The Beginner’s guide to Decentralized Finance (DeFi)
The term Decentralized Finance or DeFi is already quite popular, but most people are still unaware of what it actually means. The fact is that the DeFi Industry has exploded to over 100 billion USD in 2021 and is expected to grow to over 800 billion this year, that’s an 800% jump in a single year!
Be it as an investor or advisor it’s important to understand the new emerging ecosystem of decentralized finance in order to deal with it. Because the aim of DeFi is to create an independent financial system from the traditional finance (TradFi) or centralized finance (CeFi) system.
To understand what decentralized finance is, we first need to know what Centralized finance or CeFi is. We all do a lot of online transactions regularly and all these transactions are regulated by a central authority such as banks – so all those transactions and the ecosystem in which they operate comes under the umbrella of centralized finance.
Foundation of DeFi
The idea of decentralized finance is that, instead of having a central authority to regulate these transactions, we have everything recorded and automated on blockchain networks through smart contracts. Here we don’t have any centralized intermediary to facilitate the transaction like a bank, which often needs other personal details of yours and has limitations like transaction time, amount limit, etc., around the transactions.
Instead, everything is automated and trustless. The whole Defi ecosystem is built so that transactions can be done and accounted for on a peer-to-peer network, where the system is not only built for the people but also owned by the people. Plus, maintaining smart contracts is way more cost-effective than running a bank due to which the whole ecosystem is more cost-efficient.
Now you might be thinking about what this system or smart contracts are and how it can facilitate all this?
So, the answer to this question is that the core thing which enables everything is just the CODE! Yes, that’s it. Here everything is being governed by the code. That’s why we say in the world of crypto, “Code is the Law.”
The whole ecosystem of decentralized finance consists of elements like protocols, digital assets, and decentralized apps running on top of a blockchain.
Now you might be thinking what blockchain is all about. In short, blockchains are the distributed yet interconnected nodes/servers/computers which run codes and store everything that the network requires on a public ledger. These individual computers/nodes are called blocks and every block contains a copy of this ledger.
The Decentralized Finance (DeFi) Ecosystem and its Elements
The Ethereum blockchain spearheads the DeFi ecosystem. Though we now have many competitors to run DeFi applications like Terra, Avalanche, etc., Ethereum is still the largest network and was the first project as well which was used to create Defi.
The DeFi ecosystem provides many services complementary to each other like centralized and decentralized exchanges (DEXes), lending and borrowing, flash loans, betting, insurance, NFTs, and many other services that rely partially or fully on the concept of decentralized finance.
Here are some of the primary DeFi applications/ecosystem elements that you must know:
- Centralized Exchanges – Here, people can swap their cryptocurrencies with real-world currencies like the US dollar, pounds, etc. They are usually regulated by the government/central authority. Examples of these are Coinbase, Binance, Bitfinex, etc.
- Decentralized Exchanges – Also known as DEXes, they are the marketplace of various cryptocurrencies where people can interchange their cryptocurrency with the others listed on the platform. They are not regulated by any central authority. Examples of these are Bitsquare, Uniswap, etc.
- Lending and borrowing – These are amongst the primary uses of DeFi, where the owner of crypto coins lock their positions and borrow against them using the smart contracts. While others also generate yields by locking up their positions and allowing the borrowers to lend the coins. The best part of this is that the yield generated here is much higher than what is generated from the TradFi system, this is due to the fact that the whole DeFi system is cost-effective and the benefit of which is distributed to both sides.
- Stablecoins – These are also cryptocurrencies but what makes them distinct is that their value is stable and tied to a real-world (fiat) currency like the US Dollar, UK Pound, etc. To name a few Tether and USDC are two stablecoins with their value tied with the US dollar.
- NFTs – Non-fungible Tokens. These are among the hottest topics in the industry, with mixed feelings among enthusiasts and skeptics. They are basically any digital asset with proof of its ownership stored on the blockchain. Nowadays, they are mainly being referred to as Digital Art NFTs, which mostly provide the holder only with the proof of ownership of that digital art, but there are more advanced NFTs that are more than just digital art they are referred to as utility NFTs. Utility NFTs come with smart contracts which could be linked to other functionalities.
Bright and Dark side of Decentralized Finance (DeFi)
A large part of the DeFi ecosystem is open source and is also based on the idea of having the right to privacy. The users just need a wallet to access the whole ecosystem without needing to share any personal information about themselves. Users also don’t have any limitation that comes with having a centralized authority like spending limit, high transaction fees, long waiting hours to complete international payments, etc.
The fact that the whole ecosystem of decentralized finance provides a lot of freedom in the hands of individuals is undeniable. But we also can’t deny that freedom always comes with a fear of unintended consequences due to exploitation of the given independence.
Despite criticisms of the centralized finance, rules and regulations which were enforced by the regulatory authorities in the traditional fiat system was done so for a reason, like:
- To stop illegal international transactions
- To maintain the equilibrium of money within the country
- To trace down the individuals in any frauds or scams, etc.
Furthermore, we have already seen big scams within this domain, like the one by Garry Cotten, the Co-founder of QuadrigaCX. When Cotten mysteriously died in 2018, $250 million worth of Canadian cash and cryptocurrency also went missing.
DeFi will need to regulate itself with a set of governance rules so as not to fall foul of regulators. The whole Web 3.0 world is still an emerging and evolving industry that will only get better with time. Many countries are working to fix issues so that they can accept and partake in the whole web 3.0 revolution.
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