Traditionally speaking, financial products and services are executed and controlled by central institutions. These can be governments, central banks or institutions. These days, there are also a lot of decentralized financial systems, also called DeFi.
DeFi stands for Decentralized Finance, which refers to financial products and services that operate on a blockchain. This means that these products and services are operated and maintained decentralized.
What is DeFi?
DeFi stands for Decentralized Finance. It is a term that is used to refer to financial products and services that run on the blockchain. The name is pretty self-explanatory: decentralized finance.
Traditionally, financial services and products are centralized. This means that they are managed by a central institution, such as a bank or government. For example, fiat money is a centralized financial product. The central bank is responsible for issuing the money and decides when new money needs to be printed.
Another example of a centralized financial service is insurance. Insurance needs to be taken out with an insurance firm or through an intermediary. The application is then processed by an employee, after which the insurance firm will issue a policy. When damage occurs, the insurance company is the only entity that will check and process the claim.
Products and services in the DeFi world are not managed by a central authority. Because these products run on the blockchain, the network ensures that everything is managed properly. This bring several advantages when compared to centralized financial products and services. For example, lower costs, faster processing times and less censorship.
How does DeFi work?
DeFi couldn’t operate without blockchain technologies and smart contracts. Smart contracts fare contracts that run on the blockchain. Developers can pre-program which actions should automatically be performed when certain conditions are met. These contracts form an essential part of DeFi products and services.
Every application can use smart contracts differently. As a result, large applications are created that are used for different purposes.
Which DeFi applications exist?
The DeFi world has a massive offering, since pretty much every financial product or service can be converted into a DeFi application operating on the blockchain. Yet, we can sub-divide all products and services into a number of groups, with the below applications being the most common.
Cryptocurrency exchange rates can fluctuate significantly. Consequently, not all cryptocurrencies are suitable as payment method. For example, if a restaurant receives a payment in Bitcoin, the value of this payment could halve by the next day. Stablecoins are regarded as a solution to this problem.
A stablecoin is a cryptocurrency with a value that is linked to a fiat currency. This can be the euro, American dollar or another currency. There are various types of stablecoins, which all work differently to keep their value in line with that of the fiat currency.
The benefit of stablecoins is that they can easily serve as payment method. A stablecoin will always keep the same value that is linked to the fiat currency.
In addition, crypto traders can use stablecoins as safe storage. When a crypto trader gets a nice return on a certain crypto coin, he can sell that for Bitcoin. However, Bitcoin’s exchange rate could subsequently drop, in which case the returns would also evaporate. By selling cryptocurrencies for stablecoins, the realized returns are kept.
There are various stablecoins, with DAI and Tether (USDT) being the most famous ones. However, these coins need to be covered. For example, Tether is covered by fiat money (the American dollar), while DAI is covered by cryptocurrency (ETH)
Decentralized exchanges (DEX)
A decentralized crypto exchange, abbreviated as DEX, is an exchange that runs on the blockchain. However, the blockchain needs to support smart contract for this, so that an application can be built on the blockchain.
Just like on a decentralized exchange, like Bitvavo, crypto traders can buy coins and tokens on a DEX. The difference is, however, that transactions are not executed and processed by a central organization. The nodes in the blockchain network will check the transactions and add them to the blockchain.
To be able to do this automatically, an Automated Market Maker (AMM) is often used. This is a piece of code that determines a price between two assets. An AMM is not just used for a DEX, but also for liquidity pools.
When a user wants to buy cryptocurrencies on a DEX, there first needs to be another user offering those specific cryptocurrencies. A DEX in that regard closely resembles an online marketplace.
Famous DEX’s are Uniswap and SushiSwap, which offer ERC20 tokens. These are tokens that use Ethereum’s protocol. Another famous DEX is PancakeSwap, which offers BEP20 tokens. These tokens use the protocol of Binance Smart Chain (BSC) and therefore can only be bought on a DEX running on this network.
Users can stake when a blockchain uses the Proof of Stake (PoS) consensus algorithm. Staking means that a cryptocurrency amount is locked for a fixed or infinite period. The amount that is locked in, is called the stake.
With staking, users can help secure the blockchain’s network. These users then receive a reward, which depends on the size of the stake.
Receiving credit is a difficult task traditionally, since one needs to go through many steps before money can be borrowed. This is not true for DeFi applications that bring together credit providers and credit takers.
There are various platforms available for users to borrow money. However, collateral needs to be paid, so that the platform knows that a user is creditworthy and able to repay the sum borrowed.
Borrowing money from such a platform is particularly useful for crypto traders who need money, but who don’t want to sell their current positions to get this money. This is because the user needs to provide cryptocurrencies as collateral. He will get the cryptocurrencies back as soon as he has repaid the borrowed money. The user could make another investment using the borrowed money.
Before money can be borrowed, there needs to be someone willing to lend the money. A DeFi platform is decentralized, meaning it as such does not lend money. The credit providers receives a reward for the money he lends, comprised of the fee paid by the credit taker for the use of the platform.
Famous applications that offer a platform to borrow and lend cryptocurrencies are Aave, Compound, PoolTogether and Dharma.
To operate a DeFi application, data is also needed from outside the blockchain. This is called off-chain data. For example, someone’s personal data stored on a government database. When someone wants to enter into a loan on a DeFi application, these details can be used to make clear who the application is dealing with.
The problem is that there is no central authority that can check whether the off-chain data is legitimate and can be used. Blockchains can use oracles for this purpose. Oracles are special applications that ensure that off-chain data is checked, after which it is adopted by the blockchain.
Oracles are extremely important for DeFi applications, because they ensure that such applications are adopted much faster. When off-chain data is unavailable, these applications will barely have any functionality.
Many people enjoy gambling online, for example on the results of football matches. When a player correctly predicts the result, the player wins money. These types of forecast markets are also becoming more common on blockchains.
Users can create a bet themselves, that they then also pay for. Other users can then choose to join the bet. To do so, they bet a number of crypto coins and pay the participation fee.
The maker of the forecast market can earn money when enough users participate. And that’s not all, since the winners of the bet also receive a reward.
DAO stands for Decentralized Autonomous Organization, and is an organization or company that is managed decentralized. This means that most acts are automatically executed, and that users can think of ideas that can be voted on.
The automatic execution of transactions uses with the help of smart contracts. Voting on ideas can be done by having users send tokens to the address linked to their answer.
Bitcoin was the reason for the creation of the DAO. People realized it was money to decentralize money, creating the idea of also decentralizing an organization’s management.
Taking out an insurance happens at an insurance form or through an insurance broker. They will take the application into consideration, and will assess any claims. Because there are various intermediaries, the costs are fairly high.
It is also possible to take out insurance with a smart contract. The smart contract can use oracles to check who the applicant is, and whether the applicant appears on a black list.
When a vehicle is damaged by a storm, the smart contract can investigate whether a storm in fact took place. If this is the case, and other conditions are also met, the smart contract will automatically pay compensation to the beneficiary.
Processing a claim will become much faster, because a smart contract works individually. Even though the claim is processed faster, the costs remain low for the policyholder.
The pros and cons of DeFi
The most important pros and cons of DeFi are listed below.
- There are fewer restrictions because the applications are less susceptible to the rules of external bodies.
- The blockchain technology works globally, as a result of which anyone globally can use DeFi applications without problems, so long as they have an internet connection.
- The costs for the use of DeFi applications is low when compared to centralized serves and products, where high fees are often paid to intermediaries.
- A blockchain is transparent, meaning everything can be verified.
- Depending on the blockchain, transactions can be processed quickly. Users don’t have to wait for the check and approval of an external authority.
- Because blockchains use cryptography, the contents of transactions are protected against external parties.
- Applications that run on the blockchain are available 24/7, meaning people can use DeFi applications at any time of the day.
- DeFi is still in its infancy, meaning it hasn’t been discovered and adopted as widely as central serves and products.
- The legal aspect of DeFi remains very unclear. This is partly due to the lack of legislation and regulation, which can lead to various problems with consumers and governments.
- In the past, vulnerabilities were found in Ethereum’s smart contracts. Since DeFi applications cannot operate without these smart contracts, it is important to consider the risk this creates. For example, money may be lost.
- The largest share of DeFi applications is not yet user-friendly. This is why they can often only be used when users have a lot of technical and economic knowledge.
DeFi decentralizes financial products and services that were traditionally managed by a central authority. The blockchain technology has made it possible for many products and services to be decentralized on a blockchain. This brings various benefits.
For example, there are more possibilities because there is less legislation and regulation, and anyone in the world can use the apps offered by DeFi. The costs, however, remain very low, while transactions can be processed quickly.
There are many different products and services that fall within the DeFi spectrum. For example, stablecoins, decentralized exchanges, forecast markets, lenders and DAOs.