DeFi, in the simplest terms, is the modernized merger of traditional banking services with decentralized technologies. The goal is to create a decentralized financial system that advances the principles of self-sufficiency.
It aims to accomplish this by taking out the central authorities from the core of every financial transaction or process.
To put it clearly, let us take a look at the traditional financial system. There is a central authority in every country, primarily the government and central banks, that controls the financial system.
These authorities have a centralized system and work hand in hand with banks as intermediaries for financial transactions. This entire system is built upon ‘trust’ where you believe that the government will do its best to maintain the value of the currency as public companies will keep providing better returns on investments while banks will provide the best financial services.
But, the principles of self-sufficiency that DeFi is pushing forward seeks to create an open financial system for everyone without any dependence on a central authority.
It further does away with the ‘trust’ factor by bringing about a ‘trustless’ functionality as one of its main pillars. This is because by allowing users to take direct charge of their assets and investments, these participants gain control over the dynamics of the system.
In theory, the idea of what DeFi is looks very appealing, but how does it work in practice? Are there any applications that have currently integrated DeFi technologies? How will this technology work for non-tech-savvy individuals ( the ordinary user) and provide them with benefits?
All these are questions that you have probably asked yourself while gauging the practicality of this innovative and revolutionary financial system.
Well, there are lots of areas that this disruptive financial technology is already working on, with its potentials proving to be limitless. Currently, the most popular areas of application are:
Unbanking – Borrow and lend
The promise for a globally open financial system that can be used by everyone has already taken shape. It has taken off in the form of DeFi coins that are primarily financial platforms that bring together lenders and borrowers from across the world. Since this is a decentralized financial system, it does not rely on any bank or singular party to accept lenders or determine who qualifies for a loan.
Instead, these platforms are collateral-based, making it necessary for users who want to take a loan to put up collateral. This is critical as no one is required to specify their details, such as personal information, financial history, or credit ratings.
The main reason why there are no such requirements is that DeFi is centered on preserving privacy as it is an open financial system.
Since DeFi is largely built on the Ethereum blockchain network, the collateral provided in these platforms is often Ether, the token that powers Ethereum.
The power to lend and borrow without relying on a bank has created the ultimate unbanking experience that has given more freedom to the users of these platforms.
There are lots of blockchain-based lending platforms (dApps) that have become popular today, with the leading ones being:
Compound. This borrowing and lending dApp allows users who need money for their expenditure and have crypto investments to deposit their crypto to a compound smart contract and borrow against it. The deposited crypto becomes collateral, and the compound smart contract automatically matches the borrower to the most suitable lenders. The interest rate for the provided loans is automatically adjusted based on demand and supply.
Other platforms that work similarly to this are:
As more lending platforms are created, aggregators such as LoanScan have been developed to allow users to track the interest rates across these platforms.
This allows borrowers and lenders to find the best rates whenever they need these services.
How do I make money with DeFi?
There are several ways that you can make money with DeFi. The simplest way is by loaning out money through the borrowing and lending dApps that allow you to earn interest in the amount invested. Since the entire borrowing and lending process is automated, it is one way to earn passive income.
Another way to earn money with Defi is through Yield Farming. However, this requires you to be a knowledgeable trader who can scan through DeFi tokens to find opportunities that provide larger returns.
Such opportunities can be found when DeFi applications are looking to expand their user base by providing free tokens. This provides a chance for liquidity mining, which is the most popular form of yield farming.
Note: Yield Farming has the potential to provide larger returns, but it also has larger risks. This is because it involves working with systems that tend to be complex.
It also involves users leveraging the lending prospects of DeFi coins, which calls for accurate predictions.
Another winning edge for DeFi has been how it has enabled the creation of decentralized exchanges, which are commonly known as DEX. These are trade exchanges that allow users to buy and sell cryptocurrencies by directly linking sellers with buyers.
It eliminates the need for a central platform for these transactions allowing both parties to benefit as they do not have to pay any fees. This makes these transactions cheaper and faster, creating a win-win situation.
Prediction Markets: Augur
DeFi also allows users to predict and bet on the outcome of events with prediction market platforms such as Augur.
These platforms work by tapping into the ‘wisdom of the crowd’ whereby using available information, users can vote on an event’s outcome. However, there is a catch to this, and it involves attaching a value to this vote.
Ethereum is not only the second most popular and largest cryptocurrency platform but the easiest to use. This platform’s defining aspect is that it provides and supports amazing building technologies for other decentralized applications.
As such, it is the most suitable platform for creating dApps for complex financial uses, as was highlighted by Vitalik Buterin, the Ethereum creator in the first Ethereum white paper.
Since Ethereum was designed to support the creation and deploying of smart contracts, it naturally supports most DeFi applications. These applications include:
Lending platforms. Since these platforms rely on smart contracts to replace banks or middle parties, it efficiently runs on the Ethereum platform.
Decentralized exchanges (DEXs). These online exchanges directly connect buyers and sellers without requiring an intermediary by making use of smart contracts.
Prediction markets. The DeFi version of prediction markets is open to everyone and is not limited by a centralized system.
Stablecoins. DeFi dApps allow users to create or use stablecoins, which are cryptocurrencies whose value is tied to an asset outside the cryptocurrency financial model. These assets could include currencies such as the dollar or Euro that stabilize the price of the cryptocurrency.
“Wrapped” bitcoins. Also known as WBTC, this is a way for Bitcoin users to directly use Ethereum’s DeFi system. It supports the sending of Bitcoin to the Ethereum network allowing Bitcoin users to become lenders and borrowers on the decentralized lending platforms.
How will Ethereum 2.0 impact DeFi?
The biggest change that Ethereum 2.0 will have on DeFi applications is that it will provide them with a boost by doing away with the platform’s scalability issues.
While this is not the ultimate solution to DeFi’s problems, it is a move towards a brighter future.
These advancements will also be complemented by other protocols such as Raiden and TrueBit that are working on the best techniques to tackle these scalability problems.
Increasingly, as these problems are resolved, a lot of DeFi products that are still in the experimental phases will have the capacity to go mainstream.
Ethereum remains to be the top platform for DeFi applications and developments; nevertheless, there is a lot of work in progress for the Bitcoin platform to support this technology.
This has mainly been driven by the shared proposition of cutting out the middleman from simple and complex financial transactions.
Several companies such as SuredBits and DGLabs are at the forefront of making this possible by creating a Bitcoin DeFi technology known as Discreet Log Contracts (DLC). The objective of creating DLC is to offer a way of executing complex financial transactions with the aid of Bitcoin.
Like the smart contracts supported by Ethereum, these contracts will be automated and can be used in many applications.
Is investing in DeFi safe?
As more people are drawn to DeFi, it is critical to understand that it is still risky to invest in this technology. There are lots of reasons behind this, but on the other hand, there is also the probability that one could earn massive gains by being an early investor.
The problem with this is that it has become hard to separate great DeFi projects that will keep growing and bad ones that will soon crash. This remains to be the stumbling block that many newcomers face as they seek to invest in DeFi.
The long and short of investing in DeFi is that it is a high-risk investment vehicle that promises to revolutionize the financial system. Still, it is important to note that while some users have reportedly made a lot of money, others are making massive losses.
For example, when the meme coin YAM crashed, its market capitalization went from $60 million to $0 in a span of 35 minutes.
Advantages of DeFi
The advantages that DeFi presents to the current and future financial system have been its greatest strength. It is no longer a far-fetched dream that we are headed to a more liberal and decentralized financial system.
As DeFi leads in this path, it offers the following advantages:
Everyone is accepted. This makes true its goal for a financial system that is open to everyone.
It is borderless, and it does not restrict users because of their country of origin.
Everything is done online. To access it, all you need is a smart device or computer and an internet connection.
It uses an open-source code. The code used in the blockchain is transparent and open to everyone. When it comes to privacy concerns, the transactions are pseudonymous as they are not tied to the users’ real identity. This is an extra plus to DeFi’s operational model.
It is decentralized as there is no singular authority that controls the system.
It is interoperable. Not only can new DeFi applications be easily created, but they can also be combined similar to Lego pieces to create totally new products.
Disadvantages of DeFi
Even as the advantages of DeFi place it on the winning track, it has been held back by some hurdles that need to be resolved before it becomes an open door to disaster. These include:
It is prone to cyber-attacks. Since DeFi is an open-source financial system, with every transaction that is made on the platform, there is the ever-present likelihood of hacks and cyber-attacks. These can be costly to users, as has been witnessed in several instances when bugs have led to the loss of millions of dollars or the shutdown of a DeFi project.
By giving users full control of the system, it is a riskier technology. The biggest strength of DeFi also presents a weak point as by giving people total control of the system, it becomes riskier and more complicated to manage. Higher levels of security and other checks & balances are required to make it work efficiently.
DeFi coins and tokens
Now, you should have a better understanding of what DeFi is.
DeFi is revolutionizing the financial system as we know it. And to the better.
DeFi offers high yields for those who participate now. If you buy digital coins and lend them out, you can easily earn between 5% and 10% for Bitcoin and Ethereum.
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