DeFi: A Comprehensive Explainer

DeFi applications can be designed to offer different solutions to fulfill different financial needs based on pre-programmed conditions. Hence no person is needed to verify if conditions have been met.

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Okay, so you know that DeFi stands for decentralized finance.

You probably also know that by decentralized, this means that no one entity, such as a third party or intermediary, are in control.

But how does all this work?

Decentralization is described as the process by which the activities of an organization, particularly those regarding planning and decision making, are distributed or delegated away from a central, authoritative location or group.

Through decentralization, platforms assets like Bitcoin are removing middlemen from transactions.

The benefits of a decentralized currency such as bitcoin include:

  • Permissionles – meaning that users do not need the authority of third parties such as banks and governments to use the money. Its free and open to use globally
  • Bitcoin is immune to seizure
  • Using a computational algorithm called proof-of-work (PoW), no one is able to block or censor your transactions
  • P2P transactions are very low-cost too, much less than central payment networks such as PayPal, Visa or MasterCard

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SEE ALSO: Understanding DeFi Prediction Markets and Why they are Always Right

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By decentralzing money, third party institutions such as banks, governments etc cannot make rules and earn income from people exchanging money.

DeFi brings the benefits to financial applications that includes:

  • Exchanges
  • Loans
  • Insurance
  • Crowdfunding
  • Derivatives
  • Betting

In DeFi, the above aspects of finance are decentralized using smart contracts programmed on blockchains like Etherem and Solana, designed to build a wide array of decentralized applications besides just currency.

Smart contracts automatically execute transactions if certain conditions are met.

While bitcoin only supports sending of transactions, a platform like Ethereum that is based on smart contracts can add conditions to a transaction.

For example, a user wants some money to be sent to a friend next Tuesday, but only if the temperature climbs above 90 degrees Fahrenheit according to weather.com. Such rules can be written in a smart contract.

Based on the above, DeFi applications can be designed to offer different solutions to fulfill different financial needs based on pre-programmed conditions. Hence no person is needed to verify if conditions have been met.

Smart contracts have spawned a creative streak across the world with many solutions coming up day after day.

Here is look at 4 of the most popular applications of DeFi:

Decentralized Exchanges (DEXs)

A decentralized exchange is a peer-to-peer (P2P) marketplace that connects buyers and sellers of cryptocurrencies. Unlike centralized exchange platforms like Coinbase and Binance, user have full custody of their funds on DEXs since they own their private keys.

In the absence of a central authority, DEXs employ smart contracts that self-execute under set conditions and record each transaction onto the blockchain. 

Examples of popular DEXs include Uniswap, Curve, PancakeSwap and Sushiswap which enable users to swap crypto.

Lending Platforms

These platforms connect lenders and borrowers using smart contracts essentially replacing intermediaries such as banks that manage lending as middlemen.

Popular lending platfroms include Aave and Compound.

On Compound, users can borrow cryptocurrencies or offer their own loans. Users can also earn interest by lending out their money. Compound sets the interest rates algorithmically, so if there’s higher demand to borrow a cryptocurrency, the interest rates will be pushed higher.

DeFi lending is collateral-based, meaning in order to take out a loan, a user needs to put up collateral – often ETHER, the token that powers Ethereum. This also means users don’t give out their identity or associated credit score to take out a loan, which is how normal, non-DeFi loans operate.

Another way to generate “passive income” on some of the mentioned lending platforms include yield farming. This has the potential for even larger returns, but with larger risk. It allows for users to leverage the lending aspect of DeFi to put their crypto assets to work generating the best possible returns.

Stablecoins

Stablecoins are tokens that power the DeFi economy by providing a stable means of exchange.

Popular stablecoins include USDC and USDT. These are crypto assets whose value are usually pegged to the value of one dollar, offering a stable solution for example in earning interest rather than one whose value fluctuates.

Prediction Markets

These DeFi applications let users bet on the outcome of some event.

One of the more popular prediction was – ‘Will Donald Trump win the 2020 presidential election?’

In the finance world, participants trade with contracts where the payoff will vary depending on the outcome of a future event. Prediction markets make the result of this future event tradeable.

While the goal of participants in prediction markets is to make money, these markets can sometimes better predict outcomes than conventional methods like polling.

Examples of DeFi dApps in this category include Gnosis, Polymarket, Augur, and PlotX.

DeFi is a new financial technology, which is experimental and isn’t without problems, especially with regard to security or scalability. There are multiple ongoing efforts to make the technology better, and in particular, since DeFi has drawn interest from large institutional players.

A recent report by Chaialysis indicated that institutional players are driving most of the activity on DeFi, and not necessarily independent users.

In respect to scalability, whereby different projects face the challenge to expose their service to a wider user base because of slow and expensive transactions, different solutions have emerged:

  • Ethereum, the main DeFi platform, is in the process of upgrading to Ethereum 2.0 whereby it will use a concept referred to as sharding that involves splitting the underlying database into smaller pieces that are more manageable for individual users to run
  • Layer 2 solutions like Polygon sidechain that offers cheaper and faster transactions for DeFi applications along Ethereum
  • The emergence of high perfromance smart contract blockchains like Solana

Many believe various DeFi projects have the potential of drawing in hordes of new users by making financial applications more inclusive and open to those who don’t traditionally have access to such platforms.

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RECOMMENDED READING: Celo Partners with Leading DeFi Projects in a $100 Million Initiative to Bring DeFi to the Developing World

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