DeFi or Decentralized Finance is a term given to the financial services that have no central authority controlling them, unlike banks in which decisions are usually taken by a single person or a company.
Before taking a deep dive into DeFi, Let me give you a brief overview of the smart contracts.
Smart contracts are the logic that runs the decentralized applications. Using smart contracts we can program how a certain service would work and deploy it on the blockchain. Once the smart contract gets deployed on the blockchain it becomes immutable.
In short digital smart contracts enable you to exchange anything of value in a transparent way whilst avoiding the use of a middleman. For example, John wants to sell the house to bob. However, John doesn’t trust that bob will send the money and bob doesn’t trust that john will send the house deal after sending the money. Does this bring a big problem of who sends first? Of course, they can hire a trusted middleman but this could be expensive. Neither john nor bob would want to waste money on the needless middleman here.
This is a case where smart contracts come into play. The smart contracts can be programmed to exchange the assets only if, John and bob send house deal and money respectively to the smart contract. If these two conditions are met smart contract will execute the trade automatically.
This shows that smart contracts can be used to receive and redistribute digital assets. All the transactions made in the smart contract are recorded in the blockchain. Ethereum is the biggest smart contract platform out there. If you want to learn more about Ethereum click here.
Now let's get back into our main topic. DeFi or Decentralized finance takes components from traditional finance and decentralizes them by replacing them with Smart Contracts. An example of this would be decentralized loans and earning interest.
These are some of the important components of DeFi
1. Decentralized Infrastructure
To create a decentralized financial system, we will need an infrastructure Like Ethereum for running decentralized services. Ethereum is a platform for running decentralized programs also called Dapps.
By using Ethereum’s native programming language called solidity we can write automated smart contracts that can manage any financial service we would like to create in a decentralized manner.
2. Decentralized Currency
Now that we have learned about the infrastructure for creating decentralized apps, let's start learning the next component, Decentralized currency. The first thing that is very important when it comes to a financial system is money. We will need a stable currency like DAI to operate within the system. It is not advisable to use ether as the main currency in DeFi platforms because it is highly volatile.
DAI is a decentralized currency pegged to USD i.e. 1 DAI = 1 USD. Unlike other popular stable coins like USDT, DAI is backed by crypto collaterals that can be viewed in the Ethereum blockchain. DAI is overcollateralized meaning if you lock up $1 worth of ether you can borrow only $0.66 in DAI.
Once you repay $0.66 Worth of DAI your borrowed Ethereum will be released. Since DAI is overcollateralized even if Ethereum price becomes extremely volatile, the value of the locked ether backing the DAI in circulation will remain 100% or more. DAI is an ERC-20 token
(an Ethereum smart contract). This makes DAI truly trustless and decentralized stable coin which cannot be shut down, hence perfect form money for DeFi services.
3. Decentralized Financial Services
Now that we have a decentralized stable currency we can discuss some decentralized services. The first type of use case/service I will be discussing is Dex or decentralized exchange. Dex is built using a smart contract that allows users to buy/sell cryptocurrencies in a decentralized way i.e. no middleman(exchange operator) is involved. Any KYC/signup is not required to trade in a Dex. A good example of a decentralized exchange would be Uniswap.
Another important financial service would be decentralized money markets. It is a service that connects borrowers with lenders. For example Compound ( a DeFi project) is an Ethereum based lending Dapp. So, you can use a compound to lend your crypto and start earning interest. You can also use it for borrowing. For suppose you dint have any money to pay the bills, the only money you had was in crypto. In that case, you can deposit your crypto as collateral and borrow against it.
The process of earning interest on cryptocurrencies has become very popular these days. This process is also called “Yield Farming”. In yield farming, Crypto assets are kept into work to generate the most returns possible.
These are some of the important decentralized services that everyone in the DeFi space should be aware of.
DeFi vs CeFi
Decentralized financial systems do not rely on a central authority and hence everyone is treated equally. Everything that happens in DeFi is transparent and public. The services in Defi are interoperable and flexible too.
Coming to Centralized Finance or CeFi all the services rely on a single person or a central authority. So, that why CeFi services are prone to mismanagement i.e. a single person’s wrong decision can make everyone suffer. And We are very much aware of the frauds and corruption that take place in Centralized services i.e. Banks.
Keeping these things in mind, It looks like DeFi can really replace our financial services one day, or at least it can help in making our current financial system better.
Risks in DeFi
One of the major risks associated with the DeFi is that it is still not developed completely i.e. DeFi is in an infancy stage. This means that there is a high probability that things can go wrong. There have been many issues in the past where rules for the smart contracts were not defined perfectly for certain services which allowed hackers to find the loopholes and steal all the money associated with that contract.
So, Whenever you decide to try a new DeFi project make sure you are investing only the amount which you can afford to lose. Some services may not be completely decentralized and may involve some centralized aspects too. Always do your own research before investing in a certain DeFi project.
In my personal opinion, Decentralized Finance is not any bubble and is here to stay. As people receive more exposure to DeFi services, the world will start realizing its true potential. Currently, as of Nov 14th, 2020, According to the DEFI PULSE more than 13.8 billion dollars are locked up in DeFi based projects.
That is approximately an increase of over 1700% compared to where it was in January 2020. This huge amount of money doesn’t get locked up without any good reason. It would be really interesting to see whether if DeFi will be able to capture the 1.7 billion unbanked people in the world that are eagerly waiting to get access to financial services.