What is DeFi? Decentralized Finance in layman’s terms
DeFi simply stands for “Decentralized Finance.” Simply put, “DeFi” is a term given to a variety of decentralized financial services that aim to replace our current centralized financial system.
DeFi takes components of traditional finance and decentralizes them by removing middlemen and replacing them with smart contracts.
I dislike banks because their services are completely centralized. There’s always someone in charge, and this comes with its own risks, like fraud and corruption. With centralized finance like banks, your money is held by banks and corporations. These guys don’t care about you, their sole purpose is to make money, and there are a lot of third parties, each charging some kind of fee for using their services.
To fully understand DeFi, let’s take a look at Bitcoin, a payment system in which anyone can send money to anyone around the world. Bitcoin laid the foundation of the crypto revolution and isn’t controlled by any bank or government. I would love to call Bitcoin a form of decentralized money, not necessarily DeFi.
In a centralized financial system, there are a lot of things you can do, from loaning, saving, insurance, and stock trading. All these services are built around money in a centralized financial system.
The idea behind decentralized finance is to decentralize the entire financial system as a whole, from lending, insurance, stock, and savings. Similarly, Bitcoin, Decentralized Money.
Now, using decentralized money like certain cryptocurrencies (Stable Coins) that can be programmed for automated activities, we can build exchanges like _lending services, insurance companies, and other organizations _that don’t have a owner and aren’t controlled by anyone.
With DeFi, you can do most of the things that the centralized banks support, like earning interest, borrowing, lending, buying insurance, trading derivatives, trading assets, and even more.
The amazing part is that, with DeFi, the process is much faster and doesn’t require paperwork or a third party.
For us to achieve this, we need an infrastructure for programming and running decentralized financial services. This is where Ethereum comes in.
In order to create a decentralized financial system, we need an infrastructure for programming and running decentralized services. Luckily for us, Ethereum does just that. Ethereum is a technology that’s home to digital money, global payments, and applications (Dapps).
With Ethereum, we can write automated codes, also known as smart contracts. A smart contract is a self-executing contract with the terms of the agreement between buyer and seller being directly written into lines of code.
With smart contracts, we can manage any financial service we like to create in a decentralized manner. This means we can determine the rules for how a certain service should work, and once we deploy those rules on the Ethereum network, we no longer have control over them—they are immutable.
While Ethereum was the first smart contract blockchain, many others have risen to prominence, including Algorand, Solana, Binance Smart Chain, Cosmos, and others.
Once we have a system in place like Ethereum for creating decentralized apps, We can start building our decentralized financial system using a Dapp, or decentralized application, which is a software application that runs on a distributed network.
Not so fast, though! The first thing any financial system needs is money. I know what most likely comes to your mind is Bitcoin. Unfortunately, we can’t use that. The next best option is the ether, because it belongs to Ethereum. we can’t use that either.
Then why can’t we use bitcoin or ether?
Bitcoin is decentralized, but it has very basic programmable functionality, and it’s not compatible with the Ethereum platform. Ether, on the other hand, is compatible and programmable-the problem is that it is highly volatile. We need a stable currency if we really want people to adopt these financial services.
Stable coins are cryptocurrencies that are pegged to the value of real-world assets, usually some major currency like the US dollar. For the purpose of DeFi, we would want to stick to a stable coin that doesn’t use fiat money reserve since it will require some sort of central authority.
There are several stable coins out there – some of which are Ampleforth, Augmint, DAI, DefiDollar, Digix, EOSDT, Empty Set Dollar, Frax, Gemini Dollar, HUSD, Money on Chain, Pax Dollar, pTokens, TrueUSD, USD Coin, WBTC
For the purpose of this article, we will stick with Dai. Dai is a stable coin whose value is pegged to the U.S. dollar, which means it is shielded from the wild swings in prices that are typically associated with cryptocurrencies. 1 Dai = 1$.
(Fiat-collateralized stablecoins maintain a fiat currency reserve, like the U.S. dollar, as collateral to issue a suitable number of crypto coins. Tether (USDTUSD) and TrueUSD (TUSDUSD) are popular crypto coins that have a value equivalent to that of a single U.S. dollar and are backed by dollar deposits.)
Dai is a form of crypto-collateralized Stablecoin that is backed by other cryptocurrencies. Because the reserve cryptocurrency may also be prone to high volatility, these stablecoins are over-collateralized—that is, a larger number of cryptocurrency tokens are maintained as a reserve for issuing a lower number of stablecoins. This can be viewed publicly on the Etherum blockchain.
Let me explain this. Let’s say you need to borrow 66 cents worth of DAI. You need to use $1 worth of ether as collateral. As soon as you want your ether back, just pay back the DAI you borrowed and the ether will be released.
Loans within DeFi are more like getting a loan from a local Pawnbrooker. The way this works is that customers can take an item like a car, a piece of jewelry, or any item of value and receive a loan based on the value of the item. The pawnbroker lends you 60% of the value of the item and charges you interest, and if you miss your repayment, they might sell your item to recoup the value of the loan. The pawn broker will always lend you less than the value of the item you are putting up for collateral. This is known as an “over collateralized loan.” Borrowing in DeFi is similar to this.
If you don’t have any ether to lock up as collateral, you can just buy Dai on an exchange. Because DAI is overcollateralized, even if ether’s price becomes extremely volatile. The value of the locked ether backing the DAI in circulation will most likely remain at 100% or more.
Dai Stablecoin is also a smart contract that resides on the Ethereum platform. Dai is a truly trustless and decentralized stable coin that cannot be shutdown nor censored. Hence, it is a perfect form of money for other DeFi services.
Now that our decentralized financial system has stable decentralized money, It’s time to create some additional services.
The three most popular DeFi use cases are:
- Lending and borrowing
- Digital asset trading
- Derivatives trading
- The first used case is the DEX (Decentralised Exchange)
Decentralized exchanges take a different approach to buying and selling digital assets. They operate without an intermediary organization for clearing transactions, relying instead on self-executing smart contracts to facilitate trading. Just like DAI, they also reside on the Ethereum platform. This means they operate without a central authority.
When you trade on a DEX, there’s no exchange operator, no signups, no identity verification, and no withdrawal fees. Instead, the smart contracts enforce the rules, execute trades and securely handle funds when necessary. Unlike a centralized exchange, there is no need to deposit funds into an exchange account before conducting a trade. This eliminates the major risk of exchange hacking, which exists for all centralized exchanges. Some of the major centralized exchanges are
- Binance.
- Bittrex.
- Bitfinex.
- Coinbase.
- Kraken
Some of the Major Decentralised Exchange are
- Uniswap
- PancakeSwap
- dYdX
- ApolloX DEX
- TraderJoe
- Sushiswap But the range of Decentralized financial services doesn’t stop at Decentralized Exchange.
Let’s move on to the decentralized money markets. Services that connect borrowers with lenders
Compound Finance is an Ethereum-based marketplace used by crypto investors to lend and borrow their digital assets. That means you can lend your crypto and earn interest on it. The compound platform automatically connects the lenders with the borrowers, enforces the terms of the loans, and distributes the interest. The process of earning interest in cryptocurrencies has become extremely popular lately. Giving rise to the term “yield farming,” also known as “yield or liquidity harvesting,” involves lending cryptocurrency. In return, you get interest.
Let’s say you need some money to pay the bills, but the only funds you have are in cryptocurrencies, and you don’t want to sell them. You can deposit your crypto as collateral and borrow against it.
Now that we know about stable coins, decentralised exchanges, and decentralised money markets, how about decentralized insurance? A decentralized platform that connects people who are willing to pay for insurance with people who are willing to insure them for a premium.
DeFi services work in conjunction with one another, making it possible to mix and match different services to create new and exciting opportunities.
Let’s liken this scenario to LEGO blocks. The term “Money Legos” has been coined to refer to DeFi services. These Lego blocks are built for borrowing, staking, or lending assets, and they can be put together to create a single multi-functional financial application. Hence the term “money Legos.”
Once the developer has selected the number of Legos needed to create their project, they can be pushed together, like Lego blocks, to create a new protocol. This protocol will be built on the blockchain and run by a smart contract.
You can start by using a decentralized exchange aggregator like DEX.Ag to find the exchange with the best rate for swapping Ether for Dai.
Then select the DEX you want and conduct the trade (uniswap) of ether for Dai.
Then you lend the DAI you received via AAVE to borrowers to earn interest. Finally, you can add insurance to this process to make sure you are covered in case anything goes wrong.
DeFi presents numerous advantages, some of which are
- Transparency
- Interoperability
- Decentralization
- Free for all services
- Flexible user experience
DeFi is still in its infancy, and this means that things can go wrong. Smart contracts have had issues in the past where people didn’t define the rules for certain services correctly and hackers found creative ways to exploit loopholes to steal money.
A website you should have on your radar is www.defipulse.com. As of today, there is $92.86 billion locked up in the DeFi ecosystem. I hope the term “DeFi” no longer sounds gibberish to you. Drop your questions in the comment section below. Don't forget to follow me on twitter Chinonso Anyaehie