What is DeFi? Minddeft’s Beginners Guide
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on September 17th,2020

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 some more into the nitty-gritty of 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 expectations 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. 

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.

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

  • 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.

  • 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.

  • 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.

  • 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.

  • 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:

  • 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 interests 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.

Due to the transparency, the lenders are able to acquire more returns and a better hold over the potential risk. Smart contracts enable Instantaneous settlement of transactions and new secured lending methods. These platforms are also known to enable broader access for loans because there are no credit checks.

The most successful and prevalent decentralized lending platform is MakerDAO, built on top of Ethereum. It uses Dai as a digital currency which is price-stable to the value of the US dollar. Its popularity can be measured with the multiple stability fee raises caused by scalability problems to maintain its price equal to the dollar. Other popular lending protocols are Dharma and BlockFi.

  • 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 market places are Binance DEX, Radar Relay, and EtherDelta.

  • 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.

Fluidity is a popular name in offering tokenized mortgages that will make the process frictionless. Etherisc, Nexus Mutual, and Opyn are popular names in providing decentralized insurance.

  • 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.

Crypto-collateralized stablecoins are those cryptocurrencies that are backed up by other cryptocurrencies. Owing to the volatility of cryptos used as collateral, these stable coins are over-collateralized. This means that a large number of cryptocurrencies is used to back up a lower number of stablecoins. Although MakerDAO’s DAI is pegged against the US dollar, it uses diversified crypto-assets to back it up.

Then there are algorithmic or non-collateralized stablecoins. These use a working mechanism to retain a stable price. For example, bitcoin is a dollar-pegged stablecoin that uses a consensus mechanism to decrease or increase the supply of tokens on a need basis.

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.