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In the current centralised system, a single entity is in control of all financial services, and its ultimate objective is to make money. There are several third parties in the current financial system to facilitate money transfers among parties, and each one charges a fee for doing so. All financial transactions cost some money, loan applications may take several days to be granted, and if you're travelling, you might not even be able to use bank services.
But what if we could link individuals peer-to-peer to make it simpler and more affordable for them to access basic financing? Here is where Decentralized Finance (DeFi) comes in.
DeFi is a transparent, open, and global financial system designed for the Internet era as an alternative to a system that is tightly regulated, opaque, and supported by infrastructure and procedures that are decades old. It gives you control over your money and increases visibility, i.e., you can see where and how the money goes. It exposes you to international markets and offers alternative financial or currency options. DeFi products allow anyone worldwide to access financial services without any intermediaries and permission, only with an Internet connection. These services are largely owned and maintained by their users. Also, markets are open 24/7 in DeFi, and no centralised entity is in control to prevent you from making payments or denying your access to anything. Now, since services are automatic and managed by codes that anybody can view and scrutinise, they are safer than in centralised finance, where everything is slow and susceptible to human error.
Bitcoin can be considered the first DeFi application. You can truly own and control value with Bitcoin and send it anywhere in the world. This is accomplished by giving a mechanism to people who don't trust one another to agree on a ledger of accounts without the necessity for a trusted middleman. Anyone can use Bitcoin, and nobody has the power to change its operating principles. The principles of Bitcoin, such as its scarcity and openness, are the intrinsic characteristics of its technology. It's unlike traditional finance, where corporations close markets and governments generate money devaluing your savings.
Before going any further, it is essential to review some of the most important terms in DeFi to ensure we are all on the same page!
Blockchain is a system for storing data in a way that makes system changes, hacking, and cheating difficult or impossible. A blockchain is simply a digital ledger of transactions duplicated and distributed across the entire network of computer systems.
Stablecoins are a type of cryptocurrency with values pegged to another asset, such as fiat money, an exchange-traded good, or another cryptocurrency. Stablecoins offer a more stable alternative to highly volatile cryptocurrencies like Bitcoin and Ether to address price fluctuations.
Decentralised Exchanges (DEXs) connect cryptocurrency sellers and buyers and allow users to conduct transactions over a peer-to-peer network. They let users trade different cryptocurrencies, but they cannot use decentralised exchanges to purchase digital assets with fiat money or withdraw money into their bank accounts.
In DeFi, derivatives are contracts whose values are derived from how well an underlying financial asset performs.
DeFi crypto margin trading is the practice of using borrowed money to increase a position in an asset, just like traditional finance. The traded financial asset serves as the loan's collateral.
The DeFi ecosystem mimics the insurance component of centralised finance. In return for the payment of a premium, insurance offers promises of reimbursement. Insurance is frequently utilised in the DeFi industry to protect deposits and guard against failed smart contracts.
A website or application that runs on top of a blockchain is referred to as a decentralised application (dApp). Smart contracts are the only power source for dApps, negating the need for any centralised third party.
A smart contract is a blockchain-native computer program that executes instantly when certain conditions are satisfied. All DeFi applications and protocols are dependent on smart contracts.
Users pay gas fees to cover the cost of computing power needed to process and verify transactions.
The protocols that determine the price of assets on a decentralised exchange are known as Automated Market Makers (AMMs). AMMs, the foundation of decentralised exchanges, let users trade against liquidity locked in smart contracts referred to as liquidity pools. They also give anyone who complies with the smart contract's predetermined terms the ability to participate as a liquidity provider (LP).
When liquidity providers lock an equal number of two tokens into a smart contract, a liquidity pool—a dual-asset market—is created. From there, buyers and sellers can trade directly against this liquidity without waiting for an order to be matched.
Liquidity providers are the funding suppliers to the liquidity pools that, in turn, power the DEXs.
In blockchain networks, a consensus mechanism is a fault-tolerant technique used to reach the necessary agreement on a single network state or a single data value across distributed processes or multi-agent systems, such as with cryptocurrencies.
The idea behind Proof-of-Stake (PoS) consensus mechanism is to choose validators based on how much of the associated cryptocurrency they hold. It was created as a replacement for Bitcoin's resource- and energy-intensive Proof-of-Work consensus mechanism.
Staking is the process of locking cryptocurrency to secure and maintain the blockchain's integrity through the Proof-of-Stake consensus mechanism. Stakers receive compensation through a share of the network's generated block reward.
Yield farming is the practice of pursuing the best yields using several DeFi platforms and protocols. It entails ongoing borrowing, lending, and staking of cryptocurrencies to earn interest, which is then reinvested in new pools to generate even more income.
Non-Fungible Tokens (NFTs) are unique, non-interchangeable data units that can denote ownership over associated digital goods like photos, music, or videos.
Fungible tokens can be exchanged for another token, in contrast to the well-known Non-Fungible Tokens (NFTs).
In the context of cryptocurrencies, total value locked (TVL) refers to the total amount of assets deposited in DeFi protocols to earn rewards, interest, new coins and tokens, fixed income, etc.
Blockchain oracles are entities responsible for connecting blockchains to external systems, allowing smart contracts to execute based on inputs and outputs from the real world. Oracles give the DeFi ecosystem access to off-chain systems, current data sources, and cutting-edge computations.
ERC-20 is a technical standard for fungible tokens built on top of the Ethereum blockchain.
DeFi provides several opportunities to the world that was not available in centralised finance (CeFi) systems. The most significant characteristics of DeFi services include being permissionless, censorship-resistant, and trustless. The figure below shows a complete comparison between DeFi and CeFi.
DeFi offers financial instruments using smart contracts and cryptocurrencies without intermediaries' involvement. In DeFi, a smart contract processes transactions instead of financial institutions. In this context, a smart contract can be considered a special kind of account that can keep money and send or refund it per agreed criteria. When a smart contract is live, no one can change it, and it always functions as programmed. For example, a contract intended to provide pocket money or an allowance could be set up to transfer funds from account 1 to account 2 each Monday. It will never stop doing that unless account 1 has the required amount. Nobody can alter the contract and designate account 3 as a receiver to steal money. Contracts are also public for anyone to inspect and audit. This means bad contracts will often come under community scrutiny pretty quickly.
DeFi uses blockchain technology, where transactions are recorded in blocks and then verified by other users. If these verifiers agree on a transaction, the block is closed and encrypted, and another block is created containing the information about the previous block. The term "blockchain" refers to how the blocks are "chained" together by the data in each subsequent block. There is no way to edit a blockchain since changes to the information in earlier blocks always impact later blocks. This idea, coupled with other security measures, gives a blockchain its security.
DeFi has many functionalities and offers various services open to anyone around the globe. DeFi has some core components that can be seen in the following image.
DeFi provides users with alternatives to many of the centralised finance services. Moreover, several unique products can only be found in DeFi. Let’s take a look at the most significant ones below.
All you need to make a money transfer is a wallet and an Internet connection. DeFi makes it possible to transact securely and freely, as easy as sending an email. Just enter the destination account address from your wallet, and you are all set! The money will transfer in less than a few minutes.
The volatility of cryptocurrencies affects many financial products and general spending. With stablecoins, the DeFi community has found a solution. Their value continues to be pegged to another asset, typically a well-known currency like the dollar. The value of coins like Dai and USDC is consistently within a few cents of a dollar.
There are two general ways of borrowing in DeFi as follows.
The question here is, why should someone use DeFi instead of centralised services for borrowing? What are the advantages? Let’s see!
Lending and borrowing in centralised finance revolve around the individuals involved. Financial institutions need to make sure you're likely to repay a loan before you can take it.
However, decentralised lending operates without requiring either participant to provide their identity. Instead, the borrower is required to put up collateral, which the lender will get if the loan is not paid back. Even NFTs are accepted as collateral by some lenders.
For example, if you're using Ethereum, borrowing can let you get the money you need without having to sell any of your ETH (which is a taxable event). Instead, you might use ETH as collateral against a stablecoin loan. This allows you to preserve your ETH while providing the required cash flow.
Using a decentralised lender gives you access to funds deposited from all over the world, not just those held by your chosen bank or institution, which lowers interest rates and increases loan accessibility.
You can borrow money using flash loans, a more experimental type of decentralised lending, without putting up any collateral or revealing any personal information. Flash loans work on the basis that the loan is obtained and repaid in one single transaction. If it is not repaid, the transaction is considered to have never occurred.
To put it simply, consider someone using a flash loan to borrow an asset in large quantities at a price to sell it at a better price on another exchange. In other words, in a single transaction, the following steps happen:
The transaction would fail if exchange 2's supply unexpectedly reduced and the user could not purchase enough to repay the initial loan.
The scenario above would require considerable money to execute in the conventional financial realm. Only people with lots of money have access to these money-making techniques. Flash loans represent an ideal time in the future when making money does not always require possessing money.
Decentralised insurance seeks to reduce costs, increase payout speed, and increase the transparency of insurance. Increased automation makes insurance coverage more inexpensive and accelerates payout times. The information used to evaluate your claim is fully transparent.
DeFi provides opportunities for users to save money. There are two general ways users can do so:
By lending your cryptocurrency, you can earn interest on it and watch your money increase in real-time. Currently, interest rates are substantially greater than what you'll find at banks or financial institutions. Some of the most well-known dApps for lending are Aave, Compound, and Oasis.
No-loss lotteries, such as PoolTogether, are a new way of saving money that has become possible thanks to DeFi. In this mechanism, you pay 10 Dai tokens, purchase 10 tickets, and receive 10 plDai representing your 10 tickets. If you are the lucky winner of the lottery, your plDai balance goes up by the size of the prize pool. The good news is that if you do not win the lottery, your 10 plDai will be safe and go to the next round’s draw. If you do not like participating in the lottery, you can withdraw your tokens anytime.
You might be curious where the prize comes from. Well, the prize comes from the accumulated interests generated from lending the ticket deposit!
You can swap various tokens whenever you desire using Decentralized Exchanges (DEXs), where you will never lose control of your possessions. DEXs are comparable to using a currency exchange abroad, with a big difference that the DeFi version never closes. The markets are open every day, whenever you need them, and technology ensures that someone will always be willing to accept a trade.
There are more advanced solutions for traders who prefer a little more control. It is possible to use limit orders, perpetual, margin trading, and more.
DeFi provides the opportunity for people with innovative ideas to raise funds to bring their ideas to the world. Anybody from any corner of the world can be a funder. Due to the transparency of DeFi, fundraisers can prove the amount of raised money, and you can keep track of how the money is spent. Moreover, fundraisers can set up automatic repayments for specific situations. For instance, when there is a deadline but the minimum amount of funds is not met.
There are numerous products in DeFi, such as Zapper, Zerion, and Plasma.Finance that enable you to manage all your DeFi activities in a single place. This represents the elegance of DeFi's open architecture. Developers can create user interfaces that let you use their features in addition to seeing your balances across all your products.
According to Defi Llama, the Total Value Locked (TVL) of the whole DeFi market is $85.84 billion when writing this post. Not interestingly, almost 64% of this value is locked in Ethereum, and more than 88% of the total value is associated with only the top seven chains of the industry. The following chart shows the share of each chain.
According to DeFi Llama, the top three DeFi projects in terms of TVL are MakerDAO, Uniswap, and Lido, which will be introduced in the following.
MakerDAO has a TVL of $7.93 billion when writing this post, making it the most valuable project in the DeFi industry in terms of TVL. It is a platform for lending and borrowing cryptocurrencies in a peer-to-peer manner that connects lenders and borrowers directly through smart contracts. MakerDAO pioneered lending protocols that initially introduced Collateralized Debt Position (CDP). CDP is a system that locks up collateral in a smart contract in exchange for stablecoins known as Dai.
The $6.96 billion TVL made Uniswap second in the ranking of top DeFi dApps. It is one of the world's most successful and widely-used decentralised exchanges built on top of the Ethereum network. Practically speaking, it is a set of smart contracts that define a standard method for establishing liquidity pools, providing liquidity, and swapping assets.
Lido, a multi-chain liquid staking solution available on Ethereum, Polkadot, Kusama, Solana, and Polygon, set a TVL of $6.2 billion on July 26, 2022. Lido is the industry's top option for liquid staking, offering a quick and secure way to earn interest on various digital assets. Your assets will remain liquid if you stake through Lido, allowing you to use them in a variety of DeFi applications to increase yield.
If you are curious about finding more in-depth data about DeFi, here are some reliable resources to look at.
DeFi Llama is one of the best data sources for the DeFi industry, which keeps track of all well-known chains and their corresponding dApps. The data team analyses trading behaviour in the biggest chains throughout the world. The platform compiles the data and makes it available to everyone for free, including the cumulative data for all chains.
For instance, you can see reports on the TVL of the entire DeFi industry and filter out by chains. It also ranks the protocols built on the chains based on TVL and tags each protocol based on its functionality.
Moreover, you can see details of each project by clicking on it. For instance, here is a part of a report for MakerDAO:
APY.Vision describes itself as an all-in-one analytics dashboard in the DeFi industry that targets yield farmers and liquidity providers. It is integrated with many chains and projects, such as Ethereum, Solana, Polygon, Fantom, and Uniswap.
APY.Vision allows you to track your liquidity by offering performance and impermanent losses across chains and Automated Market Makers (AMMs). Moreover, you can calculate your net profits, monitor your vault and farming activities, and analyse pools' historic APYs to find the best liquidity pools.
All you need to do is connect your wallet to the application and enjoy the insights that are hard to find anywhere else.
Chainbeat is a platform for Web 3.0 data insights and analytics. With real-time alerts and customised reports based on real-time smart contract usage, Chainbeat enables full cross-blockchain analytics and offers in-depth insights on active users, transactions, events, and token transfers. Real-time data insights are provided to facilitate quick decision-making.
Here is a preview of what you can expect using Chainbeat.
You can easily see how much attention a coin has gotten in the DeFi market by keeping track of its active users, transactions, volumes, and changes over various timeframes. Also, you can see which chain the coin is built on by a small tag below the coins’ names so that you know how to proceed if you want to invest in that coins.
By clicking on each coin, you will see a comprehensive report about its transactions over time, gas, active users, and much more.
There is no doubt that DeFi opens up valuable opportunities to the world. However, there is always a dark side to every technology that you should beware of before entering the market. CFA Institute elaborates on the risks associated with DeFi very well. What we cover in this section is mainly inspired by this article.
DeFi uses smart contracts to automate particular financial primitives. One of the most crucial risk factors in the DeFi sector is the dynamism of such protocols. Because DeFi is open-source, smart contracts are accessible to everyone, which makes them more exposed to hackers than traditional systems secured by layers of security around a proprietary source. Smart contracts are vulnerable to a number of problems due to their nature, including logical errors, flash loan attacks and economic exploits.
Smart contracts rely on external data, such as a stock market price feed. It is the responsibility of Oracles to maintain the connection, without which certain steps in a transaction may not be able to be completed, and the contract may not be upheld.
DeFi is not widely accepted yet, and to gain general acceptance, it needs blockchains to advance in scalability. The blockchain infrastructure is still in its early stages and is difficult for both developers and market players to use. Transactions on some systems move slowly, and this situation will persist unless scalability is enhanced, which is the premise behind the creation of Ethereum 2.0, also known as Eth2.
Through a user's private key, self-custody in the form of a digital wallet secures access to cryptocurrency assets. But a lost or stolen key might have fatal consequences, i.e., "You lose your cryptocurrency if you lose your private key," CFA Institute states.
DeFi has grown considerably over the last few years, but it is still young and in its early days. Therefore, the legal details have probably not fully developed yet. Governments worldwide may try to fit DeFi into their current regulatory frameworks or create new rules that apply to the industry. For example, Russia announced the acceptance of Bitcoin and Ethereum in early 2022.
Generally, a token's investment risk increases when its market capitalisation decreases. Therefore, consider the coin’s liquidity score before investing in any crypto project. Before you invest, be careful to research a DeFi protocol's operational history and the total amount of deposited funds. You can look at its website to see if the company has taken reasonable steps to reduce its risks. You can also look for news items about the protocol being hacked on the Internet and their precautions to prevent it from happening again. Needless to say, there is no riskless DeFi protocol, but the above considerations can help you evaluate the investment risk before you put your money into any protocol. Now, the question is, where to find such information?
Cryptogi.st provides valuable information and analyses about blockchain projects, especially DeFi projects. It offers code audits, historical financial performance analyses, and simplified reviews for DeFi applications. For instance, you can see a report about Solana’s market cap, price, and liquidity score in the picture below.
The first step to starting your journey in DeFi is to create a wallet. There are two types of wallets: single-chain and multichain.
Single-chain wallets are designed and developed to serve a single chain, while multichain wallets can be used in more than one chain in the DeFi ecosystem. Metamask is among the most common multichain wallets, allowing you to get started and get involved in the DeFi ecosystem. You only need to install it as an extension on either Chrome or Firefox; you do not need to register on the website. Both iOS and Android mobile users can access this wallet. After configuring your wallet, you must purchase the appropriate coin for the DeFi protocol you intend to use. For instance, if the application you want to use is based on the Ethereum network, you will need to purchase either ETH or another ERC-20 coin to use its services. At this step, you are all set! You can start enjoying DeFi with any activity you want!
DeFi is still young and has a long way to evolve. For beginners, it is not fully regulated. Therefore, there are still plenty of infrastructure mishaps, hacks, and scams in the ecosystem. Tools are becoming available to streamline using DeFi services. The current laws were developed based on the idea of separated financial jurisdictions, each with its own regulations. The ability of DeFi to conduct borderless transactions imposes crucial issues for this kind of regulation. For instance, who is in charge of looking into a financial crime that happens across borders, protocols, and DeFi apps? Who and how would carry out the regulations' enforcement?
System stability, carbon footprint, energy usage, system upgrades, system maintenance, and hardware failures are additional issues.
DeFi's eventual success or failure will depend on its ability to deliver open, trust-minimized, non-custodial, yet reliable financial services as promised.
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