What Is DeFi And How Does It Work

Decentralized finance, or DeFi, is a new banking technology that aims to remove the control banks and financial institutions have over money. It allows you to hold your money in a secure digital wallet instead of keeping it in a bank. You can access and transfer your funds anywhere with internet connections and have it done instantly securely. You also don’t have to pay any kind of transaction fees in DeFi, like you would at a bank.

What Is DeFi

Decentralized Finance or DeFi is a term that describes a new financial ecosystem that provides banking services to people. The difference here is that instead of depending on the obsolete textbook methods that traditional banks use, DeFi is based on blockchain technology. The term DeFi was first coined back in 2018 in a telegram chat, and this budding industry has seen an enormous amount of growth ever since.

Now you must be wondering, what does all of this mean to you, and how does DeFi affect your life? To understand it better, let’s take a look at some of the disadvantages of traditional banking systems.

Image you have $10,000 in your bank account. If the bank goes bankrupt, you will only be insured 25% of your money.

And even if the money is yours, you can’t freely cash it all out whenever you want either, due to a withdrawal limit. Alternatively, you might even be penalized if your balance is low. Lastly, banks take your money and invest it strategically to earn about 10% returns and only share 0.1% with you.

Advantages of DeFi

This is where the need for a new banking system is born, one that is designed to benefit the public. Today, there are many DeFi services that give you much higher interest rates than banks do and have way better terms and conditions.

Here are a few major advantages of DeFi that account for its unstoppable growth.

Permissionless

DeFi eliminates the need to depend on corporations for banking, giving you the freedom to make transactions in a permissionless way. Decentralized finance relieves the burden of relying on institutions for monitoring, data storage, server space, and other aspects.

By ensuring that individual transaction histories can be easily shared with the user, blockchain networks are successful in achieving all of these qualities.

Immune to Human Error

When banking activities are processed by individuals working in a bank, there is always the probability of human and operational errors. DeFi relies on self-executing smart contracts.

Smart contracts are programs that run on the blockchain. Basically, it’s a piece of code that runs and executes automatically when certain conditions are met. These conditions can be anything, from the outcome of a football match to a bet on tomorrow’s weather. The best thing about them is that they are immutable and cannot be changed.

The use cases for smart contracts are wide and varied. They can be used to store information such as an agreement between two parties or property rights, financial dealings, or even as a digital marriage certificate, with no need for a third party like a government agency to mediate or enforce the contract.

Using smart contacts removes the probability of human error because all transactions are executed on a blockchain. Unless, of course, the smart contracts themselves contain the error.

Transparency

Since DeFi is based on blockchains, anyone with an internet connection can see the record of each and every transaction ever made to and from the financial services you are invested in. It is transparent to everyone as all the data is processed through smart contracts that are openly available to the public. You can see and track all the movements of every single fund. Yet, it is so secure that no one can hack into this system and modify it.

Cons of DeFi

Scalability

DeFi platforms are definitely a great tool to provide access to banking to everyone. However, there are concerns with the limitations of how much load a blockchain network can take at a time.

The credit card company Visa can handle 65,000 transactions per second. On the other hand, blockchains like Etherium can only handle 14 to 15 transactions a second. While there are other blockchains out there that aim to solve this issue, it’s still a work in progress.

Liquidity Concerns

As of the last quarter of 2021, the market cap of the worldwide banking industry was estimated to be around $8.23 Trillion. Comparatively, DeFi is still a relatively small market.

At the time of this article, the total value locked in DeFi protocols is around $74.6B and has recently touched an all-time high of just over $110B in November 2021. So it may also be hard to put your faith in a sector that is so much smaller than regular banks.

Responsibility

Let’s say you transfer money to a wrong account. In DeFi, there is no chance for you to get back your money since there is no governing body overlook the transaction. In short, there is little room for mistakes.

Types of DeFi Platforms

In the world of Decentralized Finance, services or companies are called protocols as they are just bytes of self-executing code. With the increasing demand for DeFi services, there are a lot of new platforms being launched every day. Most of them are divided into four major categories – borrowing and lending, staking, insurance, and decentralized exchanges. Let’s take a deeper look into them.

Borrowing and Lending

An obvious problem coming to mind with DeFi is that how will a decentralized banking system be able to give out loans? Taking a loan from a DeFi service is just like taking a loan from a traditional bank. With services like MakerDAO, Compound, and AAVE, anyone can take out a loan without disclosing their real identity to anyone within a few minutes.

However, there is a slight difference here. Since there is no way to verify the annual income which banks use to calculate the payback capacity of the borrower, the responsibility to determine to amount to loan comes down to the collateral size.

To take a loan from a DeFi service, the borrower will need to provide a collateral of greater value than the amount they intend to borrow. For example, if you wish to take a loan of $1,000 from a DeFi protocol such as MakerDAO, you will have to collateralize $150 worth of Etherium. This over-collateralization prevent a sudden drop in the price of the collateral.

As a lender, DeFi allows anyone to loan their crypto assets to someone else and earn interest on them. Until DeFi, such luxury was a bank exclusive. However, since these loans are granted through smart contracts, which execute themselves without the need of an intermediating body, now anyone can have a bite of the lending and borrowing business.

Staking

In layman’s terms, securing or storing cryptocurrencies in a network is called staking it. When you stake your crypto, as the staker, you earn rewards in the form of the currency you’ve staked. But these rewards are there for a reason. Staked assets help proof-of-stake (PoS) based blockchains improve their speed and security.

Staking does not involve a lot of work from the user’s end after you’ve gone through the staking process it will work very well as a source of passive income. The returns on your investment would range somewhere between 5-20% per annum, depending on the crypto market and your staked coin’s price.

Insurance

It makes sense to think that a financial system that exists entirely on the internet is very susceptible to cyber-attacks or system malfunctions which may put your assets at risk. To prevent this, companies have started insuring DeFi assets for their customers against hackers, smart contract failures, stablecoin price crashes, or others.

You can get your assets insured by paying a premium based on the size of the assets you’re insuring. For example, insuring 1 ETH against hacks on Binance for a year will cost you around 0.0259 ETH.

You can also become a coverage provider and earn interest on the assets you have lent to the company to be used as security in case a claim needs to be paid. There is obviously a risk here, as your assets might be used up to provide for a loss, but this is why the interest you earn as a coverage provider is also higher than DeFi lending.

Decentralized Exchanges

Decentralized exchanges, also called as DEXs, are peer-to-peer marketplaces that facilitate the trading of cryptocurrencies without handing over your money to a third-party governing body. These exchanges use smart contracts to allow traders to execute orders without the need for a middleman. In contrast, centralized exchanges are run by a centralized institution that is in complete control of the exchange and can change its terms and conditions anytime.

DeFi Services You Can Use Today

1. Anchor

Anchor protocol is a lending service that aims to provide a 20% return on stablecoins. The lenders make a return on the money they provide to the borrowers. Borrowers, in turn, have to provide collateral in the form of LUNA or ETH. This is done to prove their financial worthiness to take a loan.

When borrowers put these assets in the protocol, Anchor automatically stakes them, allowing them to earn staking incentives. Borrowers receive UST, the Terra ecosystem’s stablecoin, in exchange for their money. The funds come from lenders who deposit UST in the Anchor protocol.

To avoid liquidation, the assets that borrowers deposit must be well-collateralized. Borrowers will also be responsible for the interest on this loan, which will be reflected in their collateralization levels.

Interest rates are also determined by the amount of UST lenders on the Anchor protocol who have deposited. This interest, plus the returns from the staked “bonded” assets, is what pays lenders their 20% fixed interest rate.

2. Aave

With a rapidly expanding market size, Aave might become one of the world’s most widely used DeFi lending platforms. Aave has simplified and expedited the process of lending and earning interest on digital assets. This allows one Aave user to borrow funds from another Aave user in just a few minutes.

The maximum amount of such loans is usually kept low because they are not collateralized and are subject to costs. One of the benefits of having such a wide scale of operation and utilization is that interest rates for particular assets are steady. Another perk with Aave is that it supports over 15 cryptocurrencies, which makes the entire process of borrowing and lending even smoother.

3. Terra (Luna)

If you’ve ever traded in crypto, chances are that at some point, you’ve had some USDT tokens in your wallet. Well, even though a major segment of the idea of cryptocurrencies is based on supporting decentralization, USDT tokens are centralized.

Every USDT token ever minted is backed by actual US dollars kept as collateral to balance USDT’s value against the US dollar in the real world. The involvement of these central authorities has caused numerous clashes. It resulted in the appearance of Tether scams which have the potential to disrupt the entire crypto market.

Terra is here to solve this very problem. Terra or UST token is a stablecoin that represents the true value of a dollar. However, instead of being backed by fiat currency, its value is matched by the US dollar using advanced algorithms that control the price of UST by managing the supply and demand of these tokens.

These tokens are hosted on Terra’s own blockchain that seeks to address a variety of concerns and challenges that plague even the most popular stablecoins on the market. With its Decentralized Financial infrastructure, it strives to overcome centralization and eliminate technical grudges on stablecoins.

Terra offers multiple stablecoin options, such as its TerraUSD (UST), pegged directly to the USD. It also offers TerraSDR (SDT), directly pegged to IMF’s SDR, TerraKRW (KRT) linked to the South Korea currency (Won), and TerraMNT pegged directly to Mongolian tugrik.

4. Uniswap

Uniswap is one of the largest decentralized cryptocurrency exchanges in the world. It allows you to easily exchange cryptocurrency tokens without having to share your information with any third-party broker.

You can also participate in Uniswap’s liquidity pools to earn passive income on your crypto assets by staking. Apart from that, you can quickly trade digital assets built on the Etherium blockchain.

Another perk with Uniswap is that you do not even have to create an account to trade on Uniswap. Simply connect your cryptocurrency wallet, and you’re ready to trade. However, since Uniswap relies on Ethereum, and Ethereum gas fee is very volatile, sometimes it also leads to high transaction fees.

5. Avax

Avalanche (AVAX) is a very easy-to-use decentralized platform that allows anyone to launch their own smart contracts on the blockchain. It’s primarily designed to help people build fast, affordable dApps that are compatible with Solidity.

AVAX enables low-cost interoperability between third-party tokens. This helps enhance the DeFi environment with a permissionless framework that allows users to establish private or public customized blockchains.

It also serves as a marketplace for DeFi users, allowing them to trade, swap, and store their assets and products. Additionally, Avalanche users can customize the fundamental technology that underpins their blockchains, including validators.

Within the DeFi space, Avalanche uses a peer-to-peer payment system that has shown to be a quick, secure, and scalable network. And with the promising roadmap ahead, it is on its way to help developers easily make decentralized applications like games and social media platforms and launch them on their own customized blockchain, all using a single platform.

The Future of DeFi

DeFi is rapidly changing and expanding to replicate the traditional financial services ecosystem through decentralized exchanges, lending, and borrowing of various asset types or insurance products.

Just by analyzing the growth, we can assume that DeFi can eventually have an impact on the future of centralized finance companies. DeFi is considered cheaper, faster, and more relevant alternative.

However, it’s still in the beginning stages of its evolution, which means the ecosystem is still riddled with infrastructural gaps. So before DeFi wins the title of “better solution”, there are a lot of issues that need to be solved.

If DeFi succeeds, banks and businesses will almost certainly find a way to get into the system, if not to control how you access your money, then at the very least to profit from it. And it may have already begun. The big names of the finance world like PayPal, who once used to advocate against the DeFi, are now not only supporting and promoting it, but they are also trying to be part of it.

Frequently Asked Questions

1. Is it safe to keep money in DeFi platforms instead of banks?

Even though DeFi platforms are fairly safe due to their solid algorithms, errors can appear. It is because sometimes it takes years to find out a bug in the smart contracts running them that someone can later exploit. However, no form of store of value can be considered safe, neither banks nor DeFi. So it all depends on what risk you are willing to take.

2. What is TVL in DeFi?

In the DeFi industry, TVL stands for Total Value Locked. It refers to the total amount of money invested by people in a protocol. For example, Anchor has a TVL of $15B. This means that the total sum of money staked with them is $15B.

3. How to find good DeFi projects to invest in?

To find good DeFi coins to invest in, you can use crypto screeners like Coinmarketcap or CoinGeko that list out all the DeFi coins in a separate index. Moreover, they also provide basic information about DeFi projects, including details like their market cap, circulating supply, and most importantly, a summary of what the project is about.

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