What is DeFi? A Beginner’s Guide on Decentralized Finance

March 16, 2021

Imagine yourself in a world where financial services have no central authority or someone in charge. Using decentralized money, like certain cryptocurrencies, that can also be programmed for automated activities. We can build exchanges, lending services, insurance companies and other organizations that don’t have any owner and aren’t controlled by anyone. Yes, that’s what DeFi or Decentralized Finance promises to offer.

Decentralized finance is one of the hottest topics in the crypto verse right now with many speculating that it could be significantly bigger than the legendary ICO bubble of 2017.

Confused? Don’t worry, most of the people when hear about DeFi have similar pressing questions like:

What is DeFI and what it could mean for the crypto space? Can you use it to earn interest on your cryptocurrency holdings? Is DeFI risky? And will DeFi really change the future of finance as we know it?

But, before rocking and rolling into DeFi, let’s quickly go through concepts that are intertwined with DeFi and can possibly help us understand DeFi and its meaning in the easiest possible manner.

ETH

Ethereum is a Do It Yourself platform for writing decentralized programs also known as decentralized apps or Dapps.  Through the use of Ethereum we can write automated code, also known as smart contracts, that manage any financial service we’d like to create in a decentralized manner. This means that we determine the rules as to how a certain service will work, and once we deploy those rules on the Ethereum network we no longer have control over them - they are immutable. Once we have a system in place like Ethereum for creating decentralized apps we can start building our decentralized financial system.

On the flipside, ETH’s rising gas fees have been of grave concern, and entrepreneurial gods are working to solve the problem as we speak. Average ETH gas fees hit a yearly high on 23rd Feb, 2021, with the average transaction fee hitting $38.21. Well, no surprise that Ethereum layer 2 solutions are also getting popularity. In one of the recent events, Andreessen Horowitz (a16z) is investing $25 million into Optimism, a platform built to focus on scaling the Ethereum network. This has also given rise to ETH killer products, one of the recent famous being PancakeSwap.

SMART CONTRACTS

Smart contracts are in short digital contracts that enable you to exchange anything of value in a transparent way, whilst avoiding the use of a middleman. Let's say that Elon Musk wants to sell a SpaceX rocket to NASA. However, Elon doesn't trust that NASA will send the money, and NASA doesn't

trust that Elon will send the deed to the rocket. This brings up the age-old problem of who sends first! Now alternatively a middleman could be used to act as an escrow, however this could be expensive and neither Elon nor NASA want to waste needless money on a middleman. This is where smart contracts could prove useful.

The contract could be programmed to only switch the assets if Elon sends a digitalized rocket deed to the smart contract and NASA sends 100 million dollars in Bitcoin to the smart contract. If both these criteria are fulfilled then the smart contract would execute the trade. Automatically the key thing to know here is that smart contracts can be programmed to receive and redistribute digital assets. They can also be programmed with custom rule criteria and transactions made are recorded on a public blockchain. This means that the ownership of the assets cannot be disputed. And presently, Etherium is the biggest smart contract platform out there.

BITCOIN AS DECENTRALIZED FINANCIAL SYSTEM

We all know that Bitcoin is a form of money that isn’t controlled by any central bank or government.

It can be transferred to anyone from anyone around the world, without the need of a bank or a financial institution. Bitcoin is decentralized money, and if you’re just starting out you may want to read more about Bitcoin before moving forward. However, transferring money is only the first of many building blocks in a financial system. Aside from sending money to one another, there are a variety of services we use today. For example, loans, saving plans, insurance and stock markets are all services that are built around money and together create our financial system.

Today, our financial system and all its services are completely centralized. Banks, stock markets, insurance companies and other financial institutions all have someone in charge, whether it be a company or a person, that controls and offers these services. This centralized financial system, or CeFi for short, has its risks like mismanagement, fraud and corruption to name a few.

But what if we could decentralize the financial system as a whole in the same way Bitcoin decentralized money? That’s exactly what DeFi is all about. Decentralized finance takes components of traditional finance and decentralizes them by removing middlemen and replacing them with smart contracts. A straightforward example of this is decentralizing loans and earning interest.

But wait, wait! Not giving you the clear picture about this ecosystem would be pretty unfair as we promised to make you thorough with the concept. DeFi products and services are not truly decentralized as elements of the current DeFi ecosystem are pretty heavily centralized. Many DeFi services or products have a central company behind them creating the smart contracts, instead the way to think about DeFi is that it's non-custodial finance where you don't need to trust a third party like a bank with your money.

Yield Farming

Yield farming/Liquidity Mining are catchy terms for amassing interest in any way possible, quite similar to staking. Before yield farming people used to get % on their funds by staking their tokens. Now they stake their tokens and get % on it, but majorly not always the same token. Difference lies in the fact that in yield farming you stake in pools. mostly 2 pairs simultaneously. There are many pools, and the rewards are usually clarified in that pool.

For instance, To Yield Farming on Sushi, you first find a pool that has a good ROI. In this case, let’s say ETH+USDT pool. As a result, you would get % rewards in 'Sushi Coin', the % that you got is your yield, and that’s what doing Yield Farming looks like. 

Compound is one the many many many places you can do such actions where you get Comp as yield.Therefore, it's possible to get yield on one of the 2 coins that you stake, instead of the platform token, but nothing is set in stone.There are more details around yield farming, new protocols implement new ways to yield farm. In more layman terms, it's getting interest on your capital.

Money Legos and DeFi

DeFi's central philosophy: design for interoperability. This enables the financial market to prosper from human success and continuously pushes autonomous finance forward. DeFi services work in conjunction with one another, making it possible to mix and match different services to create new and exciting opportunities. This kind of resembles how you can use  different LEGO blocks and get creative with whatever it is you want to build. Hence the term ‘money legos’ has been coined to refer to DeFi services.

Here’s a classic example of how this works:


(Source:Medium


Here's where you can figure out what each product does:

Considering using DeFi services and products?

Decentralized finance is all about building more complex financial systems on top of the blockchain and enabling them to work with that store of value, that currency, that payment system. Blockchains that supports smart contracts enables you to interact with money and empower you to participate in things like loans, collateralized debt and fundraising, all this while being outside of the traditional banking system.

Most people in the DeFi ecosystem  are borrowing money and supplying money to earn interest. Taking out a loan or borrowing money in DeFi is that it's not the same as getting a loan from your bank where you essentially bring future cash flows forward to today. Loans within decentralized finance are more like getting a loan from your local pawnbroker.

Borrowing in DeFi is pretty similar to this. To get a loan you need to bring collateral in this case cryptocurrency and that's locked up in a smart contract called a Collateralized Debt Position or CDP. The thing to know is that if you're borrowing money in DeFi it will be over collateralized, and if the value of your collateral falls too much you can have your crypto liquidated by the CDP.

The coolest thing about DeFi is that it essentially enables you to access many financial products or services without having to KYC or get approval from anyone. It doesn't use credit scores or discriminate based on the location you live in. In short DeFi opens up financial products to a global audience and does away with the annoying barriers to traditional finance.

Now you might be wondering, how big is the DeFi ecosystem? Well, the website that should be on your radar to keep up with DeFi market should be Defipulse.com. And to put things into perspective, the DeFi market last year, same time around the corner had $815 M locked up, and fast forward to today, it’s whopping $36.7 B. That’s massive and pretty serious growth! And its popularity is only expected to grow further more and more.

Here are some cool products and services that make up the current DeFi ecosystem. If you've been with us till this point then the chances are that you're thinking about earning interest on the crypto. The thing to know is that there isn't just a single DeFi interest rate and you'll need to shoparound to get the best deal.

That's where websites like LoaScan.io come in. The platform lets you compare the different interest rates on the different DeFi platforms and choose the deal that's right for you. And if you're interested in earning interest on your crypto then a good place to start is Compound.finance with over $8.3 B worth of crypto assets earning interest across 9 markets on the platform.

In terms of DeFi trading platforms,  it’s the forte of the likes of Dydx.exchange which offers non-custodial margin trading. Tokensets.com platform offers Robo sets that automate your crypto portfolio management and you can select the trading strategy of your choice.

Our opinion and why we believe that DeFi could be the future of DeFi

DeFi is still very young and that's why so many people believe in its explosive growth potential. The fascinating thing about the whole Decentralized Finance or DeFi movement is the possibility to completely democratize access to financial services. There’s no doubt that a decentralized financial system can benefit a huge portion of the population that currently suffers from financial discrimination, high fees and inefficiencies in managing their funds.

Majority of Crypto and blockchain enthusiasts are optimistic about the future of DeFi and believe that it's only going to strengthen as more products and services around it are built. More than $40 Billion) don’t usually get locked up in something without good reason. No one can argue about the amazing growth trajectory of decentralized finance. The key thing to supercharge DeFi growth is the terrible returns that banks try to give you on your savings. When people know that they can get five and a half percent per year on Dydx by supplying USD to earn interest. Also, you wouldn't need to lock up your money for three years in DeFi either. Another interesting solution to consider is where retail bank interest rates will go in the future with all this funny money flying around interest rates on cash deposits are sinking lower and lower. It wouldn’t be a surprise if DeFi starts attracting a more mainstream audience looking to earn a bit of interest on their cash.

Financial experts foresee a loan reputation system coming about in the near future. One that's recorded on the blockchain and which enables people to get access to under collateralized loans a bit like how a bank lends you money for a mortgage after you've put down a deposit for a house. However the key thing here is that a bank account would not be needed. The greedy banker would be cut out and the world's unbanked population could get access to these financial services with just a few taps of their smartphone.

But how on earth is a non banked person going to trade their local currency for crypto to participate in the DeFi ecosystem? Well, one way is to use a service like Localbitcoins and just do a real-world peer-to-peer exchange and we are positive that new methods may be defined in the future.

It would also be interesting to see if DeFi will be adopted at scale in developing countries as a way to hedge against inflation and if decentralized finance can truly open access to financial products to the world's 1.7 billion unbanked people.

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