What is DeFi, and why is there so much hype around it?
“In our digital age, tokenization compliments the information-based technology as a decentralized way of capital allocation”.
- Abdulla Bin Touq Al Marri, the Minister of Economy of the United Arab Emirates
The finance sector is always known for the regulations imposed by the governments, tied up with decades-old technologies and practices. The Decentralized Finance (DeFi) covers traditional Finance with an accessible international banking system that provides control and visibility over your money. Also, it exposes you to global markets and offers alternatives to your national currency or banks. An interesting fact about DeFi space is that the Total Value Locked (TVL) has crossed the mark of $69 Billion. It gives a green signal as people transition from traditional to decentralized Finance.
Summary
- DeFi stands for ‘Decentralized Finance’ and works based on smart contracts.
- A smart contract is a set of rules and regulations that execute after meeting certain conditions.
- Decentralized Finance vs. Traditional Finance boasts several notable differences that make DeFi stand out from the crowd.
- DeFi boom has welcomed hundreds of projects for making a place in the blockchain space.
- Transactions through DeFi can be more efficient, flexible, secure, and automated.
What is DeFi?
DeFi stands for ‘Decentralized Finance’ that harnesses the power of blockchain technology for providing financial services. Blockchain helps several entities retain a copy of transaction history and prevents centralized intermediaries from controlling money. Large corporations also take care of financial applications, including loans, insurance, crowdfunding, derivatives, and more. So, one of the ultimate benefits of DeFi is removing intermediaries from all transactions, unlike the traditional banks.
How does DeFi work?
The concept of Decentralized Finance is made successful by smart contracts. A smart contract is a set of rules and regulations that execute after meeting certain conditions. Smart contracts are an alternative to traditional banks. The code (or the rules in the smart contract) cannot be changed or altered once the smart contract is live.
For example, consider a scenario where you have to transfer a certain amount of money to your parents every month. If a smart contract contains rules to transfer funds from your account to your parent’s account every month, it will not do unless your account has the necessary cash. Similarly, no one has the authority to modify the contract by any means.
DeFi vs. Traditional Finance
Decentralized Finance vs. Traditional Finance boasts several notable differences that make DeFi stand out from the crowd. However, both the finances differ majorly on three points:
- The root of decentralized Finance is a public blockchain that acts as the trusted source for governing all operations in the financial sector. On the contrary, traditional Finance involves using law and licensed financial institutions for governing all the functions.
- Being an open and transparent financial medium, decentralized Finance continues to gain traction as anyone can build financial services and tools on blockchains with programming skills.
- On the contrary, a person has to pass through several hindrances that make it improbable for the traditional finance system to embrace the emerging trend. One must obtain proper licenses and authorization from regulators to work in a conventional finance system, limiting innovation.
Popular Projects of DeFi
DeFi boom has welcomed hundreds of projects for making a place in the blockchain space. Some projects are trendy that an avid crypto user might have interacted with, while some platforms are trying to climb up the ladder for retaining a top seat. Out of the Top 5 projects on DeFi Pulse, three are from the lending sector. But, what are lending platforms, and how do we group them? Let’s look at some of these answers.
Lending Platforms
Decentralized Finance has opened up a more expansive space for people as it offers crypto loans in a trustless manner. DeFi doesn’t require the route of intermediaries and allows users to enlist their crypto coins on the platform for lending purposes. A borrower can take a loan through P2P (peer-to-peer) lending or liquidity pool based lending. It provides complete transparency to users and seamless money transfer. DeFi lending is favorable to lenders as they earn interest, while borrowers often use the funds for margin trading options.
DeFi helps users borrow loans at much lower interest rates than traditional finances. DeFi has the highest lending growth rate and is the most prevalent contributor for locking crypto assets among all decentralized applications (DApps). It offers a censorship-free environment and provides equal opportunities to everyone. Some of the popular lending platforms are Maker, Aave, and Compound.
Decentralized Exchanges (DEXs)
DEX or decentralized exchange is a marketplace where transactions occur directly between people and automated market makers (AMMs). They do not involve any intermediary such as banks, brokers, or payment processors, making it easy for anyone to trade cryptocurrencies on the platform. Unlike centralized exchanges that allow trade between fiat and crypto, decentralized exchanges allow trading between cryptocurrency tokens.
Nowadays, decentralized exchanges also allow people to do margin trading and advanced trading options that were once limited to centralized exchanges. If we talk about the working of DEXs, they harness the underlying technology of blockchain and smart contracts for executing trades on the exchange. An exciting fact distinguishing CEX and DEX is the former record transactions on that exchange’s internal database, while the latter directly settle transactions on the blockchain.
The most popular DEXs such as Uniswap, Curve Finance, and Sushiswap are part of the growing suite of decentralized Finance (DeFi) tools, making a vast range of financial services available directly from a compatible crypto wallet.
Other DeFi Projects
Other DeFi projects (such as yield aggregators, derivatives, and payments platforms) are prevalent in the blockchain space, apart from decentralized exchanges and lending platforms. Instadapp is one famous project that consists of a smart wallet built on top of popular DeFi projects like MakerDAO, Compound, Uniswap, etc., for managing assets. The platform allows users to perform complex trading actions without needing advanced technical or financial experience.
Final Thoughts
Decentralized Finance has improved the way people think of Finance by providing various benefits to customers and investors. It induces trustlessness and eliminates intermediaries from the scenario. DeFi harnesses blockchain technology that instills a sense of immutability with the help of cryptography and consensus algorithms. The wide applications are an example of DeFi continuing to explore the space.
However, it also served with some of the downfalls that include an issue of scalability. They might encounter difficulties in the scalability of hosting blockchain from various perspectives. DeFi is also prone to instability as the project could automatically inherit instability from the host blockchain. Liquidity concerns are a critical factor as the TVL value speaks that there is a way to go for Decentralized Finance.
Decentralized Finance is still in its growing stage where it is thrown to severe challenges that involve smart contract risk to technological dangers. DeFi is a new venture that provides immense benefits and outperforms traditional financial instruments. It doesn’t distinguish anyone in any regard and allows anyone with a working internet connection to access any global currency, earn interest on deposits, and obtain loans instantaneously. It provides an alternative source of currency (stablecoins) that is making its move for widespread adoption and revolutionizing how we do Finance
