DeFi, short for decentralized finance, is an emerging category of financial services based on blockchain technology and decentralized applications (dApps). DeFi lets its users make transactions without intermediaries such as traditional banks and financial institutions, enabling payments, lending, or investments based on open protocols that allow for new and flexible ways of financial relationships.
Historically, banks, funds, brokerage companies, and other intermediaries served as agents of trust and security, serving a crucial role in the complex financial system. However, after the 2008 financial crisis and the introduction of Bitcoin in 2009, there has been an ongoing search for alternatives to the existing system that would feature more independence and lower costs than those of traditional banks.
DeFi is a general term that covers a diverse variety of services. Since DeFi develops and changes so fast, it is hard to fully comprehend it once and forever. In this article by KvaPay, we will cover five main categories of decentralized finance: exchanges, stablecoins, credit, insurance, and derivatives.
The Foundation of DeFi
DeFi operates with the help of various technologies and protocols, some of which have been shaping the cryptocurrency market so far. Below is the list of the elements of DeFi.
Blockchains: Distributed ledger, or collection of accounts, that serves as a settlement layer for financial operations. Currently, most decentralized finance applications operate on the Ethereum network, since it is the most capable and widely adopted. Other blockchains, like Polkadot, also host DeFi.
Wallets: User interfaces for software that let people control blockchain-stored assets. Using their private keys, users of non-custodial wallets have sole control over their money. Custodial wallets have a service provider in charge of managing private keys.
Digital Assets: Tokens in the form of value that may be exchanged or moved around a blockchain network. Blockchain-based digital assets were originally introduced with Bitcoin and other cryptocurrencies. Others are often meant to serve purposes other than just making payments.
Smart Contracts: A blockchain-based piece of software code that controls and documents actions and events according to the terms and rules defined by the parties of the contracts.
Governance Systems: Software-based systems, frequently based on tokens that grant stakeholders voting rights, that oversee modifications to smart contracts or other blockchain protocols.
Decentralized Applications (dApps): Applications based on smart contracts and blockchain that operate on a distributed peer-to-peer system of computers rather than based in a data center or a single computer.
Decentralized Autonomous Organizations (DAOs): Entities with rules in the form of smart contracts.
How Does DeFi Work
DeFi uses the available developments in blockchain and peer-to-peer financial networks, decreasing the need for centralized financial institutions. These firms charge consumers and businesses for using their services, which is essential to the functioning of the present system. Blockchain technology with DeFi lessens the need for these middlemen and allows for smaller fees.
Trust-minimized settlement
DeFi projects are operating on public blockchains that offer smart contract functionality, usually Ethereum or Polkadot. Transactions are settled and recorded according to the rules in the smart contracts. The so-called trust minimization is the elimination of the need for centralized financial institutions.
DeFi applications are created to coexist and work with blockchains, giving users opportunities to pay, loan, gift, invest, or perform other actions with their money.
Exchanges
In a traditional financial system, the market participant is required to trust the exchange to manage their funds and provide accurate price quotes, and ensure the security of funds. This is true for purely fiat exchanges (like NYSE), fiat+crypto exchanges (like KvaPay Online Crypto Exchange), and crypto-based exchanges (like Uniswap). So, centralized exchanges are capable of trading digital assets used in DeFi, yet they are custodial and not trust-minimized.
On the other hand, exchanges in DeFi are decentralized. They can be accessed programmatically together with non-custodial wallets. Transactions on those exchanges are made on a p2p basis with the use of smart contracts. Exchanges can use blockchains to list transactions or do it off-blockchain. For example, the most notable form of DeFi exchanges, automated market makers (AMMs), operates entirely with traditional books, not with blockchain.
If you have any funds available on your account on a DeFi exchange, you can lock them up to provide liquidity for the platform, earning interest for your capital the same way as in a traditional bank.
Stablecoins
Stablecoins are essential to DeFi since they have less volatility compared to most digital currencies. Financial exchanges require stable prices for lossless exchange of value between different market participants. All stablecoins can be organized into three categories:
- Custodial (centralized) stablecoins like governments’ own digital currencies or USDC issued by a private company. Such instruments are not related to DeFi since they require trust in a centralized entity.
- Asset-backed stablecoins use smart contracts to maintain their peg to the asset currency. The most prominent example is Tether (USDT).
- Algorithmic stablecoins maintain the peg using a system of contraction and expansion of token supply, thus affecting the price through available supply manipulation.
Stablecoins of the latter two types are considered DeFi services themselves because they are decentralized and non-custodial.
Credit
Lending and borrowing have been the central functions of finance since ancient times. The classic source of credit is a bank. The bank is in charge of the spread between the interest rates paid to the depositors, and the interest it receives from the loan-takers. Credit organizations assess the trustworthiness of the borrowers to be sure the bank does not risk giving out a loan.
Opposed to this, DeFi has its credit protocols such as Aave and Compound. When lenders give their capital to DeFi credit services, they are rewarded with platform-native tokens that represent their tokens with an addition of the specified variable interest rate. Both sides keep custody of their funds at all times.
Flash Loans
As long as the liquidity is repaid after the same transaction, flash loans allow users to borrow money instantaneously using decentralized credit protocols like Aave and dYdX without needing collateral. If the liquidity is not repaid, the entire transaction is immediately reversed.
DeFi loans are usually backed by cryptocurrency collaterals. There is no need for credit checks or other borrower evaluations because loans are secured by assets locked in smart contracts.
Insurance
Unfortunately, risk is always an unneglectable part of finance. Investors and other market participants often would like to be protected from risk by sacrificing a small amount of money regularly. A traditional centralized insurance company collects insurance premiums balanced the way that their combined amount exceeds the payouts for clients’ claims.
There are possibilities for DeFi derivatives to insure against financial defaults, but still, DeFi insurance usually protects against solely DeFi-associated risks such as smart contract failures and exploits.
DeFi insurance pools are collateralized with cryptocurrency that makes capital used for reimbursements to premium-paying users.
Derivatives
Derivatives greatly diversify our financial landscape, being a sophisticated addition to other protocols of financial relations. A derivative can be based on some stock’s or other asset’s current or future value or even some real-world event, which is called betting.
DeFi derivatives connect sellers and buyers directly with collateral pools just like in other categories of DeFi.
Outlooks of DeFi
DeFi is evolving rapidly within the categories we described. Developers are experimenting with new forms of financial instruments to shift the way we manage our finances to a more independent, center-free way. A noteworthy aspect of DeFi development is the composition and implementation of dApps. The composability of DeFi might create new instruments and services, as well as challenges, due to the somewhat unpredictable nature of technological advancements.
Tags:
Share: