Decentralized finance (DeFi) is a term for financial products and services that operate on decentralized platforms using blockchains and cryptocurrencies. DeFi allows people to send, purchase, and exchange financial assets without relying on banks or other intermediaries. DeFi challenges the current centralized banking system and aims to democratize finance by replacing legacy institutions with peer-to-peer relationships. DeFi is closely related to the Ethereum blockchain and its cryptocurrencies, and it uses programming capability on blockchains to enable complex contractual relationships and asset trading¹.
Components of DeFi
DeFi is composed of several building blocks that work together to create a decentralized financial ecosystem. Some of the key components are:
- Stablecoins: These are cryptocurrencies that are pegged to a stable asset, such as the US dollar or gold, to reduce volatility and facilitate transactions. Examples of stablecoins include Tether (USDT), USD Coin (USDC), and Dai (DAI).
- Smart contracts: These are self-executing agreements that are written in code and run on blockchains. Smart contracts can enforce the rules and terms of a transaction without the need for a third party. For example, a smart contract can automatically transfer funds from one account to another when certain conditions are met.
- Decentralized applications (DApps): These are software applications that run on decentralized platforms, such as Ethereum, and use smart contracts to provide various financial services, such as lending, borrowing, trading, investing, and more. Examples of DApps include Uniswap (a decentralized exchange), Compound (a lending platform), and Aave (a liquidity protocol).
- Decentralized autonomous organizations (DAOs): These are organizations that are governed by smart contracts and their members, rather than by a central authority. DAOs can manage funds, make decisions, and execute actions based on the collective input of their members. Examples of DAOs include MakerDAO (a stablecoin issuer), Yearn.finance (a yield aggregator), and The DAO (a failed venture capital fund).
Benefits of DeFi
DeFi offers several advantages over traditional finance, such as:
- Accessibility: DeFi is open to anyone who can use Ethereum – anyone with an internet connection. DeFi does not require any identity verification, credit history, or intermediaries to access financial services. DeFi can also provide alternative options for people who live in countries with unstable currencies or limited banking options².
- Efficiency: DeFi transactions are faster, cheaper, and more transparent than traditional transactions. DeFi eliminates the fees that banks and other financial companies charge for using their services. DeFi also reduces the risk of human error, fraud, or censorship by relying on code that anyone can inspect and verify².
- Innovation: DeFi enables new and creative ways of creating and exchanging value. DeFi allows users to create their own financial products and services, customize their risk profiles and returns, and participate in novel markets and opportunities. DeFi also fosters collaboration and experimentation among developers and users who can build on top of each other’s work².
Challenges of DeFi
DeFi is not without its challenges and risks, such as:
- Volatility: DeFi is still a nascent and evolving sector that is subject to high price fluctuations and market uncertainty. DeFi users may face significant losses due to sudden changes in supply and demand, liquidity issues, or external shocks. DeFi users may also be exposed to the volatility of the underlying cryptocurrencies that power the platforms³.
- Complexity: DeFi is based on sophisticated technology that may be difficult to understand or use for some users. DeFi users need to have a basic knowledge of how blockchains, smart contracts, and cryptocurrencies work, as well as how to secure their digital assets and wallets. DeFi users may also face technical glitches, bugs, or hacks that could compromise their funds or data³.
- Regulation: DeFi is largely unregulated and operates outside the legal framework of traditional finance. DeFi users may face legal uncertainties or liabilities regarding the compliance, taxation, or jurisdiction of their transactions. DeFi may also attract regulatory scrutiny or intervention from governments or agencies that may view it as a threat to their authority or stability³.
How does DeFi work in practice?
To illustrate how DeFi works in practice, let’s look at a simple example of borrowing and lending using a popular DApp called Compound.
Compound is a protocol that allows users to lend and borrow cryptocurrencies on Ethereum. Users can supply cryptocurrencies to Compound’s liquidity pools and earn interest from other users who borrow from them. Users can also borrow cryptocurrencies from Compound’s liquidity pools and pay interest to the lenders. Compound uses smart contracts to automate the interest rates, collateralization, and liquidation of the loans.
To use Compound, a user needs to have an Ethereum wallet, such as MetaMask, and some cryptocurrencies, such as Ether (ETH) or Dai (DAI). The user can then connect their wallet to Compound’s website and choose which cryptocurrency they want to supply or borrow. The user can also see the current supply and borrow interest rates for each cryptocurrency, as well as the amount of liquidity available in each pool.
For example, suppose a user wants to borrow 100 DAI from Compound. The user first needs to supply some ETH as collateral to Compound’s smart contract. The user can choose how much ETH they want to supply, but it has to be at least 150% of the value of the borrowed DAI. This is to ensure that the user can repay the loan in case of a price drop in ETH. The user can then borrow 100 DAI from Compound’s smart contract and use it for whatever purpose they want.
The user will have to pay interest on the borrowed DAI, which is calculated based on the current borrow rate and the duration of the loan. The user can repay the loan at any time by returning the borrowed DAI plus interest to Compound’s smart contract. The user will also receive their ETH collateral back, minus a small fee. The user can also monitor their loan status and collateral ratio on Compound’s website.
If the user fails to repay the loan or if their collateral ratio falls below a certain threshold (usually 125%), Compound’s smart contract will automatically liquidate their ETH collateral and use it to repay the loan. This is to protect the lenders from losing their funds in case of a default or a price crash in ETH.
This is just one example of how DeFi works in practice. There are many other DApps that offer different financial services and products, such as decentralized exchanges, derivatives, insurance, asset management, and more. DeFi is constantly evolving and expanding, creating new possibilities and opportunities for users around the world.
DeFi is a revolutionary financial system that leverages blockchain technology to create a more open, efficient, and innovative alternative to traditional finance. DeFi offers users greater access, control, and transparency over their money and financial services. DeFi also faces some challenges and risks, such as volatility, complexity, and regulation, that users need to be aware of and prepared for. DeFi is still in its early stages of development and adoption, but it has the potential to transform the way we interact with money and finance in the future.
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(3) Decentralized finance (DeFi) | ethereum.org. https://ethereum.org/en/defi/.
(4) What is DeFi? Everything you need to know about the future of … – ZDNET. https://www.zdnet.com/finance/blockchain/what-is-defi-everything-you-need-to-know-about-the-future-of-decentralised-finance/
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Meet Krishnaprasath Krishnamoorthy, a finance content writer with a wealth of knowledge and experience in the insurance, mortgage, taxation, law, and real estate industries.