A Beginner’s Primer to DeFi
The term DeFi encompasses the fast growing set of financial tools in the crypto space
It is one of the fastest growing applications of blockchain technology and crypto
It allows anyone with internet access, the ability to access banking, lending or borrowing, without having to go through a middleman
So — what is DeFi ?
DeFi (Decentralized Finance) allows anyone on the internet to access most features offered by traditional banking — and with an ever growing set of features. Here’s how CZ (Binance) puts it-
Using decentralized finance people can make transactions directly with each other through blockchain and do not have to go through centralized Institutions like banks. This leads to cutting out the middleman; reducing transaction charges and making the process more efficient and quick.
In the world of decentralized Finance your funds are held in digital wallets instead of bank accounts. Transactions are enabled through smart contracts on the blockchain. You can get access to a huge selection of financial services starting with peer to peer lending as well as trading via access to decentralized exchanges .
The big difference here is accessibility- in DeFi, anybody with an active internet connection can access financial services.
How DeFi Works
As discussed earlier decentralized finance uses smart contracts and does not require intermediary Institutions like banks to act as guarantors. Instead, users of DeFi transact directly with each other and transactions are secured via the blockchain. Your funds remain in your custody in most cases — in your own digital wallet .
For transactions to be initiated, smart contracts are used — which means you and the counterparty agree to a set of specific conditions which are DeFined in the contract. For example a smart contract can be set up to send funds to an account periodically , and this will keep happening until sufficient funds are available.
However it must be noted that a smart contract cannot be changed once it set up and hence the funds cannot be re-routed to a different account.
The majority of applications are on the Ethereum chain — however other platforms such as Cardano and Solana are developing similar applications. DeFi is still at a very early stage as compared to centralized finance and new applications keep popping up all the time
The Three Primary DeFi Applications
If you own Crypto tokens you can lend the tokens to protocols like Aave or Compound and in exchange earn interest or rewards.
Similarly it is possible to borrow digital assets from such protocols which you can use for trading
Yield Farming is a popular method to earn rewards in which users need to lockup funds in a pool for a duration of time to earn the rewards.
Using a decentralized exchange like Uniswap, you can trade while maintaining custody over your digital assets in the safety of your own wallet. This is different from centralized exchanges where you need to rely on the exchange to take custody of your assets.
Decentralized exchanges allow people to trade directly with each other and remove the middle man. Also, decentralized exchanges allow people to list new tokens for trading .
Certain decentralized platforms like Synthetix and dYdX allow users to go beyond spot trading and utilize leverage to trade derivative(synthetic) assets.
The Future of DeFi
The pace of growth of decentralized Finance has been exponential with the total value locked growing from less than USD 20 billion in November 2022 to more than USD 260 billion in 2021. We could very well be at the cusp of a huge DeFi wave. The advantages of an open financial system which is accessible to all are pretty compelling and could take up a big chunk of the global financial system in years to come.
However there are multiple challenges including several scams which have caused DeFi users more than 10 billion dollars in 2020 and 21. Such occurrences have drawn the attention of regulators like the SEC — which is working on tough regulations for DeFi platforms.
Statement on DeFi Risks, Regulations, and Opportunities — published by the SEC in Nov2021
It remains to be seen how the space shapes up!