DeFi: A comprehensive guide to decentralized finance

DeFi: A comprehensive guide to decentralized finance

 

Following the debut of Bitcoin in 2009, focused on the asset, its concept, and its underlying technology, a robust industry sprung up. Different niches exist in the crypto and blockchain ecosystem, where projects and businesses build solutions for distinct use cases.

Decentralized finance (DeFi), which was formed as an alternative to traditional financial services, is one such specialty. DeFi, in specifically, is made up of smart contracts that power decentralized applications (DApps) and protocols. Many of the first DeFi applications were built on Ethereum, and Ethereum still holds the majority of the ecosystem’s total value locked (TVL).

Bitcoin (BTC) has properties that are considered as the foundations of decentralization at its core. DeFi, on the other hand, builds on such qualities by introducing new capabilities and features.

What is DeFi?

DeFi is a subgroup of the broader crypto sector that provides many of the conventional financial world’s services in a way that is managed by the people rather than a central body or entity. It also includes Islam DeFi within the Islam DeFi ecosystem.  

Although lending started it all, DeFi applications today include a wide range of functions, including saving, investing, trading, market-making, and more. The ultimate goal of decentralized finance is to challenge and eventually replace established financial service providers. DeFi frequently makes use of open-source code, allowing anyone to develop on top of pre-existing apps in a permissionless, modular manner.

What is Decentralization?

„Finance“ is simple to grasp, but what exactly is „decentralization?“ In a nutshell, decentralization means that no single authority has control over something. Banks and other financial institutions have some control over your money. These organizations can freeze your funds, and you are at the mercy of their operating hours and cash reserves.

Decentralization in DeFi entails not only a distribution of power but also a distribution of risk. In the traditional finance sector, Defi promotes a broader approach to general decentralization. The initiative’s core goal is to make traditional financial services more accessible by creating a blockchain-based ecosystem of unlicensed financial services.

Overall, Defi is a bold attempt to decentralize traditional financial applications such as blockchain trading, lending, investing, wealth management, payments, and insurance. Decentralized applications or protocols are the foundation of Defi (dApps). You ensure a financial network of peer accounts by executing these dApps on the blockchain. Each dApp can be combined in the same way that Lego building blocks can. In traditional systems, smart contracts are similar connectors with well-defined APIs.

The Rise of DeFi

Although the open-source funding project is not entirely blockchain-based, it does rely on more flexible blockchains (programmable smart contracts) and a big developer community. Blockchain solutions for Defi are being offered by an increasing number of crypto institutions. The five most common smart contract protocols include

  • Protocol – Volume 1-1-21
  • Binance Smart Chain – 141.53 million
  • Ethereum – 2,5 billion
  • Waves – 37.61 million
  • Eos – 8.4 million
  • Tron – 8.03 million

You can see, each of these blockchains have a cryptocurrency associated with it. Many investors as a result are interested in Ethereum (ETH), BinanceCoin (BNB), Waves (Waves), EOS (EOS), and Tron (TRX). As of 1-1-21, the total volume of Defi of these smart contracts was $ 2.04 billion. Smart contracts were also employed in exchanges ($854.49 million) and gambling ($10.6 million).

Now that we’ve covered the fundamentals of Defi, let’s learn more about the Defi ecosystem.

The DeFi Ecosystem and its Products

Since it is an ecosystem in which blockchains, digital assets, and open protocols are incorporated into traditional financial structures, many products featured in Defi are also known as open-source financing. Let’s take a closer look at a few of these products in relevance to Use Cases, advantages, and risks

Open Loan Protocols

As the name implies, it is a blockchain platform for digital money borrowing. Among other open financial industries, open lending protocols have become increasingly popular in recent years. Users deposit money in the same way they would in a bank, and when someone lends them digital assets, they get interested. Smart contracts, rather than middlemen, are used to set loan terms, connect creditors and borrowers, and distribute interest rates. Because of the blockchain’s inherent transparency and the lack of intermediaries, the lender makes more money and has a better understanding of the dangers.

The open lending protocol is built on a public blockchain like Ethereum (ETH), and it has the potential to be extensively embraced globally due to its capacity to lend digital assets. It has a number of benefits over typical credit services.

  • Digital asset integration with loans or borrowings
  • In the event of a loan default, a digital asset will be guaranteed.
  • Current transaction settlement and new loan security methods.
  • Automation can help cut expenses by promoting standardization and interoperability.
  • There will be no credit check, which implies that people who are unable to use traditional services would have better access.

Stable Coins

Stablecoins, unlike other cryptocurrencies with fluctuating prices, are tokens produced by a blockchain and are designed to have a fixed value. This is commonly connected to fiat currencies such as the US dollar, but it can also be related to other assets such as gold. The collateral in a stable currency is used to adjust to price changes.

The association, on the other hand, renders stable coins centralized, resulting in a so-called „single point of failure.“ Because these stable coins rely on trust in a centralized body, they are vulnerable to capital losses and destabilization as the result of external geopolitical forces. It’s especially problematic when there’s skepticism about the central bank’s ability to protect bills of exchange.

Making these currencies stable and verifiable solves the problem. Firms behind these stable currencies profit from the money that users put into their bank accounts. According to research, this pricing margin will reduce with time, benefiting the client more. Please visit our dedicated stable coin page if you want to learn more about stable coins (to come).

MakerDAO Transparency

MakerDAO has grown in popularity as a decentralized financing protocol. Due to scale issues, the firm has suggested periodic stability rate hikes in order to maintain parity with the Dai-USD price parity. The latter allows users to borrow and lend digital assets, but it does so via traditional credit models including credit checks and a firm that handles bank loan applications.

Leverage and margin

The margin and leverage components advance the decentralized financial market by letting users borrow cryptocurrencies on margin and utilize other cryptocurrencies as collateral. Smart contracts may also be built to contain leverage, which might possibly increase the user’s returns. The usage of these DeFi components also raises the user’s risk exposure, especially as the system is dependent on algorithms with no human component in the event of a malfunction.

DeFi Risks and Challenges

Although DeFi provides a number of advantages not attainable with traditional financial products and services, it is not without danger and flaws. Fortunately, the builders are working hard every day to minimize and eliminate as many of these flaws as possible.

Threats to Security

Smart contracts are often open-source, which means that anyone, including malicious entities, has access to their source code. They’ve gone a long way since the DAO breach, but there’s still a lot of room for improvement when it comes to security.

Several breaches of DeFi platforms have occurred in recent months, demonstrating that these systems are not totally safe against hacking. Because failure generally results in the loss of millions of dollars in user assets, security is and should be a top priority for financial systems.

MakerDAO’s protocol has been thoroughly scrutinized by various security research firms in order to provide users with peace of mind. However, because DeFi systems are still relatively new, it’s difficult to be certain that any of them will be totally safe form theft.

Systemic Threats

Liquidity and credit risks are the most common systemic hazards in decentralized financial networks. Lenders would be unable to exit if a large number of borrowers failed to repay their CDPs (Collateralized Debt Positions) in full.

Another issue, especially for crypto-collateralized DeFi systems, is the tremendous volatility of crypto markets.

If the underlying assets in CDPs fall hard and fast enough, mass liquidations could occur, resulting in a system collapse.

To mitigate this, DeFi systems now rely mostly on asset over-collateralization. Downward pressure on the asset could be mitigated by locking up more assets than the amount borrowed.

Conclusion

Decentralized financing, often known as Defi, aims to disrupt the current financial system by introducing new solutions to the public blockchain. Defi reorganizes old financial institutions based on centralization and allows users to communicate directly through decentralized, secure, and transparent protocols. The movement’s sheer nature relies on the code which executes to provide perfect security.

It’s unclear how things will turn out in the future in terms of adoption. Traditional finance may absorb components of DeFi while preserving elements of centralization, rather than DeFi entirely displacing mainstream financial options, as one possible conclusion. However, completely decentralized alternatives may continue to exist outside of mainstream finance.

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