A beginner’s guide to Decentralized Finance- Exclusive Insights
What is Decentralized Finance? Can you use it to earn interest on your cryptocurrency holdings? Is it risky? And will it really change the future of finance as we know it?
Today, our financial system and all its services are completely centralized. Banks, stock markets, insurance companies, and other financial institutions have someone in charge, a company or a person, who controls and offers these services. This centralized financial system, or CeFi, has its risks – mismanagement, fraud, and corruption, to name a few.
DeFi is a term given to financial services that 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 an owner and aren’t controlled by anyone.
Decentralized Infrastructure – Ethereum
To create a decentralized financial system, we first need an infrastructure for programming and running decentralized services. Ethereum does just that. Ethereum is a platform for writing decentralized programs, also known as decentralized apps or Dapps. Through 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 particular service will work, and once we deploy those rules on the Ethereum network, we no longer have control over them. They are immutable.
Decentralized Stable Money – DAI
Bitcoin or Ether could not be used as DeFi’s currency. While it is indeed decentralized, Bitcoin has only basic programmable functionality and is not compatible with the Ethereum platform. Ether, on the other hand, is compatible and programmable. However, it is also highly volatile. To build reliable financial services, we need a more stable currency to operate within this system.
Stablecoins are cryptocurrencies pegged to the value of a real-world asset, usually some major currency like the US dollar. For DeFi, we need a stablecoin that doesn’t use fiat money reserves for maintaining a peg since this would require some sort of central authority. This is where DAI comes into play. DAI is a decentralized cryptocurrency pegged against the value of the US dollar, meaning one DAI equals one US dollar. Unlike other popular stablecoins whose value is backed directly by US Dollar reserves, DAI is backed by crypto collaterals that can be viewed publicly on the Ethereum blockchain. DAI is over collateralized, meaning if you lock up $1 worth of Ether, you can borrow 66 cents worth of DAI. As soon as you want your Ether back, just pay back the DAI you borrowed and the Ether will be released. If you don’t have any Ether to lock up as collateral you can just buy DAI on an exchange. Since DAI is over collateralized, even if Ether’s price becomes highly volatile, the value of the locked Ether backing the DAI in circulation will most likely remain at 100% or more. In essence, the DAI stablecoin is also a smart contract that resides on the Ethereum platform. This makes DAI a genuinely trustless and decentralized stablecoin that cannot be shut down nor censored. Hence it’s a perfect form of money for other DeFi services.
Decentralized Financial Services
Decentralized Exchange (DEX)
DEXes operate according to a set of rules, or smart contracts, that allow users to buy, sell, or trade cryptocurrencies. Like DAI, they also reside on the Ethereum platform which means they operate without a central authority. When you trade on a DEX, there is no exchange operator, no sign-ups, no identity verification, and no withdrawal fees. Instead, smart contracts enforce the rules, execute trades, and securely handle funds when necessary. Also, unlike a centralized exchange, there’s often no need to deposit funds into an exchange account before conducting a trade. This eliminates the significant risk of exchange hacking which exists for all centralized exchanges.
Decentralized Money Markets
These are services that connect borrowers with lenders. For example, ‘Compound’ is an Ethereum based borrowing and lending Dapp, meaning you can lend your crypto out and earn interest on it. Alternatively, you can deposit your crypto as collateral and borrow against it. The Compound platform automatically connects the lenders with borrowers, enforces the terms of the loans, and distributes the interest. The process of earning interest on cryptocurrencies has become extremely popular lately, giving rise to “yield farming” – a term given to the effort of putting crypto assets to work while seeking to generate the most returns possible.
These new financial products entail some risks, so you need a service that insures your funds if something goes wrong. It is a decentralized platform that connects people who are willing to pay for insurance with those willing to insure them for a premium. Everything happens autonomously without any insurance company or agent in the middle.
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 LEGO blocks and get creative and build what you want. Hence the term ‘money legos’ has been coined to refer to DeFi services. For example, you can create the following service from different money legos. You start by using a decentralized exchange aggregator to find the exchange with the best rate for swapping Ether for DAI. You then select the DEX you want and conduct the trade. Then you lend the DAI you received to borrowers to earn interest. Finally, you can add insurance to this process to make sure you’re covered in case anything goes wrong. This is just one example out of the many opportunities DeFi offers.
It seems that the DeFi revolution has reached its early adopter stage, and the coming years will tell if it manages to cross the chasm into mainstream adoption. There’s no doubt that a decentralized financial system can benefit a vast portion of the population that currently suffers from financial discrimination, high fees, and inefficiencies in managing their funds.