What is Decentralized Finance (DeFi)

Decentralized Finance (DeFi) is an ecosystem of applications built on blockchain to facilitate permissionless financial services. The protocols, smart contracts, dApps, and digital assets built on Blockchain are the components of decentralized finance. Decentralized Finance (DeFi) offers a range of marketplaces to ensure that an individual is the only owner of his assets.

The Decentralized Finance (DeFi) protocols are interoperable, programmable, and composable. Interoperability means that the functionality of the system is isolated and they work together in transparent nature. Programmable means that the smart contracts control the transactions without the need of people. Composable means that there are no limitations to what can be built within the system. The largest and major application of DeFi is MakerDAO founded by Rune Christensen.

Let’s get deeper to understand more about DeFi. 

DeFi is unique because of its decentralization. The concept of Decentralized Finance revolves around the concept of “money legos”. The money legos concept is that anyone can create, modify, mix-and-match, link, or build on an existing system without the need for anyone’s permission. The DeFi protocols are adaptable to pile up on each other to develop a condensed system of interoperating parts. 

The interdependence feature of Decentralized Finance may sometimes become a risk because if the key component like DAI gets corrupted, there are chances that the entire system may be crashed. According to the DeFi pulse, a total of $1.75 billion worth value is locked in various DeFi products.

Decentralized Finance products can open up financial access to millions of people on earth. Anyone with an internet connection can access lending services, complex financial products, stable stores of value, and investment and trading opportunities. DeFi products are deployed using code that is distributed across a decentralized network. So, whoever wants to use the product can use it without any inconvenience. 

Those who can write smart contracts can create DeFi applications. InstaDApp which is a DeFi asset management platform built a DeFi product by developing a better UI on the existing DeFi products. InstaDApp was able to create a spike in other Decentralized Finance products by making DeFi access more user-friendly and simplified. Hence, they were successful in raising $2.4 million in funds without the need for any permission. 

Any individual can use the Decentralized Finance products by visiting the application’s website and connecting a MetaMask wallet or some similar wallet. The users need not provide any personal information or register in most of the DeFi DApps. But they should provide their ETH address to process transactions through the Ethereum network.  

MakerDAO’s Oasis app and compound allow the users to take a loan or earn interest on the stablecoins invested. Users can exchange tokens and crypto assets without the need for registration or any sign-ups on Uniswap and Kyber which are DeFi products. The Set protocol allows users to buy tokens to initiate automated trading. 

Decentralized Finance is a new technology that came into existence in 2019. Although it is the latest technology, DeFi has tons of products out there. Let’s understand them one by one. 

• MakerDAO: MakerDAO is a stablecoin project pegged to the US dollar and backed by crypto. The Decentralized Autonomous Organizations (DAO) maintain the Maker protocol and its lending of DAI stablecoin. MakerDAO ensures that the DAI stablecoin retains its value at $1.  The MKR token holders vote on how much collateral should be held in each Maker CDP software. The token holder’s votes and the collateralization ratio are noted into the blockchain and the collateralization rule is carried out automatically. 

• Aave (LEND): Aave is a DeFi lending protocol where users can borrow and lend cryptocurrencies for stable and varying interest rates. Lend is a native token of Aave which offers the traders with some discounted fees. It uses Nexus Mutual to protect users against smart contract risks. It offers the most diverse range of DeFi collateral of any lending protocol in the market. Aave supports nearly 20-Ethereum based assets.

• Compound: Compound is a popular DeFi lending and borrowing platform which allows any individual to lend & borrow unless they have relevant crypto assets to lend or use as collateral. Once the individual decides to lend or borrow their request is matched automatically with the respective lenders & borrowers. They can adjust the interest rates depending on demand, supply, and open lending protocols.

• Uniswap: Uniswap is a cryptocurrency exchange platform that allows any individual to engage in Decentralised Finance. This exchange platform runs on smart contracts and allows users to trade from their wallets. Users can become liquidity providers to supply crypto to Uniswap in return for a small fee. This platform uses Automated Market Making to settle trades near market price automatically. 

• Augur: Augur is a prediction market platform where an individual is rewarded for correct predictions. The users can vote on the outcome of events by giving certain value to the vote. In this product, users can buy and sell shares in the outcome of an event. For example, the difference for Bitcoin to hit $10.00 within a month which means a share on either side costs$0.50 which accounts for a total of $1. Hence if the user predicts right then he will receive $1 in return. The whole concept of Augur is based on crowd wisdom. 

• dYdX: dYdX depends on liquidity pool with rates. They do not participate in p2p loans as there is no guarantee about the liquidity. This platform focuses more on the use-cases of margin trading. Users can open margin positions with a resistance of up to 4x. The dYdX smart contract holds the money sent by the trader into the contract and sells the deposit. If the trader wants to close the margin position the smart contract will buy the lent amount. Hence, if the trade is successful then the user will receive his deposited amount with some good profit.  

• Set Protocol: Set Protocol is a DeFi product where users can create a set of underlying assets. The users can also set management rules like how the basket should be rebalanced and when this should happen. Hence the users can create strategies in the smart contract. There are two categories of protocols which are:
  • Social trading in which humans can execute strategies.
  • Hard-coded rules which define the guidelines of how the contract should trade. 

• Opyn: Opyn is a DeFi product that offers insurance to its DeFi users. This platform allows users to be safe from both technical and financial risks like hacks, bank runs, or even administrative key compromises. If the user comes across any such risks, then he can claim for a payout to get back their deposited amount.

There is no need for middlemen, no extra charges, and transaction times in Decentralised Finance (DeFi). Apart from these few benefits, this platform has a lot more benefits let’s have a look at them:

1. Multinational access to financial services

Anyone who has an internet connection and a smartphone can access their financial services through Decentralised Finance. DeFi treats all its traders equally whether it is a top trader in a financial firm or a farmer in a remote area in India. It also eliminates the barriers of status, wealth, and location to provide global access to all the traders.

2. Permissionless finance

According to a study, 1.7 billion people worldwide are unbanked. In India, nearly 80% of the citizens have bank accounts, but half of them were inactive. The reason for this may be that they do not have identification documents and credit scores which are necessary to open bank accounts and take loans. DeFi application MakerDAO allows anyone to take a loan unless they have ETH to use as collateral. 

3. Simplified applications

DeFi offers plug & play apps to use the services of decentralized finance eliminating the complexities of the centralized system. If you have a decentralized application then you can receive a loan from the US, invest it in a business in Columbia, and then clear your loan and purchase a new house, all through these interoperable apps.

4. Enhanced Privacy and Security

The traders who use decentralized finance are in charge of their own wealth and can carry out transactions without any authorization from the central party. 

5. Improved transparency

A trader in DeFi can get any important information easily. If a trader is looking to gather information on lending protocols like Compound, it is easily available and transparent. The trader can visit Maker’s Platform Data to receive all the necessary information. 

6. Cross-border payments are cheap

DeFi eliminates costly intermediaries to make remittance more affordable to the people around the world. The remittance fees in DeFi are below 3% while in the current system it is 7%. 

Despite all the benefits that DeFi offers, there are some challenges that lie in the path. Let us look at them to understand the risks in DeFi:

1. Smart Contracts may get hacked

While you do not trust humans in DeFi-based smart contracts, you need to trust the smart contract that he has written. There are chances that he may have missed out on something which may lead to some tragedy. As DeFi is growing day-by-day hacking attempts are also increasing every day.

2. Data feed centralization

Blockchains use oracle which allows traders to access price feed in a blockchain-compatible format. Smart contracts receive information from oracle about the changes in a specific process. If oracle misleads the smart contracts intentionally or unintentionally, then there are chances of a big blunder. The more centralized the oracle is, the bigger problems may arise. 

3. Capital Inefficient

Although the DeFi loans are permissionless, they’re capital inefficient. The loan amount which the user receives relative to his collateral isn’t commendable when compared to a traditional loan. 

Despite the bear market, the amount of ETH locked in DeFi products is increased tremendously since 2018. If the same thing follows, then according to the DeFi maximalists, this is just the beginning of the DeFi wave. 

Today, we have an internet browser that gives us all categories of news and information across the world. Similarly in the future, we can expect that the crypto wallet will be a portal for all our digital asset activity. 

To fill in the gap DeFi should overcome its roadblocks like low liquidity, unintuitive UX and accessibility, capital inefficiency, hidden risks, and regulation. Promising solutions are on their way to make the future of DeFi an exciting one. 

Financial liberty is one such thing that a trader needs badly. DeFi creates solutions that are accessible, efficient, and transparent. Defi brings various financial services like borrowing, lending, asset issuance, prediction markets, and more to anyone anywhere.

There are now a lot of lending and borrowing platforms built on DeFi. Users should research about the platform and the team behind it before investing. Some of the platforms give unbelievable interest rates and return, invest smartly. No doubt DeFi will be the creation of the global financial revolution.