Cryptocurrency and blockchain-based financial solutions, known as "Decentralized Finance" (DeFi), belong under the same umbrella term. Using blockchain, the technology behind Bitcoin, DeFi aims to create a system that isn't controlled by a single, centralized entity or source.
DeFi vs. Traditional Payment Systems
Unlike other Dapps, DeFi enhances the usage of blockchain beyond simple value transfer. Traditional financial institutions maintain control over the transactions as they own the main transaction ledger on their server. Technically, they can suspend or stop transactions. In some cases, they can even cancel accounts and kick the user out of the system.
DeFi gets rid of the need for these institutions to be involved by using a public ledger that can't be changed. Therefore, all financial applications that operate on the blockchain are interoperable and self-sustaining. Decentralized finance used to be called "open finance" before the term "decentralized finance" became more common.
What Are Decentralized Applications (DApps)?
Unlike Bitcoin which was made as a store of value, Ethereum was built to facilitate smart contracts. This makes it easier to use for building decentralized apps.
DeFi applications offer permissionless solutions.
- If you need a loan, you don't need a bank because you can borrow directly from the protocol.
- If you need Bitcoin futures or other derivatives, let the protocol take care of it.
- If you want to trade your crypto, you can do it on a decentralized exchange to avoid high transaction fees.
Vitalik Buterin, co-founder of Ethereum, emphasized in the Ethereum white paper that the digital asset is intended to create more complex financial use cases. Smart contracts, which automatically carry out transactions when certain conditions are met, were built into Ethereum's blockchain. Compared to Bitcoin, smart contracts on Ethereum give the platform more flexibility by making it possible for blockchain developers to use it for different applications.
Examples of DApps:
Decentralized Exchanges (DEXs)
Online currency exchanges let users trade currencies for other currencies, such as US dollars for Bitcoin or Ether for DAI. Users can trade cryptocurrencies directly with one another on DEXs, a popular kind of exchange that eliminates the need for an intermediary.
Smart contracts that run on the Ethereum blockchain enforce regulations and execute deals. DEXs don't need a central authority to work, but they do need a reliable source of liquidity to allow crypto trading.
It is true that DEXs differ in design, but the way they link buyers and sellers over a global liquidity pool is very much the same. To trade on most DEXs, the user must have at least enough Ethereum (ETH) in their wallet to cover the transaction fees. Others reimburse a part of the cost to traders who freely contribute capital to their liquidity pools, while others don't charge transaction fees for Maker orders but instead charge higher fees for Taker orders.
Lending Platforms
Smart contracts are used on these platforms to eliminate the need for middlemen in the lending process. Lenders can earn interest on the assets they lend out. Stronger demand for cryptocurrency means that interest rates will rise. To get a loan through DeFi, a customer will often have to put up ETH. This means that, unlike with non-DeFi loans, customers don't have to give their personal information or credit score in order to apply for a loan.
AAVE is one of the most prominent DeFi lending platforms today. A non-custodial system that allows you to earn interest on your crypto deposits and borrow money by staking your assets is available. As well as lending and borrowing crypto assets, the AAVE liquidity protocol has a wide range of other functions. Using AAVE, customers may either deposit or borrow money. Different sites make it easy to compare deposit and loan rates because the interest rates are written out clearly.
The AAVE Protocol includes a variety of concepts, such as Bug Bounty and Flash Loans. As an added bonus, you can even earn up to $250,000 in USDC tokens from the community of developers if you report any bugs to them.
Prediction Markets
One of the first applications of DeFi on Ethereum was a place where people could bet on the outcome of an event, like the US elections back in 2020. Wagering on the results of future events, such as elections, takes place in these markets. Prediction markets in DeFi format are made to work the same way as traditional markets, but without the need for middlemen.
Intrade and PredictIt are two of the best-known central prediction markets.
Stablecoins and Wrapped Tokens
Stablecoins
There are several methods to ensure the value of a stablecoin is stable. An asset outside of cryptocurrency (the dollar or euro, for example) is used to stabilize the price of a cryptocurrency. Stablecoins peg the price of cryptocurrencies to an external asset, such as the US dollar. "Stability" is the goal of stablecoins, as their name suggests.
- Stablecoins With Fiat Collateral: Fiat-collateralized stablecoins hold a reserve of fiat currency (or currencies), like the US dollar, to make sure the value of the stablecoin stays stable. The most common type of collateral for fiat-collateralized stablecoins is U.S. dollar reserves, although other options include precious metals like gold or commodities like crude oil. Independent custodians are responsible for maintaining these reserves, which are audited frequently. Tether (USDT) and USD Coin (USDC) are two well-known stable coins that are backed by US dollar reserves and worth US dollars.
- Stablecoins With Crypto Collateral: Stablecoins that have gone through the crypto-collateralization process are backed up by other digital currencies. Because the reserve cryptocurrency may also be prone to high volatility, such stablecoins are “over-collateralized”. In other words, the value of the crypto held in reserves is more than the value of the stablecoins that have been issued. To protect against a 50% decline in the price of the reserve cryptocurrency, it is possible to hold a cryptocurrency worth $2 million as a reserve when issuing $1 million in a crypto-backed stablecoin. MakerDAO's Dai (DAI) stablecoin, for example, is backed by ETH and other cryptocurrencies worth 150 percent of the DAI stablecoin in circulation.
- Stablecoins Based on an Algorithm: When compared to central banks that don't need reserve assets to maintain the value of the currency they issue, algorithmic stablecoins are not all that different. Reserve assets may or may not be held by algorithmic stablecoins. In order to maintain a steady value for the stablecoin, they use an algorithm, which is a piece of computer software that follows a predetermined formula.
Wrapped Token
It is possible to transfer the value of one blockchain's native asset to another by the use of a "wrapped token." Wrapped Bitcoin is one of the most well-known wrapped tokens (WBTC). Bitcoin's (BTC's) price is fixed at a 1:1 ratio with WBTC, meaning that one WBTC should always be equivalent to one BTC. When it comes to the Ethereum and Tron networks, WBTC is accessible as ERC-20 or TRC-20 tokens, which implies that it may be traded on both platforms.
Wrapped Tokens are means to transmit Bitcoin to the Ethereum network for the DeFi system.
DeFi Concepts
Yield Farming
Yield farming involves looking through different DeFi tokens to find ones with higher potential returns. Users may lend or borrow cryptocurrencies and get paid for their services. Other strategies could also be implemented to increase yield.
Liquidity Mining
"Liquidity mining" is a way for people who own cryptocurrency to earn rewards by lending their assets to a decentralized exchange. Most of these incentives come from the costs that traders pay when they exchange tokens. On average, swap fees are around 0.3 percent, and the total compensation depends on how much of a liquidity pool a person owns.
Composability
Because DeFi applications are open-source, anybody may examine the source code that powers them. With this useful feature, the code in these applications may be used to "assemble" new apps.
Money Legos
Using a different metaphor, DeFi applications may be compared to the toy bricks children use to create houses, cars, and other structures. DeFi applications can be put together like "money legos" to come up with new ways to handle money.
Is DeFi Safe?
Smart contracts have a lot of power, but once the rules are programmed into the protocol, they can't be modified. Problems in the code are usually permanent, raising the level of risk associated with them.
On the other hand, taking part in innovative technologies like DeFi provides great opportunities for significant returns but should entail a lot of research and due diligence.
Disclaimer: The information and publications in this article are not intended to be and do not constitute financial advice, investment advice, trading advice, or any other advice or recommendation offered or endorsed by Coins.
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