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DeFi Explained: What is Decentralized Finance?

DeFi is short for Decentralized Finance, a new financial system building on blockchain technologies. Access to these financial services is permissionless and without intermediaries.

DeFi on Ethereum

Most DeFi apps build on Ethereum, which is the oldest and most prominent smart contracts blockchain. Ethereum is a distributed computer – multiple nodes execute code simultaneously. Therefore, it supports any kind of application. There are certain advantages and trade-offs:

Advantages:

  • Security: Because programs are executed on multiple computers at the same time, transactions on Ethereum are highly secure. There’s no single entity that can decide about the blockchain’s state.
  • Permissionless: Ethereum is permissionless and open – any computer can join as a node.

Disadvantages:

  • Transaction Speed: Every node has to validate every transaction, which makes the network slow and inefficient.
  • Transaction Fees: Transaction fees are typically high on Ethereum.

Using DeFi is pretty expensive today because most DeFi services build on Ethereum. However, transactions are very secure, and everyone can participate.

Financial services on Ethereum include exchanges, synthetic assets, stocks, real estate, and anything else in traditional finance (TradFi). In TradFi, a single entity controls each service, which means you need permission to access financial services. In contrast to TradFi, DeFi services are permissionless. This applies to both users and developers:

  1. Developers deploy code on Ethereum to build DeFi services without permission. The code is open-source, and anyone can contribute.
  2. Users use those services without permission from the developers.

Once the smart contract is on the Ethereum blockchain, nobody owns it; therefore, we call DeFi applications “protocols.”

Open source code enables developers to build applications that build on existing defi applications. We call this concept “money legos.” On Ethereum, defi protocols are not designed to work on their own. Defi Protocols also build on other apps – benefiting from their functionality. Therefore, open finance brings up many more possibilities that are not possible in the financial world today.

For example, decentralized money markets can build on existing decentralized exchanges to bring up more possibilities for users to earn a yield on their investments; the opportunities are endless in an open source environment!

Interoperability

The Ethereum blockchain is not the only blockchain hosting DeFi services. A variety of other chains develop network effects:

  • Layer one chains (e.g., Cardano, Polkadot, Cosmos)
  • Ethereum side chains (e.g., xDai, Polygon)
  • Second layer solutions (e.g., zk-rollups, optimistic rollups)

Research suggests that multiple chains will exist in the future. Financial applications on Ethereum will be completely composable with all other blockchains – accelerating effects of “money legos.”

Splitting financial applications across multiple chains will increase transaction throughput. More transaction throughput leads to more transactions per second – ultimately increasing DeFi’s scalability.

In addition, we can customize chains to fit the needs of the underlying application if certain conditions apply.

Realm of Decentralized Finance (DeFi)

There are multiple use cases of DeFi. Here is a list of the most common use cases:

Money Markets: Users borrow and lend money. Money markets are permissionless protocols. That’s why they don’t require middlemen. We measure the success of Money Markets by their total value locked (e.g., Aave, Compound).

Automated Market Makers (AMM): AMMs are like traditional exchanges but without central entities controlling the process. Also, AMMs don’t require order books (e.g., Uniswap, SushiSwap, Kyber Network, Curve).

Stablecoins: Stablecoins peg to FIAT currencies (e.g., Tether, USDC, Dai).

Prediction Markets: Users bet on anything they can imagine. For example, a user could bet on the US elections. Oracles connect the blockchain with the outside world. So, smart contracts know whether or not the person won (e.g., Augur).

Insurance Protocols: Insurance protocols are similar to traditional insurance companies. Users insure themselves against smart contract risk and third party hacks. If they get hacked, the insurance protocol will automatically transfer funds to them (e.g., Opyn, Nexus Mutual).

Synthetic Assets: The synthetic asset market is the biggest in the world. Tokens represent the prices of any asset, e.g., gold or stocks. Users mint synthetic tokens using smart contracts by locking up collateral to guarantee that the assets are always sufficiently backed (e.g., Synthetix, UMA Protocol, Mirror Protocol).

Asset Management: Protocols enable users to manage assets for other people – just like traditional hedge funds. Value locked inside asset management protocols determines their success (e.g., Enzyme, PieDAO).

Oracles: Oracles bring information from the outside world to the blockchain (e.g., Chainlink).

Money Verbs

DeFi Lending: The act of lending money to another person to earn interest. Unlike traditional financial institutions, interest rates are determined by supply and demand.

Borrowing: You can borrow money from Money Markets.

Liquidity Providing: Users can provide liquidity to a Liquidity Pool. Liquidity Pools are smart contracts that collect user’s funds. By putting their money at price risk, users earn trading fees.

Liquidity Mining: Users earn inflation rewards by locking up funds in the protocol.

Staking: The act of locking up your funds in a DeFi protocol.

Airdrop: When protocols issue a token for the first time, early supporters may be able to claim a part of the token supply. It’s a gift by the protocol.

Stake Drops: You are eligible to receive an airdrop only if you stake the native asset on-chain. In some cases, it may only apply if you stake at a certain validator.

DeFi FAQ

What are the risks in DeFi?

Decentralized Finance (DeFi) is very risky. The magnitude strongly depends on what you do. This list covers the most common risks in DeFi:

  • Hacks & Smart Contracts Risk: If the code is flawed, bad actors can exploit value locked inside smart contracts (third party risk).
  • Rug Pulls & Exit Scams: When a team disappears and the product becomes worthless.
  • Price Volatility: DeFi tokens are extremely volatile.
  • High Competition: DeFi is one of the most competitive industries in the world. Projects can lose market share within weeks.

How can you make money investing in DeFi?

There are many ways to make money. For example, you can deposit crypto assets into DeFi applications to earn a yield (defi lending and borrowing). However, if that doesn’t fit your risk appetite, you can invest in the protocol’s native token. In some cases, it’s enough to use financial products when they don’t have a token. Users may be eligible to receive an airdrop in that case. Smart contracts automatically know whether a user has used the protocol in the past.

Is Ethereum scalable for the masses?

Not yet, but it will be. ETH 2.0 is being developed to scale Ethereum. ETH 2.0 will essentially split Ethereum into 64 blockchains to increase transaction throughput without compromising decentralization; however, it will only launch in 2022. Apart from that, second layer solutions and other layer-one blockchains are developing network effects, which will scale Ethereum simultaneously to ETH 2.0.

Is Decentralized Finance the Future?

Yes! DeFi will revolutionize the old financial system like the internet disrupted the media industry. It’s faster, cheaper, and “money legos” enable us to rethink finance. Smart contracts enable us to build a better financial system. Services like AMMs and Money Markets

How do you buy DeFi tokens?

There are currently two ways to buy DeFi tokens:

  1. Decentralized Exchanges (DEXs): You can buy tokens on DEXs, which are exchanges that nobody owns. Because these exchanges are based on permissionless smart contracts, you can trade any token in existence on these DEXs.
  2. Centralized Exchanges (CEXs): Typically, order book-based, CEXs rely on a central party to coordinate trading. You can trade only selected tokens there. That’s why CEXs are permission-based entities that require trust. They usually hold your tokens for you in custody.

How much money is locked in protocols?

The Total Value Locked (TVL) in DeFi changes every single day. DeFi Pulse is the best way to monitor it. As of May 2021, DeFi apps hold a value locked of $52 billion in protocols.

Is it too late to invest?

No. We are at the beginning of the greatest revolution the world has ever seen. Decentralized Finance is still early and completely unregulated. Remember that it’s still immature. That’s why investing in DeFi tokens bears extreme risks. But the risk could also generate big returns. Nobody knows what happens in the short term; however, experts agree that DeFi will overtake traditional finance in value locked. Nobody knows when this will happen though.

Why is DeFi better than CeFi?

DeFi enables us to rethink finance. By combining money legos, we build an entirely new set of financial applications; This isn’t possible in TradFi because regulatory frameworks make it impossible to combine different financial instruments. That’s how we build a completely new financial system from scratch. This new system could potentially be way more efficient. Furthermore, it could include way more use cases than traditional finance.

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