilitate the P2P trading of cryptocurrencies. Smart contracts play a crucial role in allows trades to be made directly between user wallets.

In most cases, decentralized exchanges or DEXes, do not store the digital assets of the users. This makes them safe and minimizes the risk of being hacked. They also have higher chances of preventing wash trading (the faking of trading volume).

Decentralized exchanges do not require too much maintenance and therefore charge lower trading fees than centralized exchanges.

Advantages of DeFi

The traditional finance system is based on banks and courts, which respectively act as intermediaries and arbitrators. DeFi applications function without the need for intermediaries or arbitrators. The code written in the smart contracts resolves any possible disputes. The elimination of intermediaries and arbitrators renders DeFi services cheaper and faster to use.

DeFi products are built on top of blockchain networks. The decentralized model of blockchain technology eliminates the possibility of having a single point of failure. The data used by the Dapps is distributed on nodes spread across the world, and this reduces the censorship or shutdown of such services.

The DeFi movement is an inclusive platform that gives financial access to people who would otherwise not have access to financial services under the traditional system.

DeFi challenges

  • Speed and performance – blockchain, due to their decentralized nature, are slower than centralized networks, and this obviously extends to applications built on top of them. This is one thing that the creators of DeFi products need to take into account and put their best effort into dealing with. Ethereum co-creator has previously spoken about the blockchain trilemma – the near impossibility of achieving scalability, decentralization, and security in blockchains at the same time.
  • Poor user experience – DeFi applications provide bad user experiences and their interfaces are not clear cut. This requires more effort from the user, whereas users of apps built on a centralized systems enjoy user-friendly interfaces. For DeFi to truly take over, it needs to provide applications and services that make the switch from the traditional system easy and seamless.
  • High risk – DeFi users have more responsibility in their hands because they have to perform the roles that were previously reserved for intermediaries. This leaves room for errors from the users.
  • Cluttered ecosystem – It is likely going to be a difficult job to find a Dapp that is designed for a required use case. This forces users to find the best applications that best suit their needs.

The future of DeFi

Money and finance will always be a part of the world we live in, but they have always existed in different forms over the course of time. The current financial system has been around for many decades and the crypto movement could be the next wave of a new financial system.

There is a possibility that in the coming years, financial services we use today may be built on top of blockchain. We now have countries such as China, which have been traditionally hostile to crypto, accelerating the development of a central bank digital currency (CBDC). So far, we have seen trading, borrowing, lending, custody, and exchange services built for crypto.

DeFi is still in its early days and has proven to a certain degree that it can fit in the broader financial system. But there is still a long way to go. So far, DeFi Dapps require collateral, basically meaning that you need to own crypto in advance if you want to borrow.

In the future, borrowing and lending could be based on identity in order to build up someone’s credit history. As the DeFi movement gains more traction, we will see an inclination towards decentralized governance.

Final thoughts

Decentralized finance is building a new financial system different from the current financial system. We are slowly moving towards a more open and inclusive financial system with little to no censorship. If DeFi becomes a success, many large and powerful organizations will lose their power to either new startups or existing major companies embracing the new financial movement.

But, in all honesty, not everything needs to be built on top of a blockchain. This is why some people have argued that blockchain is a “hammer looking for a nail.” As for now, the future of the DeFi movement looks bright.


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