DeFi or Decentralized Finance has raised storms in the conventional financial systems. It has eliminated the middleman culture and made financial services accessible to all. It has various other things beyond the middleman and banking to all aspects. There are some drawbacks and limitations also which we need to be aware of before we onset with DeFi.
This guide is a Beginner’s Guide to DeFi. By the end of the article you will know what DeFi is, how is it different from the conventional financial system, reasons for its popularity, building blocks of DeFi and its use cases. Let us begin.
Table of Contents
What is DeFi?
Decentralized Finance or DeFi refers to the financial ecosystem built on top of Blockchain. What does that mean? Let us see.
We know that Bitcoin (and other cryptocurrencies) are forms of money built on Blockchain. Bitcoin can be transferred from one person to another without involving any third party like banks or bodies like PayPal, Paytm, VISA, etc.
For example, when you buy coffee from a café using your credit or debit card, then your bank sits in between you and the shopkeeper for transferring the money. Your money and transaction details are all managed by the banks. This has often invited frauds and attacks. The banks have been subject to frauds and attacks on their Central server.
Hence the concept of Bitcoin arose which eliminated the need for any third party for transferring money or value. A person can send Bitcoin directly to another person (peer to peer), without any intermediary. Rather than having all the transaction data maintained in the bank’s central server, all the members of the Blockchain have a copy of all the transactions happening.
So, we see that Bitcoin and other cryptocurrencies are a use case of the Blockchain for direct financial transactions.
But Blockchain’s penetration to financial ecosystem is not limited to cryptocurrencies only. Other financial concepts like lending, crowdfunding, loans, insurance, betting, etc. can also be built on the Blockchain (using Smart Contracts, discussed later) making them decentralized (free from any intermediaries).
This ecosystem of financial applications built on the Blockchain is called Decentralized Finance or DeFi. The users in the DeFi will have full control over their financial assets and interact with one another directly using Peer to Peer Decentralized Applications (DAPPs).
- Accessible to all: Accessing the financial products like loans, bonds, derivatives, insurance, betting, lending, borrowing, etc. of the conventional banking system, is quite difficult of a task. We need intermediaries like banks or financial institutions and the related infrastructure to access these financial products.
Add to it the personal information that we need to share (KYC) in order to access the services. Also these infrastructures are generally not present in the low-income communities and last miles of the world.
On the other hand, DeFi enables frictionless access to financial products. It makes the financial products peer to peer and decentralized. Anyone with a phone and an Internet can access the DeFi ecosystem for financial products like loans, bonds, derivatives, insurance, betting, lending, borrowing, etc.
- Secure and immutable: The DeFi ecosystem is basically made up of Decentralized Applications (DAPPs). Dapps are web/mobile applications which are built on the Blockchain platform. Contrary to traditional web applications which have their backend deployed on centralized servers, Dapps have their backend deployed on Blockchains. Dapps have Smart Contracts. Smart Contracts are codes which govern the financial interactions by setting the required rules (which otherwise are done by banks and courts in the conventional banking system).
Blockchains make the DeFi ecosystem ultra secure and immutable. The data is securely distributed among the nodes of the network using cryptography. It becomes practically impossible to tamper any data written in the blockchain.
- Lesser costs of availing the services: As there are no intermediaries involved like banks and other financial institutions, the costs of using the financial services are lower in DeFi.
- No single point of failure: DeFi as we know are built on Blockchains. In Blockchains the financial data is not stored in a Central server as is in the case of the conventional banking system. The data is spread across and copied to all the member nodes of the Blockchain. Changes by any malicious intrusion to the data of any member node is easily reflected across the network which is rectified.
How does DeFi work? What are the building blocks of DeFi?
In this guide, we will try and get a basic idea of how DeFi works and what are its building blocks.
Most of the DeFi applications are built on the Ethereum Blockchain. Computer codes are written on the Ethereum blockchain which automate the execution of financial contracts. These codes are known as Smart Contracts.
Smart Contracts are programmed to automatically execute financial transactions upon the completion of certain pre-defined actions. For example, there can be a Smart Contract ,which automates the payment of some pre-defined sum of money from Alex to Geuken when the BJP government wins the election (betting). Or there can be a Smart Contract written which sells all the shares of a company X, which Alex holds when the price exceeds USD 100.
Other popular blockchain platforms on which DeFi applications are built include Solana, Cardano, Polkadot, Avalanche, Polygon.
Popular Use Cases of DeFi.
As we discussed in this Beginner’s Guide to DeFi, applications (Smart Contracts) are built on the Ethereum Blockchain which enable different types of financial activities to be performed in a decentralized manner, without any intermediary. Some of the popular types of DeFi applications are listed below. I do follow this to keep myself updated on DeFi and its use cases.
- Decentralized Exchanges (DEXs): DEX enables exchange of currencies without any intermediaries involved. One can directly connect to another person for exchange of cryptocurrencies or exchange of cryptocurrency for a fiat currency.
Ex: MDEX, Uniswap, PancakeSwap, Sushiswap, Curve Finance, etc.
- Lending Platforms: Lending Platforms help lenders to directly connect (without any intermediary) with borrowers to lend cryptocurrencies. Lenders are paid interests for lending cryptocurrencies. The algorithm of the lending platform increases the interest rate of lending a cryptocurrency as its demand increases. DeFi lending is c0llateral based, meaning one needs to put up a collateral for accessing a loan. This collateral is often Ether, the native coin of the Ethereum Blockchain. This means one does not need to disclose their identity or associated credit score for receiving loan as it is required in the conventional financial system.
Ex: Compound, InstaDApp, dYdX, etc.
- Stablecoins: Stablecoins are cryptocurrencies whose values are tied to the value of fiat money to reduce the volatility.
- Prediction Markets: Prediction markets allow users to bet for future events and in return get rewarded for right predictions. For example, users can bet on “Whether Biden be the next US President?”.
Ex: Augur, Gnosis and Polymarket. Omen.eth, etc.
DeFi is certainly going to transition the financial landscape of the world. It gives the users more accessibility and security and lesser fees and friction to use the services. But it has its own set of limitations in terms of potential hacks and frauds. But as we evolve, we are ought to see improvements and reforms which will delimit these drawbacks.