Page Summary
Decentralized financing aims to create a financial system that is open to everyone and that minimizes the need for trust in a central party. Technologies such as the internet, cryptocurrency, cryptography, and blockchain give us the tools to build such a financial system.
Almost all DeFi applications are built on the Ethereum blockchain. Like Bitcoin, Ethereum has a blockchain that acts as a shared ledger that tracks digital value. The participants of the network control the issuance of Ethereum, the network’s cryptocurrency. This distribution of Ethereum is not controlled by a single central authority.
Developers can program applications on the Ethereum blockchain. These programs are smart contracts and decentralized applications (DApps). They allow users to make complex, irreversible agreements without the need for an intermediary.
Decentralized financing has the potential to create a more resilient and transparent financial system. Anyone with an internet connection can access and interact with smart contracts built on the Ethereum blockchain. Many smart contracts are open source and can work with existing smart contracts. You can even click these together like Lego bricks to offer new DeFi products.
Anyone is able to create or build on top of an existing DeFi DApp without permission. DeFi protocols are modular. Users can build them on top of each other to build a dense system of interworking parts.
What are examples of popular DeFi applications?
Lending platforms, cryptocurrency exchanges, and fiat-to-crypto gateways. Many different DeFi products and services exist. DeFi’s most popular and fastest-growing sector is lending platforms. Users deposit money at these platforms and earn interest from other users who borrow their assets.
Digital smart contracts connect the lenders with the borrowers and distribute the interest. And it all happens without having to trust each other or the intervening bank. By cutting out the middleman, lenders can achieve higher returns. They can also understand the risks thanks to the transparency the blockchain provides.
If you read about earning passive income with cryptocurrency, it is about the interest you receive for lending your coins on these types of platforms.
Stablecoins are also important to the DeFi ecosystem. These are tokens designed to hold a specific value, such as the value of 1 US dollar. Tether is a central stablecoin, because there is a party that keeps a dollar in their account for every Tether issued. A decentralized variant of this is Dai. This is a stablecoin pegged to USD and backed by Ethereum. For each DAI, there is $1.50 worth of Ether in the MakerDAO smart contract as collateral.
Another popular DeFi application are decentralized exchanges or DEXs. DEXs are cryptocurrency exchanges that use smart contracts to enforce trading rules and transact funds. When trading on a DEX, there is no exchange operator, no sign-up required, no identity verification, and no withdrawal fees. To keep a DEX running, users pay transaction costs. A DEX can use either one of two methods to make a market: order books or liquidity pools.
Liquidity Pools
If you buy cryptocurrencies on a DEX, the crypto coins do not come from other users. Instead, they come from a liquidity pool. Users provide the tokens in this pool. They lend out their coins (and receive a reward for doing so) so that you can then buy them.
Liquidity pools are the foundation of the DeFi world. It is impossible for many decentralized applications to work without liquidity pools. Applications of this kind need tokens, which can only be supplied by the liquidity pools.
What is a liquidity pool?
A liquidity pool is a group of cryptocurrencies locked into a smart contract that DeFi applications use. Decentralized applications (dApps) run on the blockchain. This means that there is no central party behind it that can provide liquidity to the application. Instead, the community supplies the liquidity, so this part is also set up in a decentralized way.
Liquidity providers (LPs) provide liquidity. They send crypto coins to the liquidity pool, after which the smart contract will store the address from which the coins come. The LPs will get their coins back after a certain period of time, including a reward for lending the coins. It is possible to realize a return from crypto coins that you lock in a liquidity pool.
What is an order book?
An order book is a list of all active buy and sell orders placed on an exchange for a particular currency. Order books are an excellent source of determining investor sentiment for a particular currency. It allows traders to view a list of buy and sell orders and also get a sense of market depth.
An order book contains the terms BIDS and ASKS. Bids are bids to sell your coin for a certain price. Asks are requests from other users to buy a coin at a specific price. Most Decentralized exchanges allow you to make purchases directly in an order book.
Decentralization can vary
DeFi’s services are decentralized to varying degrees. Because the truth is that not everything can or should be completely decentralized.
We already talked about stablecoins. Not all of these are as decentralized as DAI. Many of these stablecoins are actually tokens representing fiat currency deposits, such as Tether. Anyone can create a token that can represent any product. And here we see the gray areas of the De in DeFi. You can trade, send and receive these kinds of stablecoins via a decentralized blockchain, but they will still be linked to the real world.
Suppose you want to buy a house via the blockchain. Someone places the deed of a house (in the form of a token) on a decentralized exchange and you buy it. Without the right legal framework and approval of the law, you cannot evict someone, even if you are the owner of the digital deed. To settle this dispute you have to fall back on the central legal system.
What are the risks of DeFi?
Faulty smart contracts are the biggest risk to DeFi. You can earn a lot of money with DeFi, but there are also many risks. A DeFi platform is only as strong as the underlying smart contracts. If these are not written watertight, users can abuse them. That has happened several times.
DeFi protocols are not hacked, but smart people see gaps in the lego tower of smart contracts. If there is one weak block, everything can collapse. As a DeFi user, you need to keep track of the changing terms of service between the various DeFi products, wallets, exchanges, and crypto projects.
Investors use historical data and benchmarks such as a currency’s annual inflation and risk-free return to check investment opportunities. But in the case of DeFi, the lack of comprehensive historical data and benchmarks makes it difficult to estimate the risk of investments.
Non-Fungible Tokens
An NFT is a unique online certificate of ownership that is linked to a digital object. Non-Fungible means non-replaceable. Such a digital object can be a bored monkey from the Bored Apes collection, but also a video clip, sound clip, or a highlight from a sports competition. There is usually only one of these different objects or moments. Sometimes artists release them in limited editions.
To explain the difference between crypto and NFTs, let’s take Ethereum as an example. All Ethers in circulation are identical. If I buy one I become the owner of an Ether. With a unique code, I have access to the blockchain and I can access that one Ether. Only if I then sell the Ether will someone else become the owner. But all Ethers are the same and not unique.
An NFT is unique and Non Fungible. Until recently, it was inconceivable that a digital object could be captured.
Bottom Line
DeFi is still very young but is now popular with crypto traders. There are still limitations in the technology and there are no regulations yet. But once these frameworks become clear, it also becomes clear how big the role of DeFi can become in our daily lives.
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Stefan Grasic (Dipl.-Jur) is the owner of Business24-7 and has considerable experience in the financial and investment niche, but also enjoys writing articles for the general readership. Stefan is an active stock, CFD, crypto and general investment researcher, advising blockchain companies such as Blockbird, GoCrypto, Hive Terminal at their start up level. Stefan began trading in 2010 as a college student. Money was tight,…