Decentralized finance is a growing revolution that is giving individuals the power to be their own bank and control and manage their investments. This emerging ecosystem is attempting to be a lucrative option for users looking for alternatives to traditional (TradFi) and centralized money markets (CeFi).
Some investors find conventional banking and stock not fast enough and expensive. Though CeFi is touted as a crypto alternative to traditional finance, investors have concerns with this ecosystem as well. CeFi mandates strict adherence to KYC, AML, and other compliance requirements. Such directives, though intended to reduce risks, often prevent global adoption as many underserved people are left out of the financial ecosystem due to a simple lack of government issued IDs. Alongside, people will have no choice but to share their sensitive personal information with third parties. Furthermore, the centralized exchanges control the users’ keys and hence their investment. They can even choose which customers to serve and who to avoid. Additionally, they are also constrained by the geographies they operate.
How Is DeFi Different?
Unlike conventional or centralized finance, their decentralized ecosystem is community-governed. It is not bound by geographies or owned by organizations. Instead of relying on intermediary authorities to say what is right and what is not, DeFi networks depend on coded contracts to ascertain the legitimate transactions.
As a result, it is nearly impossible to censor or arm twisted by regulators to comply. Moreover, there is no single sovereign currency. Furthermore, in DeFi, trust is tacitly built into the system, and hence there is no need to trust anyone with your funds. You have the control over your private keys, which are not required to be shared with others. All one needs is a wallet and a 256-bit address that represents your account in order to work your way into this ecosystem.
Such an arrangement often comes with its vices. The simplest among them is that one could lose the keys to their wallets and lose all their funds as a result. A more malicious one is when hackers take advantage of the bugs and loopholes in the smart contract code and get away with money that does not belong to them. It is therefore critical that the code is audited and all holes plugged before the users can access them. Furthermore, a robust governance model with ways for people to get their money back if things go south goes a long way in creating an inclusive, compliant, DeFi ecosystem.
Nevertheless, it is vital to understand the basics to scale the DeFi web efficiently. To that effect, let us start by getting familiarized with the various services that are an integral part of the DeFi ecosystem. We will eventually delve into each one of these in detail in the subsequent posts.
Lending and Borrowing
Similar to its traditional equivalent, DeFi enables users to loan and borrow assets and earn interest in crypto for adding liquidity to the protocol. Since there are no middlemen, the users can garner more financial rewards than conventional lending. But, as the lending and borrowing parties remain anonymous, there is a higher risk involved. To compensate, DeFi platforms usually over-collateralize — you need to deposit digital assets worth more than the amount you intend to borrow. Aave, Compound, Maker are a few of the popular lending platforms.
How does it work? The lender accesses the DeFi platform of their choice, decides the interest rate, enters it in the application, and then waits for the borrower. Once the borrower is found, a “smart contract” seals the deal between the two. If the borrower defaults, their collateral gets automatically sold to recover the lenders’ money.
Crypto Trading on Decentralized Exchanges
Decentralized exchanges (DEX) take a non-custodial, disintermediary approach. There are several ways in which trading happens on these exchanges. Some DEXs operate in a similar fashion as centralized ones. They use an order books approach where all buy and sell orders are recorded on-chain and are used to determine the market price of the traded assets. The next generation DEXs, however, employ liquidity pools to determine asset value. A liquidity pool, in simplest terms, is a “pool of digital tokens” bound into a smart contract. Users called liquidity providers add equal amounts of two tokens into this pool and thereby create a market. dYdX, Uniswap, Curve, Binance DEX, SushiSwap are a few well-known DEXs.
Derivatives, as the name suggests, “derive” their value from something else. The underlying asset could be stocks, commodities, bonds, or even cryptocurrencies. Derivatives include futures, options, collateralized loans, prediction markets, and swaps. Their objective is to enable investors to get exposure without actually holding the underlying asset. In DeFi, instead of a broker, settlement is done by codified contracts running on a blockchain. Moreover, in the DeFi ecosystem, a derivative can be created by anyone, and its value can be based on virtually any asset. Synthetix, Cover Protocol, Barnbridge are a few of the notable protocols bringing derivatives to DeFi.
The explosive growth of DeFi comes with perils, the most alarming of all being malicious actors exploiting the loopholes in the smart contract code and making away with massive sums of crypto. In 2021, DeFi has so far accounted for 75% of the total crypto hacks. In one of the recent hacks, the attackers managed to siphon off close to $35 million from Vee Finance, a DeFi protocol running on Avalanche Blockchain.
Such exploits have necessitated insurance coverage for DeFi assets. DeFi insurance providers are predominantly decentralized, and they pool, transfer, and share the risk. Additionally, decentralized insurers offer more transparency and include blockchain benefits such as staking rewards and voting powers. Users can purchase protection against hacks, contract code vulnerabilities, payment defaults, and wallet issues.
Most often, these DeFi insurers also partner with traditional underwriters with proven track records to protect themselves. Nexus Mutual, Unslashed Finance, iTrust Finance are some of the widely known DeFi asset coverage providers.
When it comes to earning steady returns, global stablecoins prove to be more consistent than cryptocurrencies. As a result, stablecoins are favored by the DeFi market for generating yields that remain relatively unaffected by crypto market volatility. USDC and Tether are some of the prominent stablecoins.
In conclusion, decentralized finance offers a unique opportunity for individuals to have complete control of their finances, and in many cases, earn better yields than traditional means. But, exercising caution, learning how the DeFi ecosystem operates, and being prudent is a must while investing in DeFi.