Over the last year, the term “DeFi” has caused quite a stir in the decentralized community. Many in the community believe that DeFi, or decentralized finance, can completely turn the global economy on its head by making the finance sector transparent and more easily accessible. The DeFi movement leverages decentralized networks to transform old financial products into trustless and transparent protocols that run without intermediaries:
DeFi has a unique opportunity to craft a unique niche for itself in the space. There are currently 1.7 billion people around the world who don’t have access to essential financial services. However, with a simple internet connection, they will be able to access smart contracts and experience immense financial growth and security with DeFi. So before we look into the nitty-gritty of this revolutionary system, let’s understand what’s going on currently in traditional finance systems.
Traditional finance is centralized. We have central banks an authorities taking care of our money for us. Since we don’t have the right to choose the monetary policy that governs us, all that we can hope and pray for is that these institutions are not going to take advantage of us and opt for policies that align with the interest of the majority. However, as history has shown us, a system based on “trust,” is inevitably going to fail.
During the 2020 Coronavirus crisis, the Federal Reserve, USA’s central banking system, made the headlines by stating that they would inject as much as $1.5 trillion dollars into the market to prevent ‘Unusual Disruptions’ and bail out banks that are under immense financial pressure. However, this money isn’t free, and somebody has to pay for it eventually. Ultimately, the ordinary folks have to pay the price and it comes either in the form of increased taxes or higher unemployment rates.
Once again, this underlines the core problem with this sector. There is a massive misalignment between the interests of the people and the interests of the financial institutions. This misalignment was so apparent during the Covid-19 crisis that it led to one of the most infamous headlines of all time:
Image Credit: CNN
Even though millions around the world are losing their jobs, big companies still manage to profit.
The solution to this problem lies in decentralization.
DeFi or “decentralized finance” is an all-encompassing term that refers to the digital assets, decentralized applications (DApps), financial smart contracts, and protocols that run on top of public blockchains like Ethereum. Public blockchains have several highly disruptive properties.
Image Credit: appinventiv
Since cryptocurrencies like Bitcoin are already decentralized and borderless, in nature, why do we need DeFi?
A vast majority of the DeFi apps are built on the Ethereum blockchain since it’s the most well-known smart contract platform in the world with a huge developer community. You can think of Ethereum as a global supercomputer that rents out its computational resources to developers around the world who want to build their applications on top of it.
As per DeFi Pulse, this is what the current state of DeFi applications on Ethereum looks like:
DeFi.review gives us a complete overview of the decentralized finance landscape across all platforms.
Transparent and open lending protocols have fast become the most popular use-case of DeFi. Let’s hop back to Defi.Pulse and check out the top five most popular DeFi applications on Ethereum:
As you can see, three out of the top five are lending protocols. The reasoning behind this is two-fold:
Similar to a traditional bank, a user deposits their money to the platform and earns interest when someone else borrows it. The core difference lies in how the platform handles the money in between.
In traditional credit structure, the loans are issued by financial institutions such as banks or third-party lending services. These institutions conduct a thorough background check of the borrower to judge if they will be capable of paying back the loan or not. This check includes but isn’t limited to:
As such, many people get excluded from the process even. Even if they do get in, they still have to pay exorbitant interest rates, making the whole system highly inefficient.
DeFi lending aims to democratize this entire process and connect borrowers to a wide pool of lenders. Instead of having institutes acting as intermediaries, smart contracts directly connect the borrower and the lender with each other. The smart contract is responsible for:
Both the borrower and the lender can benefit immensely from the open nature of DeFi lending.
MakerDAO is, far and away, the most dominant project in the decentralized finance space with a whopping $484 million locked up in it. MakerDAO allows you to lock up your Ether in a smart contract called Collateralized Debt Position of CDP, in exchange for DAI, a stablecoin that’s pegged by a basked of cryptocurrencies. In the Maker ecosystem, there are no Lenders. The DAI you receive is a loan that’s collateralized by the ETH you locked up in the CDP contract. Along with DAI, MakerDAO has another native token called “MKR.” MKR is used to pay interest fees and for participating in Maker’s decentralized governance.
Interacting with CDP
Users can interact with CDP using a four-step process.
Compound is another promising DeFi Lending protocol that aims to build an algorithmic money market protocol on Ethereum. Users can lock up their assets in Compound’s liquidity pool and earn passive income via a continuously-compounding interest.
Compound currently supports BAT, DAI, ETH, USDC, REP, and ZRX. Each of these tokens connects to Compound via its native token “cToken.” cToken allows users to earn interest on their money while also enabling them to transfer, trade, and procure services in other applications.
Points to note:
Users can mint or create cTokens using an Ethereum friendly wallet like MetaMask, Coinbase wallet, or Huobi wallet.
“Derivative” is a pretty well-known term in traditional finance. It refers to a contract that derives its value from the market performance of an underlying entity such as an asset, index, or interest rate. The terms of the contract are executed by a third-party called “broker.”
Decentralized derivatives are pretty similar, save for one crucial factor - instead of a centralized broker, they use a smart contract to. There are several advantages to this approach:
So, why use derivatives in the first place? There are two main reasons:
Synthetic assets, like derivatives, form a huge and vital part of the global financial landscape. As per the Bank for International Settlements (BIS), for the first half of 2019, around $640 trillion in financial derivatives are currently outstanding. This easily makes the derivatives market the largest in the world.
With DeFi, it will be possible to bring these derivatives contracts in the decentralized space. Let’s look at just some of the derivatives use cases in the crypto world:
Synthetix is a peer-to-contract trading platform that allows users to mint various synthetic assets, including derivatives. The platform’s native Synth (SNX) token provides access to 20 different assets such as bitcoin, USD, gold, TSLA (Tesla stocks), etc.
So, how does this system work? Let’s take a look:
Exchanges serve one of the most critical functions in the crypto ecosystem, serving as a bridge between the fiat and crypto worlds. Having said that, it’s hard to ignore its many problems and the way it has plagued the crypto space over the last several years.
Decentralized exchanges or “DEX” enables trustless trading without being intermediary-dependent by running on top of a shared ledger. A DEX directly connects two parties with each other and allows them to share assets without having to go through an intermediary. Let’s look at how the process works:
Advantages of DEX
Uniswap is an Ethereum-based DEX that allows for the trading of ETH and ERC20 tokens. It uses liquidity reserves in facilitating the exchange of digital assets on its platform. These reserves are provided for by a network of "liquidity providers." Individuals can use the protocol as long as they have the MetaMask wallet installed.
Uniswap consists of two Vyper-coded smart contracts:
Kyber Network is one of the most well-known DEXs out there. Kyber works using pools of over 70 different ERC20 tokens called “reserves” that are controlled by Different parties. If you send an order to the Kyber protocol, it looks through all the reserves available and returns the best price possible.
The native token of Kyber is called Kyber Network Crystals (KNC). The reserves need to pay fees in KNC to continue their operations. The fees collected are either burned or awarded to integrated dApps.
The DeFi movement is one of the most promising offerings of the decentralized space. Not only is the tech involved intriguing, but it truly has the unique opportunity of revolutionizing the global financial landscape. If you want to be a part of this movement, then at Ivan on Tech Academy, we have the perfect course for you.
Our DeFi course will give you the fundamental knowledge needed to dive deeper into the wonderful world of Decentralized Finance. The course provides you with the fundamental building blocks required to provide you with a holistic view of the entire DeFi space. Join us and understand the true potential of this space.