What Is DeFi? In layman’s terms, DeFi is like software for financial purposes, but it interacts directly with the blockchain. The concept covers protocols, financial-based smart contracts, and digitized assets. Think about normal software that you use daily to manage your finance, but you release the software on top of a blockchain platform. DeFi is short for Decentralized Finance.
Nowadays, people use different types of software to help manage their money and assets. However, most of the programs that people use are still very centralized. We use software from banks to manage our lending, our money, and our investments. We also use software from hedge fund companies to manage our forex trading, and so on. The problem is that we need to trust the centralized entities behind these applications. DeFi is trying to change that. The goal of DeFi is to provide a trustless system.
The Purpose of DeFi
Traditionally, we put our trust in centralized entities to manage our money and handle our investments. We trust our governments, our banks, and our financial advisors. However, the truth is that many of these entities breached our trust over and over again. We have almost no ‘power’ to decide what’s best for ourselves. There’s not much transparency in how they operate.
The purpose of DeFi is to ‘decentralize trust’ in the financial industry. DeFi can be seen as a financial system that’s transparent to everybody who participates in it. The great thing about blockchain is that everybody gets to know what’s happening on the network. This is why DeFi combines blockchain and financial applications. With a public blockchain network, anybody can easily verify a transaction whenever they want. No need to ‘trust’ a single centralized entity with our money or investments. It promotes a ‘trustless’ and transparent system.
The banking features provided by DeFi uses cryptocurrencies, which lower the barrier to entry for people unable to use the traditional banking system. People might not have access to traditional systems due to nationality, debt history, a lack of wealth, etc. DeFi can help “bank the unbanked”.
DeFi Application For Lending
One of the best use cases of DeFi is lending. Many of these lending platforms don’t even require background checks for their clients. In order to understand the concept better, let’s use an example.
One of the most popular DeFi applications for lending is called Maker. You can get your loan directly on the Ethereum blockchain with MakerDAO. They do this by enabling both ‘borrow’ and ‘lend’ concepts directly on the blockchain. What you need to do is lock collateral (in the form of ETH) and enter the amount of DAI tokens that you wish to generate.
For example, someone named Bob wishes to take a loan from Maker for 100 DAIs (1 DAI is supposedly equal to $1 USD). In order to do this, Bob must send at least $150 worth of Ether (ETH) to the collateralized debt position (CDP). Let’s say Bob send $180 worth of ETH just to be safe. The system will automatically lock-up Bob’s ETHs and issue 100 DAIs to his wallet account. And just like that, Bob will get his loan from a DeFi application.
If the valuation of Bob’s contract goes below 1.5 ratios (ETH to DAI ratio), MakerDAO will instantly liquidate Bob’s ETH collaterals with a 13% liquidation penalty. MakerDAO uses this system (over-collateralization) to keep everything stable.
You can easily go through this process with the MakerDAO platform. You do not need to fill out forms or have a background check. This makes the process much faster than using traditional methods. Compared to the loan system in the traditional finance world, getting a loan directly on the blockchain is also simpler and far more transparent.
DeFi Application For Crypto Exchange
Another popular example of a DeFi use case is decentralized exchange (DEX). Unlike traditional exchanges, where everything is always stored in centralized servers, a transaction in a decentralized exchange is performed directly on the blockchain.
Centralized exchanges have a single point of failure. Hackers always try to find a loophole and exploit hot wallet addresses that are associated with these exchanges. However, with a decentralized exchange, these loopholes don’t exist anymore. The smart contract itself would have to be exploited.
Take a look at ForkDelta or DDEX if you want a good example of a decentralized exchange. They do transactions directly on Ethereum blockchain, and you can check each of the trades with Ethereum blockchain explorers (i.e. with Etherscan or ETHplorer). In decentralized exchanges, you control your own accounts and, most importantly, your private keys.
DeFi Application For Staking
In the traditional financial system, banks and other financial institutions provide a staking system for their customers. In DeFi, service providers like Staking-as-a-service and staking pools are the ones who run the staking for their customers. Usually, they run nodes for protocols that utilize proof-of-stake (PoS) in favor of their investors.
One of the DeFi staking services is called Certus.one. Certus sees itself as a premier validator for proof-of-stake blockchains. It supports PoS networks like Cosmos, loom, Terra, or IRISnet. If you use Certus.one, you don’t have to worry about the stability and the sustainability of the PoS blockchains that they participate in.
What’s To Come
There are a lot of other use cases of DeFi applications. The ‘limit’ is theoretically unlimited. The tokenization of assets is another example of DeFi’s potential.
Nowadays, there are many stablecoins that are ‘pegged’ to real-life fiat currencies. DAI is one of the most popular stablecoins, and it can be categorized as a DeFi application. Through some algorithms on the MakerDAO lending platform, DAI maintains its valuation 1-to-1 to USD.
Not only for fiat currencies, but tokenization of assets can also include every other asset in the world. Physical gold, diamonds, silver, or company shares can be tokenized and listed directly on the blockchain. In the future we will have more and more assets that get ‘tokenized’ on the blockchain through DeFi applications.
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