In this post, I am going to take a look at the basics of Decentralized Finance (DeFi). This is an implementation of decentralized applications, which aims to change the way financial systems are implemented. This will not be an exhaustive guide, as many parts of this topic warrant their own articles entirely, and those will be coming in the future, but will be a good starting point in understanding this blockchain technology.
For the usual disclosure, I am not a financial advisor, I don’t even work in finance at all. My day job is as a telecommunications software engineer. Treat everything you read here as some educational resources and not financial advise.
What Is Decentralized Finance (DeFi)
Decentralize Finance (DeFi) is the term given to a whole host of decentralized applications, with the common purpose of replacing real world financial systems. This includes things such as decentralized exchanges, liquidity pools, lending platforms, and can even extend to things such as insurance or mortgage brokerage.
Like other decentralized applications, they exists mainly through the implementation of smart contracts, and you get all the benefits of that. All of the transactions and code exists on the blockchain, so it is transparent and auditable. You don’t need to trust the parties involved, as it is all managed by code. It is also open to anybody, and has a much lower barrier to entry than traditional financial institutions.
Since they exist on the blockchain, they operate autonomously and without the need for people to handle the transactions. This makes them more secure and fast. They can also leverage oracle services, much like any other smart contract, to be able to have real world data be part of it’s operation.
Types Of DeFi Applications
This is by no means an exhaustive list, but just a nice sampling of what is out there for you to look for in the DeFi space.
Decentralized Exchanges: These would be exchanges such as Uniswap, where there is no central authority operating the trading platform. These have the benefit of having marginal requirements, generally no specific accounts on the exchange, everything is done through a wallet, and there is no Know Your Customer (KYC) requirements.
Lending/Borrowing: These are decentralized platforms where you can stake/lend your crypto to generate a return. You would provide in collateral that would in turn generate something in return. If we take a look at the MakerDAO system, you essentially provide it collateral in the form of Ethereum (ETH) and you get back Dai (DAI), a collateral backed stablecoin, which you can further stake to earn interest on. You can also use your collateral to borrow against in a lot of these platforms.
Algorithmic Stablecoins: Any stablecoin that exists by a smart contract and being collateralized by crypto, is itself a form of a DeFi application. Looking again at the Dai (DAI), this stablecoin is backed by Ethereum (ETH) and keeps it’s price pegged to $1 USD using it’s on-chain algorithm. This differs from other coins like Tether (USDT), which has a central authority handling the 1:1 custody of the USD.
Margin/Derivative Trading: DeFi applications such as Synthetix make it possible to get access to on-chain trading of non-crypto assets through derivative contracts, much like how they work in the real world. You can also get access to margin trading through liquidity pool backed DeFi applications.
Risks In DeFi
Like all thing in crypto, there are of course risks to DeFi applications. These extend beyond the usual risks associated with crypto, yes the price can go up and down and affect the value of the currency itself, but you also need to be aware of other risks that exist in the space.
Since DeFi is still relatively new, there is still a good potential for bugs and exploits to exist in the underlying smart contracts, which can lead to the liquidity being drained from them, which could wipe out your position. This could be as simple as a protocol change on the underlying network making it possible for one to be exploited.
You also need to do your research about any DeFi project, and see just how decentralized they are. A lot of DeFi projects do have some centralized aspects of them, and a decentralized project is only as decentralized, as its most centralized part. There could be a person sitting with the keys to the kingdom ready to do a rug pull, so always be sure you know what you are getting into, and what the risks involved are.
I hope this general overview of what Decentralized Finance (DeFi) is has helped. I plan to expand on a lot of these areas in their own articles later on, so stay tuned for those. I think DeFi has the potential to change a lot of the financial system that we have all grown up with, and there is the potential for fortunes to be made and lost within the new ecosystem.
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