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What is DeFi? The Beginner’s Guide to Decentralized Finance

According to market experts, the cryptocurrency space is expected to disrupt the financial services industry by retiring their centralized financial systems and ushering in peer-to-peer finance. This is the path-breaking technology also known as Decentralized Finance, or “DeFi.”

Bitcoin and other cryptocurrencies are not controlled by any federal bank or government. They can be easily transferred and are considered decentralized money. At the moment, the vast majority of our financial systems are centralized.

Financial services institutions such as banks, stock markets, and even insurance companies are all highly regulated. These centralized financial systems, while generally considered the status quo, do carry certain risks. They are vulnerable to fraud and mismanagement, not to mention corruption.

So, many people find themselves pondering: “What if… what if it’s possible to decentralize the ENTIRE financial system the way Bitcoin is doing to fiat currencies? What doors would that open?”

Is your interest piqued yet? Alright, let’s keep going!

The Importance of a Stablecoin in DeFi

As mentioned a little further up, DeFi is an umbrella term for financial services that are not governed by any financial authority.  In order to create a robust DeFi system, the first and most important requirement is an infrastructure for running these decentralized services.

Folks, please welcome to the stage: Ethereum!

A crowd favourite, Ethereum is a do-it-yourself platform used for running many decentralized applications.

This cryptocurrency can be leveraged to write automated code known as smart contracts. To put it in laymen’s terms, it helps to manage any financial service in a decentralized manner so you can determine rules about precisely how a service will work. Once these rules are deployed on the Ethereum network, they can no longer be tampered with or adjusted.

Okay, time to zoom out a bit and take a look at some of the essential building blocks of a DeFi system.

Components of DeFi

After a working infrastructure, the next thing a financial system needs is money.

Bitcoin, while it is decentralized, has very basic programmable functionality. Ether, on the other hand, is compatible AND programmable, but falls victim to the same problem as many other cryptos—it’s highly volatile.

So what then can you do if you’re looking to build reliable financial services that people will want to use? Well, you HAVE to use a stable currency to operate within the system.

This is where stablecoins come in! Stablecoins are cryptos that are pegged to the value of a real-world asset such as the U.S. dollar. For the purpose of DeFi, you will want to use a stablecoin that doesn’t use fiat currency reserves, as that would require a central authority.

DAI is a decentralized cryptocurrency pegged against the value of a U.S. dollar. Unlike other popular stable coins whose value is backed directly by U.S. dollar reserves, DAI is backed by crypto collateral that can be viewed publicly on the Ethereum blockchain. This stablecoin is over-collateralized which means if you lock up a deposit of $1 dollar worth of Ether, you can borrow $0.66 worth of DAI.

In case you want your Ether back, you can pay back the DAI you borrowed and have the Ether released. As DAI is overcollateralized, it covers for volatility in Ethereum.

The DAI stablecoin is also a smart contract that resides on the Ethereum platform. This makes DAI a trustless and decentralized stablecoin, that cannot be shut down or censored.

Use cases of DeFi

Among the most common DeFi applications and use cases are:

Decentralized exchange (DEX)

Decentralized exchanges operate through a set of rules of smart contracts that allow users to buy, sell or trade cryptocurrencies. Similar to DAI, they also reside on the Ethereum platform. It means they operate without a central authority. It’s not just us getting excited about this:

DeFi

When you trade on a DEX there is no exchange operator, no need for ID verification, and also no withdrawal fees. The smart contracts in fact execute trades and can securely handle the transfer of funds.

As seen in the chart above, the volume on decentralized exchanges touched an all-time high of US$62 billion in January 2021. 

Decentralized money markets

This money market basically connects borrowers with lenders. For example, take a look at Compound. Compound is an Ethereum-based borrowing and lending damp where you can lend your crypto and earn interest on it.

Alternatively, you might also need money to buy groceries or pay your rent. But in case the only currency you have is crypto, you can deposit your digital currencies as collateral and borrow against it.

The compound platform connects borrowers with lenders, enforces the terms of the loan, and distributes the interest. The process of earning interest in cryptocurrencies is rising in popularity in recent times which brings yield farming into the picture.

Yield farming is a term given to the act of putting crypto assets to work while seeking to generate the most returns possible.

The Final Takeaway

So, decentralized financial systems work in conjunction with one another making it possible to mix and match various services that create new and exciting opportunities.

Think of it as Lego—just as you can use different Lego blocks and get creative with what you want to build, the possibilities in DeFi are endless. We think that’s pretty darn exciting! The DeFi ecosystem offers a number of advantages: transparency, interoperability (say THAT 10 times fast), decentralization, and a flexible user experience among others.

However, as with any new frontier of innovation, there are also certain risks. DeFi is still in its infancy. Despite precautions taken, there is the potential for things to take a left turn at high speed. For example, some smart contracts in the past did run into issues when the rules for certain services were not defined correctly, allowing hackers to find creative ways to exploit existing loopholes in order to steal money.

In summary, there is almost infinite potential here. Like any other brand new industry, caution is wise when it comes to personal investment. Do research before jumping into anything new.  As the saying goes, “knowledge is power” and so with that, we hope you’ve gained a little power from the few minutes you’ve spent reading this today.