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What is DeFi? - A Detailed Guide

DeFi is the acronym for decentralized finance. The obvious question that arises here is, how do we decentralize finance? In DeFi, a wide range of financial applications is used to cut off the intermediaries. Intermediaries, in this context, imply banks, lawyers, and other non-banking financial corporations. 

Think of a typical transaction in the traditional world of finance. Suppose, you are purchasing a T-shirt using your credit card. The transaction is primarily between you and the seller of the T-shirt. However, the transaction is successful only when the bank that has issued your credit card approves the transaction. In decentralized finance, there is no need for a third-party to get involved.

Smart Contracts – A Integral Part of DeFi

Smart Contracts - A Integral Part of DeFi
Photo Source: Cryptovibes 

In decentralized finance, what governs the transactions are the smart contracts. These are self-executing contracts. They are written as codes with some predetermined conditions in place. Once both the parties involved agree upon these conditions, these codes execute themselves. These contracts, developed on blockchain protocols, are the backbone of any DeFi network.

According to market research estimates, the total value of DeFi contracts increased from US$2.1 million to US$6.9 billion between September 2017 and August 2020. This surge is based on the excellent momentum that DeFi has gained over the last few years. 

What are Decentralized Finance Platforms?

The decentralized platforms, at their core, are decentralized finance applications known as DApps. DApps operate through a chain of smart contracts. These contracts make transactions faster and eliminate the scope of intermediaries.

For any financial platform to be considered decentralized, it has to use at least one or more decentralized functions. Distributed ledger technology or DLT is one such decentralized function. In DLT, no centralized authority makes any decisions. The peers active on the network take the decisions themselves. Aspects of this financial system such as the rate of the DeFi coin, the interest rate applicable to lending are determined by the information feed and the algorithm of the blockchain network.

DeFi DApps – A Quick Intro

By now, it’s evident that DApps are the central element of DeFi services and DApps are built through smart contracts. Now, let us try to understand how DApps differ from the conventional banking system. Why is it such an important element of an alternative finance system?

One of the reasons that have already been discussed is that the platform is free from third-party interventions. Once the parties agree upon the conditions, the smart contract executes itself. 

When it comes to the codes of these contracts, anyone can audit them. These codes are extremely transparent and do not skew towards any party. These contracts are also location-agnostic. All it requires is an internet connection. DApps’ functionalities do not change with a change in the location. 

One of the most interesting aspects of DApps is that anyone can build them. Anyone can take up a defi project and build an app without seeking permission from any authority. Similarly, anyone can use them. While using a dapp, one can change the interface of the dapp as well. There are third party interfaces that help to alter the interface of a dapp.

Owing to this privacy-protected, non-intrusive, self-driven nature of the DApps, people often opt for decentralized finance rather than going to banks or large financial corporations. 

DeFi Crypto

What is DeFi crypto? The answer is not at all that complex as the question may sound. DeFi cryptos or DeFi cryptocurrency are digital assets built mostly on the Ethereum protocol. They are governed by these protocols and include smart contracts. 

According to the latest decentralized finance news, DeFi crypto projects are expanding their market size. Between June 2020 and September 2020 tit has increased from US$ 1 billion to US$ 10 billion.

However, the status of the defi markets is not that promising. According to the latest defi news published a few days ago, the market cap of all the existing defi-related assets decreased by 30%. The value of many credible defi tokens also suffered a loss ranging between 30 to 50 percent. Although, according to the proponents of these tokens, the drop was a result of these defi tokens self-correcting themselves.

In the recent market upheaval, DeFi coins exhibited a mixed reaction. While coins like Bitcoin stayed unshaken, many DeFi coins took a severe beating. 

What are the Drawbacks of DeFi?

What we have discussed so far, has to do with the benefits of DeFi. Does this system of decentralized finance have any drawbacks? Like every other financial paradigm, it also has its disadvantages. Let’s have a look at those.

One of the biggest strengths of DeFi is one of its most notable drawbacks as well. As we know, the world of DeFi is non-intrusive. It generally does not require participants to disclose their information. Also, like the traditional banking system, it does not have verification procedures. In the hindsight, this can lead to illicit money circulating in the system. To access DeFi, one only needs an internet connection. Traditional banking, meanwhile, entails a lot of checks and balances before reaching the system.

Since DeFi runs on self-executing codes, it’s security is entirely dependent on the efficacy of the codes and the protocol. Many times DeFi exchanges have been hacked resulting in the theft of hundreds of millions of dollars. 

In 2018, hackers stole US$534.8 million worth of cryptocurrency from Coincheck, a crypto exchange. In that same year, crypto-exchange Bitgrail suffered a loss of US$195 million. 

Besides this exchange hack problem, there are instances of hackers stealing from personal wallets. However, the introduction of cold wallets has helped a lot to protect personal crypto-wallets from cyber attacks.

In the DeFi environment, the participants execute the transactions themselves. DeFi players do not provide guides who help to use the platform correctly. Now, being a technology-intensive area, it’s hard to attract customers who are not that tech-savvy. Beginners need guidance. 

Finally, the Decentralized finance market’s trading volume is not that high. Although the market is expanding, it’s still full of people who have the interest and the expertise to work on decentralized finance blockchain protocols. Therefore, the overall volume of participants in the defi markets is less compared to the traditional market. This results in constricted liquidity of the DeFi exchanges.

Defi Use Cases

Defi Use Cases
Source: Entrepreneur

There are several use cases of decentralized finance. Let’s have a look at some of them.

One of the most popular use cases is the open lending protocol. In the conventional finance system, lending and borrowing require a lot of paperwork to complete. It requires approval from the third parties, guarantors, etc. It also needs the borrower to disclose his private information. In DeFi, the lending is directly peer-to-peer as it happens through smart contracts. The borrower agrees to the conditions set in the contract and gets the loan. The DeFi platforms protect the lender by collateralizing the digital assets of the borrower. However, this process of collateralization does not require any human intermediaries. 

In the DeFi system, quick, unsecured lending is possible. It solves the problem of many lenders who are unable to access traditional borrowing avenues. The lender on the other hand can set his terms. A contract is formulated as and when the borrower agrees to those terms.

Another significant DeFi use cases are the decentralized exchanges or DEX. In these exchanges, a crypto trader can trade without any central authority setting the terms or dictating the prices. These exchanges are privacy-protected and do not require any sign-ups. They also do not have any withdrawal fees.

Finally, another use case of DeFi is the stablecoin. These are called stablecoins because their prices are linked with specific values. These specific values can be that of a fiat currency, an exchange-traded fund, or a cryptocurrency.

Summary

Starting from the decentralized finance definition, we have traveled through the good and bad of this system. We have tried to understand what is DeFi and why do we need it. DeFi is a nascent field and it is still growing to achieve its fullest potential. 

But, at the same time, we should take note of the fact that the benefits of defi have inspired leading financial institutions to adopt it. For example, an alliance of 75 banks is conducting trials on the blockchain technology. This is done under the banner of ‘Interbank Investment Network’. Participants of this network include the likes of JP Morgan, ANZ, and the Royal Bank of Canada. Using the defi environment protocols and the blockchain technology together, these leading financial brands are in the pursuit to speed up their payments. 

Major asset management funds of the world are focusing more on crypto asset management than before. Grayscale, one of the largest crypto investment fund in the world, is alone managing funds worth more than US$5 billion.

The combined worth of all the tradeable tokens in the defi market used for smart contracts has reached US$15 billion. The rise has been phenomenal as it was half this value during the beginning of the year. 

All these achievements may still sound less when compared to the traditional world of finance. But, when examined from the perspective of growth, the surge is astounding. 

The rate of the surge has increased in 2020. The outbreak of the COVID-19 pandemic has encouraged investors and the common payers to go cashless. Moreover, the instability and the volatility in the traditional markets have inspired investors to hedge some of their funds in alternate markets. 

With blockchain analysis and blockchain forensic companies coming into the scene, it is expected that the issues with hacking and the circulation of illicit money will be resolved soon. With all the checks and balances put in place, DeFi will surely attract a lot more participants from the traditional world of finance. 

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