What is Decentralized Finance (DeFi)? Minddeft's Beginners Guide

DeFi, or decentralized finance, is majorly reshaping the global financial ecosystem. It is a step towards making money and payments universally accessible. Its applications have made financial products like savings, loans, trading, etc. utterly accessible to anyone with a smartphone and an internet connection.

Before diving into what is DeFi, let us know why we need it.

The Need for DeFi

DeFi before a concept or an ecosystem is a revolution to transform the existing finance industry. The traditional financial system is a closed one where power is concentrated with central authorities and third-parties. This not only limits the people’s control over their money but also the profits that their assets make.

Even the control of our assets lies with various financial organizations in expectation of higher returns. This is problematic since the centralization of control and value centralizes risk too. Other than that, sometimes even the big bankers cannot see the faults in the market. The recession of 2007-2009 due to the USA’s housing market bubble is the greatest example of that.

Since the fiat money is restricted locally, the processing fees for transactions can be very high in the case of abroad transactions. DeFi saves the day with this problem also by having significantly lower processing fees.

This centralization of power and control creates transparency problems. And DeFi is the attempt to create decentralized applications to solve those problems. By making financial use cases -- like lending, wealth management, insurance, etc. -- more accessible, DeFi works in an all-inclusive manner. For example, DeFi lending platforms have changed how loans and savings work in the digital age.

What is DeFi?

DeFi is an attempt to create an environment of financial applications built on the top public blockchain. The vision behind it is to create an open-source, permissionless, secure, and transparent financial ecosystem.

An ecosystem where power is distributed evenly and isn’t concentrated. With the help of DeFi, users will be able to exercise control over their assets using peer-to-peer (P2P), decentralized apps (dApps).

By running these dApps on a public blockchain, DeFi applications set up a peer-to-peer financial network. These dApps can be combined, modified, and integrated according to our needs. Smart contracts work as connectors — comparable with perfectly specified APIs in traditional systems.

The creation and execution of smart contracts is a major component in DeFi applications. Smart contracts can be thought of as legal contracts whose terms are defined through computer code rather than legal terminology.

Smart contracts are the secret sauce that reduces the risk between two parties in DeFi applications. They also eliminate the need for manual supervision due to their unique ability to enforce terms through computer code. 

People often confuse DeFi with open banking. They are two very different things. Open banking allows the management of traditional financial instruments by acquiring secure access to financial data through APIs. On the other hand, DeFi applications venture to manage and create entirely new financial instruments and new ways to interact with them.

How Does DeFi Work?

Decentralized finance, or DeFi, operates on blockchain technology, which ensures transparency and security. Here's how DeFi works.

1. Blockchain Foundation

DeFi applications are built on various blockchain platforms, like Ethereum, Binance Smart Chain, Solana, and Polkadot. enabling the creation of tools such as DeFi aggregators to improve user experience and efficiency. Blockchain uses decentralized technologies to record all the transactions that can be accessed by anyone.

2. Smart Contracts

Smart contracts are self-executing contracts where agreements are written into code, and they automatically execute transactions when conditions are met. This reduces the need for intermediaries, reduces costs, and improves the transaction process.

3. Decentralized Applications (dApps)

DeFi apps run on blockchain networks and offer services like lending, borrowing, trading, and insurance. DeFi utilizes a decentralized application to offer financial services. Users can interact with decentralized applications through their wallet, retaining full control over their assets. Learning how to create a DeFi wallet can be the first step towards engaging with this ecosystem.

4. Decentralized Exchanges (DEXs)

Decentralized exchanges (DEXs) allow users to trade their cryptocurrencies directly with one another without the need for intermediaries. Some popular examples of decentralized exchanges are Uniswap and Sushiswap. 

5. Tokenization

The DeFi platform uses tokens to represent assets like gaming or characters. This token can be traded with a cryptocurrency like Ethereum or any other cryptocurrency or stablecoin like DAI. Tokens are used for trading, stacking, governance, and more.

6. Liquidity Pools and Yield Farming

Liquidity pools are an important component of DeFi. Users can provide their assets to these pools and earn rewards in return. Yield farming involves staking or lending cryptographic assets to generate high returns or rewards, often paid in additional tokens.

7. Governance

Many DeFi platforms are governed by decentralized autonomous organizations (DAOs). Token holders can vote on proposals to make changes to the protocol, ensuring that the platform evolves based on community consensus.

Difference Between Traditional Finance and Decentralized Finance

1. Centralization vs. Decentralization

• Traditional Finance (TradFi): Operates through centralized institutions like banks, brokers, and insurance companies. These entities act as intermediaries, controlling and managing financial transactions and assets.
• Decentralized Finance (DeFi): Eliminates intermediaries by using blockchain technology and smart contracts. Transactions are peer-to-peer, with no central authority overseeing or controlling them.

2. Accessibility

• TradFi: Often requires significant documentation, credit checks, and approval processes, making access to financial services difficult for unbanked or underbanked populations.
• DeFi: Accessible to anyone with an internet connection and a compatible digital wallet. There are no credit checks or extensive documentation required, promoting financial inclusion.

3. Transparency

• TradFi: Operations are often opaque, with limited visibility into the inner workings of financial institutions. Customers must trust that these institutions are acting in their best interest.
• DeFi: Built on blockchain, which is inherently transparent. All transactions are publicly recorded on the blockchain, allowing anyone to verify them independently.

4. Intermediaries and Fees

• TradFi: Involves multiple intermediaries (banks, brokers, payment processors), each charging fees for their services. These fees can add up and reduce the overall efficiency of financial transactions.
• DeFi: Smart contracts automate transactions, reducing the need for intermediaries and significantly lowering transaction costs. Users can interact directly with each other.

5. Speed and Efficiency

• TradFi: Transactions, especially cross-border ones, can be slow due to the involvement of multiple intermediaries and regulatory hurdles. Settlement times for certain financial instruments can take days.
• DeFi: Transactions are typically faster since they are processed on blockchain networks, which operate 24/7 without the constraints of traditional banking hours or geographical borders.

6. Security

• TradFi: Relies on the security measures of financial institutions, which can be susceptible to fraud, hacking, and insider malfeasance. Customer funds are stored within these institutions.
• DeFi: Security is maintained through cryptographic methods and consensus mechanisms. However, it is also susceptible to smart contract vulnerabilities and hacking. Users are responsible for the security of their own funds.

7. Control and Ownership

• TradFi: Financial institutions have control over users' funds and can impose restrictions or freeze accounts. Users must trust these institutions to act in their best interest.
• DeFi: Users retain full control and ownership of their assets through their private keys. This sovereignty means users are responsible for managing and securing their assets.

8. Innovation and Flexibility

• TradFi: Innovation can be slow due to regulatory compliance, bureaucratic processes, and legacy systems. Traditional financial products and services can be rigid and difficult to adapt.
• DeFi: Rapid innovation is facilitated by the open-source nature of blockchain technology. Developers can create and deploy new financial products and services quickly, offering greater flexibility and customization.

9. Governance

• TradFi: Decisions are made by a central authority, such as a bank’s board of directors or regulatory bodies. Customers have little to no say in the governance of these institutions.
• DeFi: Many DeFi platforms use decentralized governance models, where token holders can vote on proposals and changes. This democratizes decision-making and allows users to have a direct impact on the platform’s future.

Benefits of a DeFi Ecosystem

As we saw above, DeFi offers many advantages over the existing finance industry. Let’s take a look at the major benefits of a DeFi ecosystem

1. Frictionless System

DeFi applications work without any intermediaries or third-parties. Possible disputes are tackled and resolved by the code itself. Hence, DeFi allows the financial system to be frictionless and cuts down the costs of using these products.

2. Financial Freedom

Owing to a decentralized ecosystem, DeFi doesn’t have any censorship. This means that the Users are free to choose which financial instruments they want to use and when they want to use them.

3. Borderless Ecosystem

DeFi enables worldwide participation in finance by offering the same chances to access financial products and services to every user. Because of enabling borderless participation, DeFi can create a fairer global economy by balancing out markets of different countries.

4. Inclusive

The traditional financial system relies on the intermediaries and central authorities to make profits. This makes them practically absent from the reach of individuals or communities with low income. Since DeFi applications enable financial services to be offered at significantly reduced prices, the financial instruments are accessible by everyone.

5. Modular Framework

DeFi is built on a modular framework that enables the interoperability of different applications of DeFi. These applications can be combined, modified, and integrated according to our needs. This interoperability will lead to the creation of entirely new financial markets, products, and services.

These advantages ensure that the decentralized finance system is transparent, cost-effective, and less overhead. Hence, DeFi offers a plethora of advantages as compared to our traditional financial system. 

Some Use-cases for DeFi

DeFi is all about the integration of digital assets and open protocols with conventional financial structures using blockchain technology. With the constant efforts of developers and researchers, DeFi has offered many solutions for financial use-cases over the years.

Here are some of the main use-cases for DeFi with some examples:

1. Open Lending Platforms

In recent years, the popularity of open lending platforms among other open finance applications has seen a big spike. The recent extensive usage of MakerDAO and other P2P protocols like Dharma clearly indicate that it is slowly shaping up as a credit choice.

The core model is just like traditional banking where the users earn interest for depositing their digital assets when someone borrows them. The terms, however, are defined and executed through smart contracts. They connect lenders and borrowers and are in charge of distributing the interest.

They offer many advantages over the traditional credit system. In cases of defaults, these platforms have the ability to collateralize digital assets. The automation costs are significantly reduced due to potential standardization and interoperability.

2. Decentralized Exchanges

One of the most crucial applications of DeFi is decentralized exchanges. Decentralized exchanges or marketplaces have peer-to-peer transactions of digital assets without any third party involved. This reduces the maintenance work which results in much lower trading fees for the users.

It has several advantages over a centralized exchange like Coinbase. In a decentralized exchange, a transaction can be executed without sign-ups, identity verification, or withdrawal fees. They also employ some of the innovative methods from centralized marketplaces like atomic swaps or other non-custodial methods.

Many DEXs claim to be decentralized and non-custodial but are not so. So it is better to do the homework before using them. IDEX, a dApp built on Ethereum, is the most popular DEX out there. Other popular decentralized marketplaces are Binance DEX, Radar Relay, and EtherDelta.

3. Monetary Banking Services

DeFi is also used for providing applications for monetary banking services like mortgages, insurance, etc. These services are full of intermediaries and reconciliations which makes them time consuming and opaque. With the help of DeFi, we’ll be able to cut down the manual processes substantially.

Mortgages become nightmares owing to a large number of intermediaries being involved. This makes the process tedious and time-consuming. The same goes with the applications or claims with insurance. The number of intermediaries also contributes to the interest rates and premiums.

Using smart contracts, underwriting and legal fees could be reduced significantly. Similarly, in insurance, elimination of the need for intermediaries results in lower premiums with the same quality of services.

4. Stablecoins

Stablecoins is a new class of cryptocurrencies that eliminates the very thing people are paranoid about when it comes to cryptos- the volatility. They offer this price stability by backing up their stablecoins by a reserve asset. These can be fiat currencies or other assets like precious metals (gold, platinum).

There are different types of stable coins depending upon how they maintain their price stability. Some maintain their stability by being backed up by fiat currencies or cryptos, while others use algorithms.

There are fiat-collateralized stablecoins that either maintain a fiat-currency reserve ( mostly USD) or use commodities like oil and precious metals as collateral. Tether and TrueUSD are the most popular examples of stablecoins. They are both pegged to the value equivalent to that of a single USD.

Popular DeFi Examples

Decentralized Finance (DeFi) has grown rapidly, with numerous platforms offering innovative financial services. Here are some of the most popular DeFi examples:

1. Uniswap

Uniswap is a decentralized exchange (DEX) that allows users to trade cryptocurrencies directly without intermediaries. It uses an automated market maker (AMM) system, where liquidity providers deposit tokens into liquidity pools. Traders can swap tokens from these pools, and liquidity providers earn a portion of the trading fees.

2. Aave

Aave is a decentralized lending and borrowing protocol. Users can deposit their cryptocurrencies into Aave’s liquidity pools and earn interest. Borrowers can take out loans by using their crypto assets as collateral. Aave also offers unique features like flash loans, which are uncollateralized loans that must be repaid within the same transaction.

3. Compound

Compound is another popular lending and borrowing platform. Users can supply assets to liquidity pools and earn interest, or they can borrow assets by providing collateral. The interest rates on Compound are algorithmically determined based on supply and demand.

4. MakerDAO

MakerDAO is the protocol behind the DAI stablecoin, which is pegged to the US dollar. Users can create DAI by depositing collateral into MakerDAO’s smart contracts. MakerDAO also uses a decentralized governance system where MKR token holders vote on proposals to maintain the stability of DAI.

6. Yearn.Finance

Yearn.Finance is a yield aggregator that optimizes yield farming strategies. Users can deposit their assets into Yearn’s vaults, which automatically allocate funds to the most profitable yield farming opportunities across different DeFi protocols. Yearn.Finance aims to maximize returns while minimizing risk.

7. PancakeSwap

PancakeSwap is a decentralized exchange on the Binance Smart Chain. Similar to Uniswap, it uses an AMM model for token swaps. PancakeSwap offers additional features like yield farming, staking, and lottery games, making it a popular choice among DeFi users on Binance Smart Chain.

Conclusion

Decentralized finance is a vision of a financial system that creates a line between the traditional financial and political systems. A system like this will enable transparency and a uniform concentration of control over assets. DeFi will also curb the precedents of censorship and discrimination in the system. A successful DeFi ecosystem will ensure that the power lies with the open-source community and the individual.

But, not every financial use-case would be producible in a decentralized way efficiently and securely. Hence, we must find the financial products and services that are most suitable to work hand-in-hand with blockchain. Only after that can we begin to think of mainstream adoption.

MindDeft is a Defi Development Company that specializes in creating secure, scalable, decentralized financial solutions tailored to your business needs.