The first event in the crypto field was the introduction of the world’s greatest cryptocurrency, Bitcoin. Over the past decade, Bitcoin has experienced astonishing growth and more cryptocurrencies have continued to flood the space. And as of March 2022, there were over 18000 cryptocurrencies.
It was just until recently that the crypto markets began plunging. Many say that the bear market creates the best opportunity to invest in this trillion-dollar industry and many, yet, still criticize it.
So much has changed in the crypto space since it was first introduced and decentralized finance, DeFi, is quickly gaining traction.
The DeFi space is very dazzling and if you are a little too curious, let’s dive right in and explore the nitty-gritty of this ecosystem.
Understanding decentralized finance
DeFi is a new kind of financial technology encompassing applications and other projects that run on a distributed ledger, such as a blockchain. The DeFi ecosystem mainly focuses on disrupting the traditional financial (centralized financial) ecosystem.
We can simply define DeFi as applications that use smart contracts and run on blockchain technology. The use of smart contracts allows DeFi applications to run without mediators and is easily accessible by anybody connected to the internet.
Through decentralized finance, lending, borrowing and trading of financial assets are eased. A good number of DeFi applications run on the Ethereum blockchain. However, more public blockchains with high speed, scalability, low transaction costs and security continue to be launched.
How does DeFi work?
For a while now, central authorities have been issuing and managing money (fiat currency). However, with the challenges that come with fiat currency, inflation being the most rampant, people slowly lost trust. The central authorities’ ability to govern money has since been in question.
The necessity for a more stable financial system that does not interfere with economies led to the emergence of DeFi.
DeFi creates a financial system that is transparent and eliminates the need to rely on a central body for governing financial assets.
After Bitcoin was launched in 2009, as the first peer-to-peer (P2P) digital currency on the blockchain network, the idea of DeFi cropped in. Through blockchain, DeFi would introduce a transformative traditional financial ecosystem.
Then came the launch of the Ethereum network and smart contracts later in 2015. DeFi technology became a reality through these two innovations. Ethereum, being a second-generation blockchain, was the first blockchain to leverage the DeFi technology in the financial sector.
The Ethereum blockchain network spurred interest in businesses and enterprises to create and explore various projects that ended up forming the DeFi ecosystem.
The breakthrough came in 2017, as projects encouraged more use cases beyond cash transfers. The DeFi system has since grown tremendously to include applications and protocols that offer value to many users. Currently, there are over $30 billion worth of assets stored in this ecosystem, making it the most growing section in the blockchain space.
As mentioned earlier, the use of a smart contract eliminates mediators such as financial institutions.The smart contract replaces these institutions by providing no room for alterations since they always work as programmed.
What do I mean? Let’s take an example for clarification.
If a contract is programmed to fund account B from account A on certain frequencies let’s say every Monday, it will only find that account (B). This will happen only if account A has its funds. No changes can be made to the contract and no account can be added with the intent to steal the funds.
An added advantage is that smart contracts provide transparency. Transparency helps the community to scrutinize any bad contracts and keep developers in check.
Ethereum and DeFi
We learned earlier that Ethereum provides the best base for DeFi. The reasons include:
- Nobody can claim ownership of Ethereum and the smart contracts that run on it meaning anyone can make use of DeFi opportunities and no changes can be made.
- DeFi products work together seamlessly. As a user, you can easily learn tokens on a platform and trade the tokens but their interest in a separate market. all this can be done on different applications.
- The Ethereum blockchain network helps to track financial transactions and ownership of tokens and cryptocurrencies.
- Users have full control of their assets as several products cannot take ownership of their funds.
To sum it up, DeFi can be broken into layers
- The blockchain – Ethereum keeps records of all transactions from history
- The assets – ETH and other cryptocurrencies.
- The protocols – the smart contracts that allow decentralized finance.
- The applications – the products that are used to control and manage the protocols.
Centralized vs. decentralized finance
Centralized Finance (CeFi) is a financial tool in the crypto world where traders earn interest and obtain loans on their digital assets. The centralized platform is managed by an individual, a group of people and within the legal bounds of a FinTech company.
Some of the digital assets that are traded include Bitcoin, USD Coins and Ethereum. The main characteristic of centralized finance is that assets are managed by people and the platform is centered around people’s trust in traditional finance.
Some CeFi platforms such as Hodlnaut are considered custodial. They collect user deposits and manage the accrual and payment of interests. Centralized finance offers a more holistic approach and ensures the value of cryptocurrencies is maximized.
CeFi platforms are more flexible and convenient as users are able to convert fiat currency to crypto through a cross-chain exchange. Centralized finance requires traders to provide their private details and holdings to exchanges or to a financial institution.
If the exchange is hacked, there is a real chance of people losing their digital assets because of compromised privacy. Decentralized finance was created to solve the challenges in privacy and ownership rights affecting the current financial system.
Ideally, DeFi offers a platform for people to participate, whether banked or unbanked. The platform aims to create an open-source, permissionless and transparent finance service ecosystem. Decentralized finance provides financial services such as crypto lending, storage of assets, borrowing of flash loans and yield farming.
Yield farming is the process of using decentralized finance to maximize returns. Users lend or borrow crypto on a DeFi platform and earn cryptocurrency in return for their services. Users who want to increase their yield output can employ more complex tactics through yield farming.
Decentralized finance helps users control their digital assets and holdings. Traders seeking to participate in DeFi must use decentralized applications (DApps) built on blockchain platforms to access those DeFi services.
How is CeFi different from DeFi?
- Governance– in centralized finance, the system is governed by an exchange while decentralized finance relies on the use of Decentralized Applications (dApps).
- Security – centralized finance requires users to have trust in the financial technology company (FinTech) to manage their holdings and digital assets. Decentralized finance incorporates smart contract protocols to ensure that intermediaries such as exchanges are cut off.
- Transparency – centralized finance guarantees users fiat-crypto conversions and cross-chain solutions. Decentralized finance is considered to be more transparent and non-intrusive as it does not ask for any personal data. DeFi does not have custody over the user’s holdings or place restrictions on block trading as in the case of CeFi.
- Fees – centralized finance exchanges charge higher transaction fees to maintain the site, improve products and pay the staff. A decentralized exchange offers affordable financial services and has a low transaction cost as compared to CeFi.
What is the difference between DeFi and crypto?
Cryptocurrencies are a store of value, much like fiat currency, that operate on a blockchain ecosystem. In contrast, DeFi allows users to lend, borrow and trade cryptocurrencies akin to the quintessential financial institutions like banks that require a bank account.
Decentralized finance projects are built on the Ethereum blockchain network. Users can earn interest, borrow and put on their NFTs (Non-Fungible Tokens) as collateral. In addition, users provide liquidity to decentralized exchanges through DeFi apps.
The importance of both crypto and DeFi is to eliminate the intermediaries involved in transactions linked to the exchange of money and borrowing of loans. There are intermediaries in centralized finance that take control of these activities and charge you money for it.
Both crypto and DeFi platforms deploy smart contracts that enable them to operate without a central authority exercising control over the entire system. In decentralized finance, smart contracts enable transactions once the “if…then” condition is fulfilled.
For cryptocurrencies, the use of smart contracts such as proof of work, proof of stake, and proof of concept models helps miners validate their transactions. Cryptocurrencies and DeFi are cheaper and easier ways to engage in international payments.
Although crypto adoption has gained momentum across the globe, DeFi is still catching up as people learn more about the applications and platforms.
DeFi in action: Best practical use cases
DeFi is more than just an emerging trend of projects, rather it is a massive and well-coordinated effort to create an alternative system. The Ethereum blockchain-enabled system, based on a public ledger, competes with centralized finance systems in terms of transparency, resilience and accessibility.
Here are some of the practical use cases of DeFi:
Management of Assets
Decentralized finance gives users more control over their digital assets. DeFi initiatives provide tools for users to manage their assets and secure their holdings.
Some of these tools include purchasing, selling and transfer of digital assets. Users also earn interest in their digital assets and safeguard their private data from potential cyber-attacks. A crypto debit card also lets you spend your digital assets at locations where a debit card is accepted.
Know Your Customer
Know Your Customer (KYC) protocols are highly encouraged in centralized finance banking systems. These compliance instruments help in implementing anti-money laundering (AML) and counter-terrorist financing (CTF) measures.
DeFi supports a new protocol known as the Know Your Transaction (KYT) method to address malicious issues. KYT enables DeFi to address concerns in transaction behavior and digital addresses than with the users’ identities.
Decentralized Autonomous Organizations (DAOs)
Centralized financial institutions play a significant role in overseeing basic financial operations in the traditional systems. These financial roles include administrative duties, fundraising, asset management and implementation of governance.
DAOs are decentralized systems of governance that do not follow the boundaries set by a central authority.
Data analytics
Through decentralization and transparency, users are able to discover and evaluate outstanding data. DeFi helps users to make well-informed decisions, find new opportunities and improve risk management strategies upon accessing the data.
Decentralization brings in a new style of data analytics, blockchain technology and the incorporation of dashboards. DeFi projects such as CoDeFi Data and DeFi Pulse are creating value through analytics and risk management. The financial products business has become more agile due to competitive advantages.
Derivatives
DeFi has enabled the creation of tokenized derivatives through smart contract integration. Tokenizing a derivative is the process of determining a contract’s value based on the underlying financial assets or collection of assets. Derivatives effectively create synthetic assets as they are now considered secondary securities after tokenization.
Infrastructure and Protocols
Different components of a DeFi system are now able to readily connect and communicate with each other. DeFi protocols are built on this key design principle that incorporates full-stack tooling and security integrations.
With this design principle also known as Composability, Ethereum developers now build and launch DeFi protocols. The success of these protocols is courtesy of Troffle’s smart contract libraries, Infura’s API Suite and Diligence’s security tools.
Digital Identification
Blockchain-enabled digital identities have gained traction in recent months. The pairing of digital identities with DeFi protocols provides users with easy access to the global economic system. The new digitized identities will help the underprivileged DeFi apps gain access from anywhere in the world.
Insurance
Although the insurance sector has provided novel options in obtaining coverage and protection of crypto assets. Successful implementation of smart contracts will be a boost. Smart contracts can solve the problems witnessed in the insurance sector.
Peer-to-Peer Lending and Borrowing
The emergence of lending and borrowing use cases is vital as DeFi continues to push traditional banking systems out of the market. DeFi supports peer-to-peer lending and borrowing of flash loans, hence boosting its security and transparency ratings.
Financial products such as liquidity pools have an autonomous interest-based defi protocol for borrowing and lending crypto assets. Though interest rates vary, it is common to earn between 5% and 15% annual percentage yield on your crypto holdings, and sometimes the rates can be much higher.
Prediction market
In blockchain-based prediction markets, users vote and exchange value on the outcome of events by harnessing the crowd’s wisdom. The market prices act as crowd-sourced indicators of the likelihood of an event taking place. The popular DeFi betting platform, Augur, offers prediction markets for sporting events, economic events, and election results, among other topics.
Common characteristics of DeFi apps
- Permissionless – most DeFi apps are open-source software models. Users are able to access DeFi solutions through an internet connection and crypto wallet irrespective of funds or location.
- Programmability – most DeFi apps are based on the Ethereum blockchain. The opportunity of accessing smart contracts with higher chances of programmability helps in automatic execution. It also opens up new avenues for creating new financial instruments and digital assets.
- Transparency – every transaction is broadcasted to other users in the network for verification. Enhanced transparency in transaction data enables comprehensive data analysis in an open-source code system.
- Immutability – exchange of information and financial transactions in DeFi requires the assurance of data integrity. With the assurance of safe and secure data transmission without any unauthorized modifications, DeFi could offer the assurance of integrity for all transactions.
- Interoperability – developers and product teams leverage the traits of DeFi for customization of the interfaces and integration of third-party applications. That is why DeFi protocols are referred to as Legos.
- Non-custodial – users keep complete control over their assets and personal data. The use of web3 wallets such as Metamask helps users interact with permissionless financial applications and protocols.
5 interesting DeFi projects to be on the lookout for
Cosmos
Cosmos is a DeFi project and one of the leading DeFi coins in 2022. The idea was created by the founders Jae Kwon and Ethan Buchman in 2016.
The Cosmos network aims to solve blockchain interoperability. By using open-source tools, Cosmos has provided a method for chains to share data and streamline transactions between them.
Each new blockchain created is stored on the Cosmos hub, a proof-of-stake blockchain that operates with the network’s digital token – ATOM.
Aave
Aave is one of the decentralized lending platforms where users lend and borrow a wide range of cryptocurrencies. The platform is a peer-to-peer enabled system that uses smart contracts to lend money at an interest or borrow capital with favorable interest rates upon payment.
The platform, brought forth by founder and CEO Stani Kulechov, provides users with liquidity pools for faster financial transactions.
Fantom
Since the Ethereum network experiences congestion, alternative platforms such as Fantom offer faster transaction processing at a lower cost.
Fantom, created by Matthew Hur from Digital Currency Holdings, is an open-source platform for dApps and digital assets based on smart contracts.
PancakeSwap
Founded by Henry Cavill, the PancakeSwap protocol is one of several trading liquidity providers based on the Binance smartchain. It is an automated crypto market maker that staked more than $ 5 billion in decentralized exchange (DEX).
The platform supports Legitimate liquidity mining making it possible for decentralized finance (DeFi) networks to automatically process digital currency trades.
SushiSwap
SUSHI is the token that provides liquidity to this ecosystem. Using SUSHI tokens, you can receive interest in various liquidity pools.
SushiSwap was created in 2020 by a pseudonymous individual or group called Chef Nomi, along with co-founders Sushiswap and 0xMaki.
For example, the Sushi Bar is a pool that rewards liquidity providers with a 0.05% return on all transactions taking place within the pool. SushiSwap also provides interest-earning options on its own NFT marketplaces and through yield farming.
Benefits of decentralized finance
- Non-custodial – users retain custody of their digital assets and holdings using non-custodial crypto wallets or smart contract-based Escrow.
- Permissionless – anyone with an internet connection and crypto wallet, can access financial services in decentralized exchanges regardless of geographical location.
- Real-time transactions – the underlying blockchain is updated the moment a transaction is completed and interest rates are updated severally every minute.
- Transparency – every transaction on the Ethereum ecosystem is broadcasted to and verified by other users in the network hence boosting transparency.
- Security – with the use of blockchain infrastructure, DeFi data is secure, tamperproof and auditable.
- Open source – most DeFi protocols and applications are based on open source code which is available for anyone to view, audit and build on.
Many DeFi protocols offer greater returns than savings accounts run by large corporations; they can produce yields as high as 20%, but many aren’t beginner-friendly. Some services, like Argent Wallet or Zapper, let you interface with DeFi protocols through an app that is just as easy to use as a crypto savings account
Drawbacks of decentralized finance
- No consumer protection – despite thriving in the absence of rules and regulations, DeFi just like cryptocurrencies does not provide user protection on digital assets in decentralized exchanges.
- Cyber-attacks – DeFi’s technological infrastructure has multiple points of failure that increase the attack surface available to sophisticated hackers.
- Collateral – DeFi lending transactions require collateral or at least 100 percent of the value of the loan if not more hence requirements are high for users.
- Private keys – just like cryptocurrencies, users require private keys to secure their wallets and access their funds. In the event that these keys are lost, then the users lose access to their funds forever.
- DeFi Degens – decentralized finance degenerates are traders interested in risky and unaudited crypto projects. DeFi degens are likely to be hit hard by exploits such as the Eminence hack involving DAI tokens.
The future of DeFi
In decentralized finance, all sources of value are tokenized so that value flows freely across geographies and industries. Tokens are used to represent anything ranging from employment, social clout, real estate, community membership et cetera.
Although traditional finance finds DeFi skeptical, our future seems to portray a picture where anything will be valued and transacted. Liquidity will be provisioned and aggregated across many different cryptocurrencies to enable decentralized trading.
In the coming years, you may visit your favorite store and choose to pay with a digital wallet composed of different assets that you own. From fiat currency (Dollar, Euro), some Ethereum or bitcoin, collectibles such as NFTs or obtain a loan (DeFi Loan, Flash loans). This will be made possible with the increase in DeFi services and DeFi infrastructural development across the globe.
DeFi FAQs
How do you make money with DeFi?
The simplest way to earn a passive income through DeFi is to deposit your cryptocurrency onto a platform or protocol that will pay you an APY (annual percentage yield) for it. DeFi companies are able to pay creators in real-time by getting DeFi loans based on their streams and paying back the loans once the streaming platforms pay.
Is DeFi a good investment?
Decentralized finance (DeFi) as an industry is growing at a rapid pace, with the DeFi ecosystem first reaching a valuation of over $100 billion in mid-2021. DeFi projects are still in their infancy compared to traditional finance (TradFi) and undergoing a correction in 2022, so now could be a good time to invest in DeFi.
What is DeFi?
Decentralized finance or DeFi refers to a new decentralized financial system built on a public blockchain ledger such as the Ethereum network. DeFi provides users with the ability to have custody over their crypto assets and private data.
How can decentralized finance be applied?
DeFi facilitates global access to financial services as long as users are linked to the internet and possess a crypto wallet. Users are able to trade, lend and borrow funds. DeFi projects have sprung up in different sectors such as insurance, liquidity mining and management of assets.
What can be earned in the DeFi space?
Users can earn by participating in liquidity pools at decentralized exchanges like Uniswap or auctions for derivatives or asset platforms like SetProtocol.
Is there any risk?
Scalability becomes an issue on the Ethereum blockchain hence cannot accommodate many users. The market volatility of cryptocurrency assets is also a concern in the DeFi space.
How about the future of crypto?
Opening new partnerships between DeFi platforms and engaging in conversations with decision-makers will enhance the DeFi ecosystem across the globe.
