A parallel financial system emerging to challenge the centralized systems and emerge as the only true and impartial monetary governance system; sounds impossible, doesn’t it? Well, not anymore; kudos to DeFi. DeFi, or Decentralized Finance, is the new buzzword coined on account of the mass acceptance of cryptocurrencies. DeFi is one of the components of crypto that makes money and payments accessible to anyone. The idea is to create a global network of financial services that anyone can use with a smartphone and internet connection – savings, loans, trading, insurance, and more.
This blog aims at demystifying DeFi and its features, how it works, some major DeFi projects, and more!
DeFi and its Features
DeFi, also known as open finance, is an emerging financial technology based on blockchain technology. Blockchain is a system in which a record of transactions is maintained across several computers that are linked in a peer-to-peer network. This system eliminates the control banks and institutions exercise on money, financial products, and services.
A centralized finance system entails you having your money held by banks and corporations whose main goal is to make money. Many third parties facilitate money transfers between parties in the financial system, and each charges a fee for their services. In addition to the costs involved in other financial transactions, loan applications can take days to approve; and if you travel, you may not have access to a bank’s services.
Whereas, a decentralized financial system allows individuals, merchants, and businesses to transact directly, eliminating intermediaries. Using software that records and verifies financial transactions in distributed financial databases, you can lend, trade, and borrow from anywhere with an internet connection. A consensus mechanism is used to verify the data collected from all users and aggregated from all sources; by a distributed database; accessible across various locations.
But, what exactly are the features that distinguish DeFi from traditional banking systems? Let’s have an understanding of it.
- ✅Decentralized– At its core, there is no centralized organization responsible for the business transactions; instead, programs known as Smart contracts carry out these operations when met with some specific criteria with negligible human interaction.
- ✅Trusty– It’s hard to trust humans, but not code. In a centralized system, you trust your bank with your money, but in DeFi, smart contracts are responsible for the operations. This provides a trustless environment, eliminating the chances of money laundering or fraud.
- ✅Transparency– The code for these protocols is transparent on the blockchain and can be audited by anybody. This creates a new form of trust with consumers because anybody can comprehend the contract’s operation or uncover faults. Everyone can see every transaction activity. While this may cause privacy concerns, transactions are by default pseudonymous, meaning they are not directly linked to your real-life identity.
- ✅Accessibility– Do you have a phone and internet connection? Great, because technically, that’s all you need to access DeFi products and services. This globalization and ease of accessibility is a crucial factor in the potential mass adaptation of DeFi.
- ✅Devise and utilize– A true permissionless environment would be one in which one can devise something new, and others can participate in it. DeFi applications may be created by anybody and used by everyone. In contrast to today’s finance, there are no gatekeepers or extensive formalities. Users engage with smart contracts straight from their crypto wallets.
- ✅Interoperability– Interoperability enables blockchains to communicate with one another and build on one another’s features and use-cases. Thus, new DeFi apps may be developed or integrated by mixing other DeFi products, much like Lego parts.
How Does DeFi Work?
Before getting into the working of Defi, we must understand four phrases- Blockchain, Smart contracts, Stable coins, and Dapps.
- Blockchain– Transactions are stored in blocks on the blockchain, and other users can verify them. If all of these verifiers agree on a transaction, the block is closed and encrypted, and a new block is constructed containing information from the preceding block. The blocks are “chained” together by the information in each subsequent block, thus the name blockchain.
- Smart contracts– These are pieces of code stored on the Ethereum blockchain that run when some predetermined conditions are met. They’re usually used to automate the execution of an agreement so that all parties may be confident of the conclusion right away, without the need for any intermediaries or time waste.
- Stable coins– These are the cryptocurrencies, the value of which; are pegged to another fiat currency, commodity, or financial instruments. In simple words, if 1 $ = ₹75, then 1 USDT = ₹75 (USDT is a stable coin whose value is pegged to the American dollar).
- Dapps– Decentralized Applications or Dapps are those applications that are autonomous and typically run through smart contracts on a blockchain.
Having understood the above terms, let’s figure out how DeFi works.
If you need a loan, you either approach a bank or a lender and apply for it. Once your application gets approved, you pay interest and service fees for the privilege of using that lender’s services. Whereas, in DeFi, you use dApps which facilitates a path to match you up with peers that meet your needs through its underlying Smart contract program.
The transaction is recorded in the blockchain, and you will get your loan after the consensus process has verified it. The lender will then be able to begin collecting payments from you at the agreed-upon intervals. When you make a payment using your dApp, the money is transmitted to the lender via the same blockchain mechanism.
Hence, having no centralized intermediaries, there is a minimal settlement in the form of fees and interest. You receive or lend money in the form of stable coins. The currency of DeFi at this stage of development is primarily the stable coins.
Major DeFi projects
In recent years, many interesting and efficient DeFi projects have gained traction. Some of them are emerging as alternate stable coins and decentralized crypto exchanges. Let’s have a look at three of these amazing projects.
- DAI (DAI)
DAI is an Ethereum-based stable coin launched and governed by the Maker Platform and MakerDAO. The primary distinction between DAI and other popular stable coins is that DAI is completely decentralized and is used by hundreds of dApps and DeFi projects.
The majority of decentralized coins underperformed. DAI, on the other hand, has grown in popularity and use by maintaining a consistent price near 1 USD. Furthermore, the Decentralized Autonomous Organization keeps the stable coin overcollateralized to ensure that the pegging remains stable.
- UNISWAP (UNI)
Uniswap is best known for being the current decentralized cryptocurrency exchange market leader. It is a decentralized exchange built on the Ethereum network, founded in 2017 by Hayden Adams. The trading protocol was designed as an on-chain automated market maker (AMM), capable of determining a cryptocurrency’s price based on the ratio of two cryptocurrencies within a pool.
Different DeFi tokens, as well as Liquidity Provider tokens, can be exchanged and traded on Uniswap. Even if an ERC20 token isn’t listed, you can still create a pair and exchange it for another cryptocurrency if you find the smart contract’s address.
- AVALANCHE (AVAX)
Avalanche is a platform for developing decentralized finance apps, financial assets, and other services using smart contracts. The Ethereum virtual machine, as well as application-specific sharding, network-level programmability, and NFTs, are all supported by the platform.
Avalanche employs a proof-of-stake consensus technology to provide a network where users may trade and launch decentralized assets with sub-second transaction confirmations.
DeFi and its Future
Money and finance have existed in some form or another since the birth of civilization. Crypto is only the most recent digital incarnation. It is possible in the upcoming years that every financial service we use today in the fiat system will be rebuilt for the crypto ecosystem. As of now, cryptocurrency-related assets can be issued and exchanged, lent, and accounted for.
But, decentralized finance is still in its infancy. Firstly, the ecosystem is unregulated, meaning there are still infrastructure issues, hacks, and scams. The laws currently in place are based on the idea of separate financial jurisdictions with their own laws and rules. DeFi’s borderless transaction capabilities raise significant regulatory issues. Who is concerned about investigating a scam that happens across protocols and dApps? How would the regulations be enforced? These questions are yet to be answered. Other concerns are system stability and maintenance, energy requirements, carbon footprint, and hardware failures.
Thus, DeFi is yet to emerge as the only “true and impartial monetary governance system.” With the quantum leaps in the industry, it’s hard to imagine what innovations will arise when the power to build financial services is given to anyone who can write code. Hence, all you can do is wait and observe how this next-gen technology emerges as the sole financial system of the modern era.
Mitrashis is a computer science freshman and a Metaverse, Web3, Blockchain, and Crypto investing enthusiast. He loves to play Football and Ukelele.