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What is DeFi?

Jun 14, 2022
What is DeFi? Guide to Decentralized Finance
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With the development of cryptocurrencies, decentralized finance - DeFi - has begun to develop.

DeFi is currently one of the fastest growing sectors in the world of blockchain and cryptocurrencies.

DeFi – an ecosystem of decentralized applications (Dapps) that provide financial services, based on distributed networks without any centralized governing body.

Over $200 billion are currently locked in DeFi projects.

Content:

How decentralized is DeFi?

By decentralization, DeFi can be roughly divided into three categories: centralized, partially decentralized and fully decentralized.

  1. Centralized decision-making in project management, setting interest rates, providing liquidity. Examples: Nexo and Celsius.
  2. Partially decentralized (have one or more characteristics - non-custodial, free access to liquidity, decentralized platform development/upgrades and interest rate setting. Examples: Compound, MakerDAO, dYdX.
  3. Fully decentralized - all components are decentralized - community driven.

DeFi uses various technologies, developed in the field of blockchain. All of them have applications outside of decentralized finance, but play an important role in the DeFi ecosystem.

What is DeFi made of?

First of all, DeFi projects — blockchains, distributed ledgers for recording transactions. Currently, most DeFi services are running on the Ethereum, BSC, Tron, Polygon networks due to their capabilities and popularity among developers. However, DeFi activity is also growing on other blockchains.

Digital assets come next, that is, DeFi tokens of the projects themselves, which have value. The growth of some tokens ranged from 100 to several thousand percent in 2021.

The next component — wallets: With the help of wallets, the user connects to DeFi applications.

Another important block of the ecosystem — smart contracts. It is a blockchain-based program code that executes, controls and documents the relevant events and actions, recorded in the terms of the smart contract. Smart contracts are used to create decentralized applications (Dapps)

The next step — stablecoins (digital assets, whose value is pegged to a fiat currency, a basket of fiat currencies or other assets with a stable value). Basically it is USDT, USDC, DAI, UST.

Benefits of Defi

Easy access to financial services, especially for those who for some reason are isolated from access to the current financial system.

The rules for the implementation of processes and operations are written in the smart contract. Once it's up and running, the DeFi app can run on its own with little or no human intervention.

Control over the ecosystem is evenly distributed among all network members.

Transactions are completed quickly and without a chain of intermediaries, which reduces commission costs.

The source code of applications is open for study, which allows any user to understand the functionality of the contract or identify vulnerabilities.

Unlike the traditional financial sector, there are no controlling organizations that require complex forms to be filled out.

How to use DeFi products?

DeFi - a set of products and services that are replacing financial institutions such as banks, insurance companies, bond and money markets. Decentralized financial applications allow users to combine their services, which opens up many possibilities.

Anyone can use DeFi products by going to the app's website and connecting to a DeFi-enabled crypto wallet such as MetaMask on Ethereum or Phantom and Solana.

Let’s consider the following 6 main categories of DeFi:

  1. Payments. The key role of cryptocurrencies is that they make it possible to send funds directly to another user or organization without intermediaries;
  2. Decentralized exchanges (DEX). To exchange one cryptocurrency for another, you can use exchanges such as Binance or Crypto.com. Such exchanges are centralized, they act as intermediaries for traded assets. Users of these exchanges do not have full control over their assets, which puts their assets at risk in the event that the exchanges are hacked and cannot repay their obligations to users. Decentralized exchanges solve this problem by allowing users to exchange cryptocurrencies directly from their personal wallets without transferring funds to third parties;
  3. Lending, loans, deposits. Traditional financial systems require users to have bank accounts in order to use their services. Getting a loan from a bank comes with other restrictions, such as having a good credit score and having enough collateral to convince the bank that the borrower is worthy of the loan and is able to repay it. Decentralized lending and borrowing removes this barrier by allowing anyone to use their digital assets as collateral for loans. You can also earn income from your digital assets in the lending market, earning interest on it. You can also deposit your funds into liquidity pools on Dex exchanges and earn on commissions up to 100% per annum and sometimes more;
  4. Derivatives. The derivative - a contract, whose value is derived from another underlying asset such as stocks, commodities, currencies, indices, bonds or interest rates. Traders can use derivatives to hedge their positions and reduce risk on any trade. For example, imagine that you are a manufacturer of rubber gloves and want to protect yourself from unexpected increases in the price of rubber. You can buy a futures contract from your supplier to supply a certain amount of rubber on a certain date at a price, agreed upon today;
  5. Gambling, Lotteries. As DeFi develops, more and more applications will appear that eliminate intermediaries for betting, gambling, lotteries, etc. The spread of DeFi principles to lotteries allows you to transfer control of the prize pool to a smart contract on the blockchain;
  6.  Insurance. Usually, people buy insurance for cars, home, health and life. But is there a decentralized insurance for DeFi? All tokens, involved in smart contracts, are potentially vulnerable and attract hackers who want to hit the jackpot. Although the code of most projects has been audited, we never know if their smart contracts are truly completely secure. There is always a possibility of hacking, which can lead to losses. These risks make it necessary to buy insurance, especially if you are dealing with large sums.

Conclusion

Every day, the number of DeFi projects is growing, as well as the number of users who use them.

If the trend continues, this is just the start of a massive DeFi wave. Many experts argue that the benefits of an open and decentralized financial system will increase DeFI turnover to trillions of dollars.

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