On grounds of affordability, 2 Billion+ global population still stays unbanked. With DeFi that changes. Decentralized Finance or DeFi is creating an impact as a new financial system that is inclusive and easily accessible to everyone no matter the social strata the belong to. DeFi cuts out intermediaries like banks and other financial institutions that would add an extra fee for every transaction.
What is Decentralized Finance (DeFI) app?
DeFi apps rely heavily on Ethereum blockchain, smart contracts and cryptography. Smart Contracts are what enables the transactions on DeFi apps. The reason Ethereum is commonly used for smart contracts is that it uses a language called Solidity that offers all the necessary logic and advanced functions for creating smart contracts on the Ethereum blockchain.
Ethereum is also the most developed ecosystem where developers from around the world build applications everyday and the smart contracts are value locked.
One of the first DeFi app made on the Ethereum blockchain was MakerDAO. MakerDAO allowed the user to lock in collateral and generate DAI (a stablecoin that is backed by the US Dollar). DAI can also be used as a saving on Maker’s Oasis platform. This further enables two of the key aspects of the financial system (Lending & Borrowing). Infact, DeFi is trying to create a new financial ecosystem in a permission-less and transparent way.
Further Reading: How do Liquidity Pools work in Uniswap and other DEFIs?
Some of the other aspects of DeFi are stablecoins, Margin trading, Decentralized Crytocurrency Exchanges, Derivatives, insurance etc.
Lending & Borrowing
Cryptocurrency Lending & borrowing has evolved over the years. Protocols like Compound is an algorithmic, autonomous interest rate protocol. that allows users to supply assets like Ether, BAT, 0X or Tether and start earning revenue from it. Nearly $630 Million worth of assets locked in it’s network. The supplied assets can also act as collateral for borrowing other assets. Another interesting project that is in this category is Aave.
Using the smart contract and certain incentives to entice users, we can create stable coin that is pegged to the US Dollar without storing Dollars in the real world.
MakerDAO generally allows the users to lockin collateral to generate DAI, an algorithmic stable coin. Besides DAI there are other Non-algorithmic stable coins like USDT, PAX. The problem with them is that they are centralized. The stablecoins gained a lot of popularity and are etensively used in DeFi apps like Compound or Aava.
Decentralized Crypto Exchanges (DEX)
The centralized exchanges or DEXs allow exchanging crypto assets in a completely decentralized and permission less way, without giving up the custody of the coins. There are two types of DEXs, order book based (ex. Loop ring and IDEX) Liquidity pool based (ex. Uniswap, Bancor).
Similar to traditional finance, derivatives are contracts that derive their value from the performance of the underlying asset. The main DeFi application is synthetix, which is a decentralized platform that provides on-chain exposure to different assets.
Margin trading is the practise of use of borrowed funds to increase the position in a certain asset. The main DeFi apps in the margin trading space are Dy/DX and Fulcrum.
Insurance is part of traditional financial system that can be replicated on the DeFi network. It guarantees certain compensation in return for a premium amount. One of the common uses in the insurance industry is the protection against smart contract failures and protection of deposits.
The main players in this space are, Nexus Mutual & Opyn. These are some of the main parts of the DeFi ecosystem. These services can be offered as a combined offering.
What are the Risks associated with Decentralized Finance DeFi?
One of the main risks is that the bugs in smart contracts and protocol changes. This could sabotage a range of things from misfired contract executions to impermanent loss of tokens.
Should something go wrong, the protocol could be shutdown forever with your funds locked in. It is always good to check if the exchange offering has a detailed shutdown terms in the Terms of service agreement or their support forum.
Should anything go awry with the policy makers, there is an imminent risk of the exchange/protocol from being blocked for usage in your country.
Asset prices may crash anytime if the exchange becomes illiquid suddenly. Insuring the wallet could be a great idea to cut losses.
Network Fee & Congestion
Network fee and congestion could increase when there are demand for a cryptocurrency pair. Hopefully with Ethereum V2, this would be solved as a lot of underlying changes have been made to speed up the transactions and bringing stability to the network.
The benefit outweigh the negative factors as DeFi offers a lot of opportunities and is expected to disrupt the financial sector. Being a High risk technology, it offers High reward as well .
Do let us know in the comments your thoughts on Decentralized Finance (DeFi)