What is Defi?
DeFi is an abbreviation for the phrase decentralized finance, usually refers to digital assets and smart financial contracts, protocols, and decentralized applications (DApps) built on Ethereum. In simpler terms, its financial software built on blockchain can be pieced together like Money Legos.
To get a feel for the products and services that exist in the ecosystem Ethereum DeFi, you can check out our DeFi leaderboard that tracks the current value locked in today’s popular DeFi smart contracts.
Information technology has disrupted nearly every industry over the years. Each innovation builds on the previous, and digital products and services become more sophisticated. Through technology, we serve the world in accordance with our needs. From digital assistants to home automation, programs now influence many aspects of your daily life. So what is its impact on the financial industry?
What is decentralized finance and who is it for?
To better understand DeFi, we should first take a look at how traditional finance was born. While it sometimes feels like money has always existed, that simply isn’t the case.
Humans originally exchanged goods and services. But as human society formed and developed, so did our economy. We invented money to make it easier to exchange things of value. Money then helped usher in new innovations and higher levels of economic productivity. However, progress has not come without its costs.
Historically, central authorities like governments have issued the currencies that underpin our economy. Central banks and institutions are expected to carefully manage and regulate the supply of currency in circulation. As the size and complexity of our economies grew, these central authorities gained more power as more people placed their trust in them.
You trust your government to not print more money overnight. You trust your bank to store your money securely. And, when it comes to investing, you trust your assets to a financial advisor. By giving control of your money to someone else, you hope to make a profit. But the sad truth about our current financial system is that the strength that comes with this trust does not always come with a reward.
We often have very little say in how corporations handle our investments, or even how our government manages the economy. And in most cases, investors get only a portion of the profits generated from the risks taken by these central authorities.
DeFi is trying to build something different
“Decentralized finance” aims to create a financial system that is open to everyone and minimizes a need to trust and rely on a central government. Technologies like the internet, cryptography, and blockchain give us the tools to work together to build and control a financial system without the need for central authorities.
There is a saying in space blockchain:”Don’t trust, must verify“. Because with the blockchain network, you can personally verify any and every transaction that happens on the blockchain.
DeFi allows people to take charge of their finances.
Almost all DeFi applications are built on the Ethereum blockchain, the world’s most popular programmable blockchain. Ethereum is a blockchain network that maintains a common ledger of digital value. Instead of a central authority, the participants comprising the network control the issuance of ether (ETH), the network’s base currency, in a decentralized manner.
Developers who can program applications on Ethereum can create, store, and manage digital assets, also known as tokens, on the blockchain. These are called smart contracts (Smart contracts) or decentralized applications (DApps). Their contracts or agreements are enforced by the Ethereum blockchain. Or rather, applications or scripts run only as programmed on the Ethereum network. You can build irrevocably complex agreements without a middleman.
Decentralized finance has the opportunity to bring about a more transparent and flexible financial system. Anyone with an internet connection can access and interact with smart contracts built on the Ethereum blockchain. Many smart contracts are built to be open source and interoperable with existing smart contracts. So the user can verify the code of the smart contract and choose which service suits them best.
A few examples of popular DeFi applications
There are various DeFi products and services available, some of which you may find familiar with existing financial services but with a decentralized twist.
Arguably, the fastest growing and most popular area of DeFi is the Borrowing and lending platform. Similar to a bank, users deposit money and earn interest from other users borrowing their assets. In this case, however, the asset is a digital and smart contract that connects lenders to borrowers, enforces the terms of the loan, and distributes interest. And it all happens without the need to trust each other or intermediary banks. And, by cutting out the middleman, lenders can earn higher returns and better understand the risks that blockchain provides.
Tokens are called stablecoins is also very important to the DeFi ecosystem. You might get the impression that all cryptocurrencies are volatile. However, stablecoins are tokens that are designed to hold a specific value and are usually pegged to a fiat currency like the US dollar. For example, DAI is a stablecoin pegged to USD and backed by ether (ETH). For each DAI, there is $1.50 of ETH locked in the MakerDAO smart contract as collateral.
Another popular type of DeFi application is the decentralized exchange, or for short DEX. A DEX is a form of cryptocurrency exchange that uses smart contracts to enforce trading rules, execute trades, and securely handle funds as needed. When you trade on a DEX, there is no exchange operator, no registration, no identity verification or withdrawal fees.
DeFi is like Legos smart money
With Legos, you start with a series of small bricks. You have to decide how you put the Lego bricks together to build something new. The same is true about smart contracts. With every new project, product or service launched on Ethereum, you have one more Lego in your collection. And by connecting the existing components of DeFi, you can combine, modify or create powerful new financial instruments from these coins.
cDAI is a perfect example of Legos money in action. Compound is a cryptocurrency marketplace or lending service on Ethereum. When you give DAI to Compound, you will receive a cDAI token that represents both your DAI in Compound and any interest you have earned from lending. Since cDAI is a token, you can send, receive, or even use cDAI in other smart contracts. Legos coins in action: ETH goes to MakerDAO to mint DAI tokens, DAI is provided to Compound, cDAI tokens can be used in other DApps.
For example, you can exchange ETH for cDAI on the DEX and immediately start earning interest just by holding cDAI. And since you choose how you interact with smart contracts on the blockchain, you can use a DEX aggregator like DEX.AG to compare and trade at the best prices across all popular DEXs, all in seconds.
Hierarchy is subject to change
There are different levels of hierarchy when it comes to DeFi service. Because the truth is, not everything can or needs to be fully decentralized.
As mentioned before, stablecoins are very popular at DeFi. But, not all stablecoins are as decentralized as DAI. Many of them are actually tokens that represent fiat deposits. For example, for each token USDC, there is 1 USD kept in a bank somewhere. Theoretically, you could tokenize or generate tokens to represent any real-world asset. This is where things get a little less black and white, because while you can trade, send, and receive these tokens on the blockchain, you cannot completely eliminate the need to manage or redeem your assets. products in the real world.
Take, for example, buying a house on the blockchain. Say someone tokenized the certificate to their home, put it on a decentralized exchange and you buy it. Without the proper legal setup and the law on your side, you can’t force this person to leave their home regardless of whether you own the digital version or not. For now, you need to go back to your country’s court system to resolve the dispute.
In short, there are limitations to the technology, and sometimes DeFi’s lines start to blur. In the near term, legislation will adapt to the changing financial landscape and DeFi’s place in the world will become clearer. That being said, one thing is clear: DeFi is here to stay.
DeFi won’t stop
If you believe the future holds digital currency, then come and explore what DeFi has to offer. At the time of this writing, the entire decentralized finance market is worth $494.6 million. Ethereum has become the blockchain of choice for many companies to build their financial products. And more and more DeFi applications are being built every day.
Learn more about: What is Ethereum?
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